Valuation of Apartment Complexes

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 the tax bill with the assessment for real estate, the owner has a statutory time period, the first Monday in April , to file an appeal of the assessment.

The appeal will be heard before either the Tax Court or the County Board of Taxation. The taxpayer will then have the opportunity to present expert testimony as to the assessment of the property. If filed with the County Board, should the parties not be satisfied with the County’s decision, either may file a Complaint with the Taxation Division of the Superior Court. The critical component of the above process towards a proper assessment is the method of valuation of the real estate.

There are three approaches to valuing real estate in order 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 re-built at the time of assessment.

The market approach compares your property to other similar properties in your area. The third approach is the income approach, wherein 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. The taxpayer has the burden of proof to overcome the presumption, by showing sufficient competent evidence to show the true valuation of the property.

A prospective purchaser would expect a fair return upon his investment in an apartment complex, and would therefore review the income history to determine the potential income. The income approach is initially based on an analysis of rental income. Under the income approach, the gross income is first estimated, with a reduction for vacancy and loss allowance, to compute to an effective gross income.

After expenses are deducted, this net operating income is then capitalized at a rate to arrive at a true value.

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

A landmark case which discusses the proper way to calculate economic rent is Parkview Village Assoc. v. Collingswood, 62 N.J. 21, 297 A.2d 842 (1972). In that case, 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.

Therefore, in a community without rent controls, one must compare rents payable at comparable properties in the competitive area for the relevant period. Where there are rent controls, according to ordinance, or where the apartment complex is in partly subsidized by the government, those factors need to be taken into account as well. 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.

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 a prima facie representative of the economic rent for purposes of the capitalized income valuation.

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

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.

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 which needs to be deducted from gross revenue. The vacancy rate of a complex 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.

The expenses of the complex also need to be deducted from the gross revenue. The actual expenses of a complex 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. Stabilized expenses, or a computation of an averaging of the expenses, are also an accepted practice as well. 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.

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. The management fee involves time for accounting, rent collection, advertising and supervision of the operation of the property. The management fee, however, cannot be duplicative of a wage expense to an employee performing management functions.

Reserve expenses, are the expenses for the replacement of items in the apartments. Generally, the courts presume that two percent of the gross income is proper for reserve expenses.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 that 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{ef6a2958fe8e96bc49a2b3c1c7204a1bbdb5dac70ce68e07dc54113a68252ca4} 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 ab
ove average appliances and amenities furnished to the tenants, I find that borough two percent allowance for replacement is insufficient. I find an annual eserve of three percent of the effective income is fair and reasonable.

The capitalization rate factor for obtaining market value of 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 rate of return a prospective investor expects to earn on his invested funds.

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, to produce the proper assessment.

The above 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.