NJ Real Estate Tax Appeals: Valuation of Apartment Complexes To Obtain Proper Assessment for Real Estate Taxes

March 2011Newsletters In the Zone

As an owner of an income producing property, such as an apartment complex, your tax assessment of the property is critical in maintaining a profitable business. Once an owner receives its year assessment notice (within the first two weeks of February) for real estate, the owner has a statutory time period, usually until the first Monday in April, to file an appeal of the assessment. The appeal may be heard before either the Tax Court or the County Board of Taxation, depending on the value of the assessment. The taxpayer will then have the opportunity to present expert testimony as to the assessment of the property. If the appeal is filed with the County Board and the parties are not satisfied with the county’s decision, either may file a complaint with the Taxation Division of the Superior Court. The critical component of the process towards a proper assessment is the method of valuation of the real estate.

There are three approaches to valuing real estate to obtain a proper assessment: (1) cost approach; (2) market approach; and (3) income approach. The cost approach is measured by how much it would cost to replace the property should it need to be rebuilt at the time of assessment. The market approach compares a property to other similar properties in the area. In the income approach, you determine the income of the property in order to compute the proper assessment. This article will focus upon the income approach, as it is the most practical way to value an apartment complex.

The objective in assessing real estate is to ascertain the fair-market value of the property, which will then be converted into a proper assessment. The property assessment made by a local authority is presumed correct.1 The taxpayer has the burden of proof to overcome the presumption by showing sufficient competent evidence to show the true valuation of the property.2

A prospective purchaser would expect a fair return upon his or her investment in an apartment complex and would therefore review the income history to determine the potential income.3 The income approach is initially based on an analysis of rental income.4 First, the gross income is estimated, with a reduction for vacancy and loss allowance to compute an effective gross income. After expenses are deducted, this net operating income is then capitalized at a rate to arrive at a true value.5

A critical part of the income analysis is determining the economic rent, which is known as the “market rent” or the “fair rental value.”6

A landmark case that discusses the proper way to calculate “economic rent” is Parkview Village Assoc. v. Collingswood, 62 N.J. 21, 297 A.2d 842 (1972), where the
court stated:

It is of course settled that gross rental income for purposes of applying the capitalized income approach to valuation of property is to be taken at “fair rental value,” professionally termed “economic” rent or income, if that differs from current actual rental. However, actual income is a significant probative factor in the inquiry as to economic income. Checking actual income to determine whether it reflects economic income is a process of sound appraisal judgment applied to rentals currently being charged for comparable facilities in the competitive area. The essential, however, is a plurality of comparables.7

Therefore, in a community without rent controls, one must compare rents payable at similar properties in the area for the relevant period.8 Where there are rent controls, according to ordinance or where the complex is partly subsidized by the government, those factors need to be taken into account. For example, if an ordinance permitted a complex owner to charge a maximum amount of rent and the maximum was higher than the actual rent, that maximum rent would be the “economic rent” rather than the actual rent.9

The general rule is that absent convincing evidence to the contrary, the actual rent of a well-managed apartment complex functioning with customary leases of relatively short length (i.e., one year), is prima facie representative of the economic rent for purposes of the capitalized income valuation.10

A municipality can overcome the presumption that a well-managed complex is equivalent to economic rent by proving convincing evidence that the leases are not economic because (1) the property is not well-managed; (2) they are old, long-term leases, or (3) a comparison with at least four similar apartment properties reveals they are not economic.11

Where a municipality attempts to overcome that presumption, a court will need to determine the status of the complex on a case-by-case basis. For example, where the municipality challenges a complex’s decreased gross revenue due to mismanagement, a complex owner may defend its revenue position by showing how the complex has design problems that would affect its utilities provided to the tenants, functional obsolescence and increased competition in the area.12 The municipality, in turn, could argue, for example, that the complex could provide a more efficient means of providing a heating system, which would in turn increase its revenue.

The vacancy rate of an apartment complex is a factor to be deducted from gross revenue. The vacancy rate is not determined as of the date of the assessment, but must be determined according to the long-term quality and durability of the property’s income stream.13

The expenses of the complex also must be deducted from the gross revenue. The actual expenses should be considered where there is no dispute as to those expenses and as long as they are not an excessive percentage of effective gross income.14 Stabilized expenses, or a computation of an averaging of the expenses, are also an accepted practice.15 Note that under the income approach of valuation, the inclusion of real estate taxes as an operating expense is not permitted, as the amount of those taxes are eventually determined as a result of the determination of value, and then, the appropriate assessment.16

The cost of management of an apartment complex is a proper expense for an income-producing property, regardless of whether an actual management fee is paid.17 The management fee involves time for accounting, rent collection, advertising and supervision of the operation of the property.18 The management fee, however, cannot be duplicative of a wage expense to an employee performing management functions.19

Reserve expenses are the expenses for the replacement of items in the apartments. Generally, the courts presume two percent of the gross income is proper for reserve expenses.20 However, depending upon the circumstances of each case, a court may permit an increased reserve of three percent. For example, the court in Maple Court Associates Limited v. Township of Ridgefield Park, 7 N.J. Tax 135 (1984), found a three-percent reserve for replacements was adequately demonstrated by the taxpayer’s witness and is a legitimate consideration. The sum of the overall expenses formed approximately 30 percent of the effective gross income, which the court found was appropriate.

