DALLAS—As owners and investors go through the due diligence period before closing a deal in 2014, they must consider the underwriting process. Obstacles such as decreased cash flow or increased operating expenses may impact their predictions for property tax assessments. This is due in part to a lack of knowledge and general understanding about property taxes and the underwriting process. During the due diligence period, investors are tasked with vetting out all the revenue and expenses on a given property. At the end of the day, investors are rewarded upon the accuracy of their models. Some line items are more straightforward to predict. For example, rents and occupancies are most often judged by the current rates and the anticipated oncoming supply in the market. Although investors may interpret them differently, the data exist to assist in the analysis.

However, property taxes present a unique set of problems for investors to model. The quick and dirty methodology for most is to apply a percentage of the purchase price for the first year of acquisition, and then subsequently apply a standard 2% to 3% increase on an annual basis thereafter. As you can imagine, this blanket methodology neglects to address many of the nuances of each property and jurisdiction. And, this is not a good strategy due to the simple fact that property taxes are often the largest line item in operating expenses.

There are three main issues to consider when predicting property tax assessments when determining whether to move forward with a deal: valuation methodology and timing; establishment of the millage rates; and, cash versus accrual. There are some rules of thumb which will be described below, but it is critical to recognize that each state and even jurisdiction is unique.

The most often used definition for taxable value is “market value.” Generally speaking, this is defined as the price a property would trade for in an open-market transaction. Like investors, appraisal districts utilize the three main methodologies: income capitalization, sales comparables and replacement cost. Despite the fact that investors usually have better access to information and are more astute in valuation of their properties, they do not know how districts generate their valuations. For example, we have a client with a multi-family property that has been operating at a 4% to 5% vacancy rate for the past three years. If they were to take the property to market, purchasers would probably stabilize the vacancy close to that rate. In this particular case, the appraisal district allowed us to use an 8% vacancy rate since that was the “market” level. This allowed for a reduction in value and lower tax basis. The devil is in the details.

Another major issue is timing and frequency of the assessments. There are three major buckets of assessment frequencies. The first bucket requires appraisal districts to re-assess (not necessarily re-value) each account at least every two to three years; however, districts have the option of re-assessing every year if they so choose. In Texas, the tax code states that each account must be re-assessed at least once every three years. But the appraisal districts can (and will) re-assess accounts if they feel values have increased from the prior year. The chances of getting re-assessed each year increase the higher the value of the property. Secondly, jurisdictions assess values on a given cycle. For example, in Colorado, the appraisal district only re-assesses properties every second year (on odd years). So, if a property gains a large tenant in an even year and benefits from it from an NOI standpoint, the owner will benefit from having one year of property taxes based on the previous lower NOI. The third bucket is where re-assessments only occur due to a trigger. The best known example of this is in California based on Proposition 13. Simply put, the property taxes in California can only increase by 2% annually unless there is either new construction or a change of ownership.

Although states tend to follow the general guidelines of the three buckets, they all have their nuances and different elements of the other buckets. For example in Texas, residential properties are only allowed to increase in assessed values 10% annually unless there is an ownership change or new construction. This is akin to the parameters of Proposition 13 in California.

Each jurisdiction operates differently and has different taxing laws which generally leads to a lack of understanding of expectations during the underwriting process. When looking at purchasing a deal, investors are always seeking strategies to enhance yields and thus value. While it is impossible to predict property tax amounts with 100% accuracy, the goal is to increase the investors' and owners' level of confidence during the due diligence process while limiting limit the margin of error to prevent surprises.

Amish Gupta is COO of Real Estate Tax Consultants. The views expressed in this column are the author's own.