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ommercial real estate taxes are nothing to sneeze at. In a medium-sized city like Pittsburgh, taxes on a commercial office building in the central business district can easily run between US$2.50 and $3 per square foot, or about $4 million a year on a 1.5-million-sq.-ft. (139,300-sq.-m.) building in the heart of the city. Taxes on a less high-profile location, such as a 340,000-sq.-ft. (31,600-sq.-ft.) building on the outskirts of town, can run up to $1 million. Even for buildings that are less than 20,000 sq. ft. (1,850 sq. m.), taxes run in the tens of thousands of dollars. One can expect to pay considerably more in some counties, municipalities and school districts, and considerably less in others.
The tax implications of leasing versus buying space and how those implications will affect your real estate investment should be a significant element in site location discussions. My firm’s mission is to create and manage commercial real estate that both satisfies the user and maximizes return on investment. Understanding existing tax advantages and how to use them for the greatest return is an important pat of our mission. We have assembled an assessment process that helps companies determine whether they should lease, build, buy or renovate properties. Each project undergoes a rigorous financial analysis to make those determinations. The financial analysis consists of five elements: analysis, investment goals, tax advantages, tax breaks and option comparison.
Start With a Strong Analysis
All tax issues should be addressed in the proforma, or financial analysis, of the sales agreement. Proformas typically include real estate taxes and:
- Development and acquisition costs sheets that itemize the components of the capital required to construct and/or acquire the property.
- A rent roll that lists the leases and/or tenants in the facility by square footage, base rent, additional costs, lease term, options and any special terms included in the lease.
- An operating proforma that looks at one-, five-, 10- and 15-year periods of the net operating income — including projected incomes to rents specific to the lease or per projected market conditions. Projected incomes to expenses are also included in the proforma.
Thorough examination of the proforma is one aspect of the analysis that accompanies decisionmaking. Due diligence is another. Before investors acquire a property, there is a period of time that can last up to one year to complete due diligence. This is the time to examine the real estate taxes in light of the value of the building. Are they fair or unfair? Three approaches can be used to make this determination.
First, analysts can examine the market value or sales of similar properties and compare taxes. Second, analysts can determine the cost of building the property in today’s dollars and determine whether the taxes are advantageous or not. And third, analysts can examine the building’s income. That is, they can apply a capitalization rate — approximately 10 percent — to the stabilized net operating income (NOI) and review the results. Capitalization rates vary depending upon the type of leases (tenant credit, term remaining on leases and other factors), the location of the property, the surrounding market and the age of the property, but they typically fall between 8 percent and 12 percent. So, if NOI is $1 million and the capitalization rate is 10 percent, the value of the building is $10 million. This is the industry standard to determine a building’s value.
Corporate Investment Goals
Real estate investment goals will differ based on the investor and the overall asset strategy. The definition of a “realistic” return will also differ among investors but is mainly determined by one’s analysis of the market, including demand, financing conditions and the overall economy. However, most investors who are comparing both leasing and buying space share two goals: equity build-up and cash flow. Equity is established when the value of the property minus the debt and the invested capital leave a positive net value or equity. Generally, this occurs upon stabilization, when the property reaches an occupancy level of 90 percent to 95 percent. For example, if the property value is $10 million, its debt is $6.5 million and its capital is $3 million, the equity of the project is $500,000.
In terms of cash return, is there positive cash flow after paying expenses, debt and reserves to provide a cash return in addition to equity? A healthy cash flow ranges from 10 percent to 15 percent on capital in the project.
Once these criteria are considered, investors can determine whether or not it makes sense to carry the level of real estate debt that commercial property ownership requires. Generally, if it is better for a company to have fewer debts on its balance sheet, then it might consider leasing instead of buying. In larger corporations, owning property is translated into something to be depreciated on the balance sheet. In addition, real estate development companies can help their clients find a middle ground.
For example, Gustine constructed a building for a company that will be the sole occupant and responsible for its operation. However, the company did not want to own the building, and so entered into a 10-year lease with Gustine, which retains ownership. The firm did not want the depreciation, which translates into a taxable loss or less taxable income.
Depreciation and Complementary Tax Advantages
Depreciation is a tax advantage for a company that would like to offset income from other business segments by non-cash losses. However, it is also possible for tax losses to be avoided by a public company that cannot afford to publish diminished earnings-per-share. In that case, the company may seek an alternative occupancy cost, such as leasing, or partner with an entity that seeks tax losses. The partner would then bear all of the building’s profit and losses.
Building costs depreciate over 39-years, while the market value of the building has the potential to increase. Yet, there are other ways for companies that do not want to wait 39 years for full depreciation to get tax advantages during this time period. Other components of the building can be depreciated over five, seven or 15 years. Among these elements are the building’s HVAC system, parking lot, roof, landscaping, signage and subterranean improvements.
In addition, property owners can deduct the interest on the loan, property taxes, and other building operation expenses. These expenses include contract services like security, cleaning and janitorial services, as well as repairs, maintenance, insurance and utilities costs. Rental revenues offset these costs.
Investors should prepare themselves for increased taxes if they purchase an underassessed building. Gustine may purchase a major commercial office building in downtown Pittsburgh, knowing that at some point, the purchase should trigger a reassessment.
During due diligence, investors also can examine other financing and title issues, utility availability and costs, the leasing market, property zoning, offsite improvements, and road construction and signalization issues.
Economic Development Tax Breaks
Potential property owners also may want to learn about economic development incentives in their areas. For example, in Pennsylvania, Keystone Opportunity Zones (KOZ) have been established in areas where development is being encouraged. KOZs are parcel-specific areas up to 5,000-acres (2,000 ha.) with greatly reduced or no state and local taxes for property owners, residents and business owners. This special tax status will be in place on each parcel through 2010 and may be extended through 2013. KOZs are, in fact, a partnership between each community and region, among state and local taxing bodies, school districts, economic development agencies and community-based organizations.
Another program is the Local Economic Revitalization Tax Assistance Act, or LERTA. Municipalities give LERTA designation to parcels that are blighted and in need of improvements. All or part of the value of the improvements is exempt from county, municipal and school real estate taxes for up to 10 years. Sometimes only the land value is assessed and buildings are phased in over 10 years.
Leasing Instead of Buying
Alternatively, if your company does not need an entire building and is not interested in entering the real estate business, leasing may be a better option. In a lease situation, rent is tax deductible. There is no down payment for the property. In addition, operating cost escalation and base rent increases can be deducted annually. Overall, it is much less expensive than new construction. For example, a company leasing 5,000 sq. ft. (460 sq. m.) at $20 a sq. ft. is paying $100,000 per year, which will probably increase three percent per year at lease renewal. Building the same space could cost $120 a sq. ft. or $600,000.
Essentially, outgrowing leased space can be easier for a company to deal with than outgrowing a building. If a company is uncertain about its needs for space, it should determine whether or not contiguous space is available or what other expansion options are available. In addition, it should ask for Right of First Refusal on the space.
Judge a Building by Its Tenants
Finally, whether leasing or buying space, the vagaries of property ownership demand that clients know the reputation of a building’s management company. A good real estate management company will satisfy the user and maximize their return on investment. The company will operate a building cost-effectively for the owners while maintaining a proper level of service to the tenants. Good service is the key to charging a higher lease rate and to keeping occupants satisfied while reaching your real estate investment goals.