In Borough of Little Ferry v. Vechhiotti, 7 N.J. Tax 389, the court stated:

Concerning a reserve for replacement of the short-lived items such as refrigerators, dishwashers, oven-ranges, air-conditioners and carpeting, all of which were supplied by the tenants by taxpayer, taxpayer’s expert based the amount for replacement on his estimate of cost and useful life. Although this estimate of remaining life was conservative when compared to that testified to by the taxpayer, whose experience in owning and operating apartments was substantial, his cost estimates were without foundations and were thus unreliable. Conversely, given the superior nature of this complex and the above average appliances and amenities furnished to the tenants, I find that borough’s two percent allowance for replacement is insufficient. I find an annual reserve of three percent of the effective income is fair and reasonable.21

The “capitalization rate” factor for obtaining market value of a taxpayer’s real property by means of the income capitalization approach combines cost of borrowed funds, which is a mortgage constant consisting of interest and amortization, and the rate of return a prospective investor expects to earn on his or her invested funds.22 The combination of these two rates, in the proportion of invested capital to borrowed funds, produces the capitalization rate, and multiplied by the net operating income, produces the proper assessment.23

This exercise should produce a proper assessment. Certainly, experts for the municipality and the taxpayer will produce different results, and ultimately, the parties could attempt to resolve the matter or have the court be the final arbiter to determine the proper assessment.

For more information, please contact Jeffrey M. Herskowitz at 609.572.2327 or [email protected].

1 Rodwood Gardens, Inc. v. City of Summit, 188 N.J. 34, 455 A.2d 1136 (1982).
2 Id.
3 See Middlesex Builders, Inc. v. Township of Old Bridge, 1 N.J. Tax 305, 314 (1980).
4 Parkway Village Apartments Co v. Township of Cranford, 108 N.J. 266 (1987); see also Helmsley v. Borough of Fort Lee, 78 N.J. 200, 214-15, (1978) (income method preferable for income-producing property).
5 See Appraisal Institute, The Appraisal of Real Estate, 429-450 (10 ed. 1992).
6 Parkway at 270.
7 69 N.J. at 29-30, 297 A.2d 842 (citations omitted).
8 Rodwood Gardens, Inc. at 34.
9 See Borough of Little Ferry v. Vecchiotti, 7 N.J. Tax 389 (1985).
10 Parkway Village Apartments Co. v. Township of Cranford, 108 N.J. 266, 528 A.2d 922 (N.J. 1987).
11 Parkview, 108 N.J. at 272, 528 A.2d 922 (citations omitted).
12 See e.g., The Equitable Life Assurance Society of the United States v. Town of Secaucus, 16 N.J. Tax 463 (N.J. Super. 1996) (discussing in hotel setting, how hotel’s difficulties of revenue were not caused by mismanagement but by design problems, functional obsolescence and increased competition).
13 Berenson v. City of East Orange, 6 N.J. Tax 12 (1983); aff’d, 6 N.J. Tax 493 (N.J. Super. A.D. 1984).
14 See Maple Court Associates Limited v. Township of Ridgefield Park, 7 N.J. Tax 135, 153 (1984).
15 Id.
16 Spiegel v. Town of Harrison, 18 N.J. Tax 416, 427 (1999), aff’d 19 N.J. Tax 291 (N.J. Super. A.D. 2001).
17 Borough of Little Ferry v. Vecchiotti, at 414.
18 Id.
19 Id.
20 See Inganamort Bros. v. Borough of Fort Lee, 7 N.J. Tax 564 (1973).
21 Id. at 415; see also Vornado, Inc. v. Borough of Totowa, 8 N.J. Tax 214 (1986) (finding three percent reduction for reserves was appropriate); Brunetti v. City of Clifton, 7 N.J. Tax 161 (1984) (finding two percent reduction of reserves was appropriate); but see Inganamort Bros v. Borough of Fort Lee, 7 N.J. Tax 564 (1973) (holding taxpayer’s expert’s opinion of three percent reduction for reserves was not supported by factual evidence, and therefore standard two percent reduction of expenses was appropriate).
22 Spiegel at 426.
23 Id.