Rapidly Increasing Tax Assessments Hit Real Estate
As property values throughout Colorado continue to soar, property taxes now are higher than ever. Commercial property in Denver is taxed at a 29% assessment rate, multiplied by the mill levy. Because of the 1982 Gallagher Amendment, commercial property taxes are fixed at this rate and must account for at least 55% of state property tax revenue. This means that residential property tax revenue represents a shrinking percentage of assessed value. Consequently, the tax burden falls on commercial property owners disproportionately. In some cases, tenants now face substantially higher tax burdens that jeopardize their ability to run their businesses.
From an investment perspective, spiking commercial property taxes are a major challenge for tenants, particularly when the increase is passed on in the form of a triple-net lease. Tenants in such scenarios are paying taxes that have more than doubled since the Great Recession. Furthermore, it is not uncommon for retailers and restaurants in NNN leases to pay substantially more in operating expenses than what was anticipated when they signed the lease. Not only does this increased tax burden affect business owners, in some cases it may affect returns, if not properly accounted for. While the market in Colorado is expected to cool down eventually, the question becomes whether property value will be assessed accordingly? If property values were to decrease, would tax burdens follow?
Another important factor with increasing taxes in Colorado is the role of metropolitan districts, special districts and the additional taxes they collect from tenants and consumers. Metro districts and special districts are special taxing districts that supply one or more types of services and infrastructure, such as fire, parks and recreation, drainage, etc. Metro districts differ from special districts in that they supply two services rather than one. According to the Independence Institute, there are 1,633 metro districts in Colorado accounting for a combined debt of over $19 billion. Some metro districts, such as the Sand Hills Metro District in Weld County, have over $100 million in debt. One of the main issues with metropolitan districts in Colorado is the uncertainty of the additional tax burden that will be passed onto taxpayers. Taxes in central Denver, particularly the Central Platte Valley, are approaching unprecedented levels of $15 to $20 per square foot. This level of taxes substantially impacts the bottom line of businesses.
Part of the reason for the escalating taxes within metro districts is how their boards of directors are constructed. It is common practice for metro district boards to be mostly or entirely comprised of individuals associated with the same development company the district was created for. These individuals are responsible for decisions regarding the issuance of large sums of debt, also known as debt authorization. Recently, the Sand Hills Metro District is the subject of a corruption lawsuit. According to a Denver Post investigation in 2019, metro districts hold governmental power without the typical voter oversight or restrictions on conflicts of interest. In Colorado, the Taxpayer’s Bill of Rights requires a public vote to increase taxes or debt. Metro districts, on the other hand, can levy extra taxes on the main district while still operating within TABOR regulations, effectively eliminating a direct vote by the public. Voters passed TABOR in 1992, and since then, the number of metro districts in the state has skyrocketed. Some say that metro districts have undermined TABOR’s intent.
In the office sector, tenants, particularly those occupying newly constructed buildings, are seeing rising taxes associated with increased building and operating costs, which also results in increased rents. When net rents increase, the value of the property increases. With competition in Denver at an all-time high, investors increasingly are willing to purchase property at lower cap rates just in order to enter the market. This scenario can result in higher purchase prices than what the perceived market value may be, which increases tax rates even further. In short, taxes are increasing for a number of reasons, and buyers and business owners would be wise to pay attention.
So what do increasing taxes and metro districts mean for commercial real estate investors? It may seem like this would lead to decreased market activity, but that doesn’t seem to be the case.
“There is so much money sitting on the sidelines trying to chase deals because investors don’t want to put money into a 10-year Treasury because of a low-interest yield,” said Chad Brue, CEO of Brue Baukol Capital Partners. “They can’t put it in a bond portfolio because of fluctuation and low returns, so for pension funds and institutional money and all sorts of capital to get any kind of yield whatsoever, they need to move up the risk spectrum, to real estate.”
In terms of underwriting, specifically the cap rates supplied to buyers in offering memorandums, Laura Hornbach, managing partner at Saybrook Real Estate Advisors LLC said, “Cap rates have not really been as responsive as they ought to be to either interest rate pressures or large capital events. As interest rates have gone down constantly and interminably over the last 20 years, cap rates have not been responsive to any sort of upward pressure at all. The markets have been pretty much priced for perfection, and buyers are taking on increased risk.”
Although metro districts have increased the level of debt throughout the state, they have also propelled sizeable value increases in property and infrastructure. Despite rapidly increasing tax burdens and inflating levels of debt stemming from metro districts, the commercial real estate market in Colorado remains as strong as ever. It appears the only thing that can slow it down is the next softening of the market.
Featured in CREJ’s March 2020 Office Properties Quarterly