The Desolation of… Your Real Estate Tax Base Year
Recently, scientists digging in Indonesia discovered remains of what may be an unknown species related to humans that stood three feet tall called Homo florensiensis and which the scientists have taken to calling “Hobbits“.
There was no verification as to whether this new species had large hairy feet, pointy ears or liked to smoke pipe weed.
Other than Frodo Baggins, the most famous Hobbit was Frodo’s uncle, Bilbo Baggins.
In the J.R.R. Tolkien books, Bilbo helps the Dwarf King Thorin Oakenshield reclaim the Dwarf’s ancient home and treasure from the dragon Smaug.
The problem is that Smaug loves his ill-gotten treasure, so Bilbo’s task is none too easy.
As it is often said in Middle Earth, the only thing more dangerous to your treasure than a dragon is an inequitable base tax year in your lease.
As part of the lease escalation provisions, a tenant will generally be obligated to pay its annual proportionate share of real estate taxes on the building.
In some transactions, this tenant’s share is based on the entire real estate taxes for the building, but more often this share is based on the excess of the building’s real estate taxes over the real estate taxes for an agreed upon initial or “base” year.
This allows the landlord to preserve the rent that it receives over the term of the lease as taxes (as they inevitably do) increase each year.
While this is often an equitable arrangement, if the base year is artificially low it is unfair to the tenant, and if the base year is artificially high it is unfair to the landlord.
Tenants must be particularly careful that their base year properly reflects a fully stabilized and assessed building when entering into a lease for a newly constructed building or a building undergoing (or which recently underwent) substantial revisions.
This is because renovated or newly constructed buildings will undoubtedly be re-assessed by the applicable taxing authorities to reflect the value of such renovations and new construction.
If such increased value is not reflected in the tenant’s base year, the tenant will have exposure for enormous increases in real estate tax escalations as such increased value is reflected in later years.
We have heard of increases in excess of $10 per rentable square foot; an astounding figure over the life of a 10 or 15 year lease.
So be sure to stand tall when faced with a fire-breathing real estate tax base year and consider the following approaches to allow for normalization:
- Secure an appropriate method of protection. There are various methods of protection and we address five common approaches below. The method you will be able to employ will depend on your leverage, exposure and comfort with risk. No approach is truly foolproof, and each provides tradeoffs in certainty, accuracy and simplicity.
- Address in your term sheet. As with any important economic concern, raise this issue at the term sheet stage when your leverage is greatest. Even if only raised as a placeholder, this will flag a later discussion.The first method requires calculation of an estimate of the likely base year amount. The second, third and fourth methods involve (in ascending order of tenant protection) variations of selecting a later base year. The fifth method ties increases in the assessed valuation of your building to comparable buildings.
- Calculate a base year amount. In this difficult and perhaps impractical method, you attempt to calculate the likely assessed value of the building once the project is completed and fully leased with the help of tax certiorari attorneys, appraisers and consultants. This method includes a good deal of (educated) guess work and uncertainty, not to mention quite a bit of complexity, so it is seldom applied.
- Randomly select a later base year. This is the simplest method, but it also involves a great deal of uncertainty. Your building will not be fully assessed until the renovations and construction are complete, the building is fully leased and such increased value has been reflected on the appropriate municipal tax records. This approach may be most appropriate with smaller leases and smaller renovation or construction projects and there is usually no interim payment since the base year is generally not pushed back too far.
- Select an even later base year with an interim payment. This is a corollary of the method immediately above, in which a later base year is selected (usually quite a bit later) and in the interim you pay an agreed upon amount per rsf based on historical or estimated real estate tax escalations. Once the base year is reached, you pay an amount equal to the excess over the base year plus the aggregate payment for the year immediately preceding the base year. The accuracy of this method depends on your ability to properly set the interim payment which will again be something of an (educated) guess, but if the base year is pushed out long enough you should be able to avoid worst case scenarios.
- Set base year when fully assessed. In this method, you would again provide for an interim payment of an agreed upon amount, but the base year would not be set until the first fiscal tax year that reflects the actual assessed value of the building, i.e., a fully (95% or 100%) leased building for which all the free rent for all the initial leases has expired. Again, much will depend on your ability to properly set the interim payment, but once the base year is set, it should reflect a fairly accurate amount. In this scenario, since the base year will be the actual fully normalized year, it is possible to provide for a reconciliation between the estimated interim payments and the actual increases paid by your landlord (although you must be careful to exclude interim re-assessments based on the improvements).
- Tie increases to comparable buildings. This method is focused on the amount of taxes paid, rather than on the base year itself. Under this approach, if the increase in the assessed valuation of your building in future years exceeds the average increase in the assessed valuation of four or five “comparable” buildings by an agreed number of basis points (e.g., 100, 150, 200, etc.) over an agreed upon period of time (e.g., four or five years), then the base year taxes will be increased to the amount necessary so that the average annual increase in the assessed valuation of your building for such period of time equals the average annual increase in the assessed valuation of the comparable buildings for such period of time (plus the agreed upon additional basis points), and your payments will be appropriately adjusted. This provides a great deal of protection against your base year amount being an outlier.
- Verify, verify, verify. Sophisticated lease provisions only help if you use them. You need to follow up and verify your real estate tax escalation for any of these methods to work properly.
Ronald Reagan famously said about the Soviets, “trust, but verify”. In this instance, you can ignore the trust part, but remember to channel your inner Smaug when protecting your treasure from an inequitable real estate tax base year by following the approaches above and verifying the results.
OTHER METHODS. Have you used other approaches to normalize real estate tax base years? Have you stolen treasure from fire breathing dragons? In either event, we would love to hear from you. Let us know at firstname.lastname@example.org.