Houston’s office market has steadily gained strength over the last two years.
This fact is evident in the hard statistics; occupancy, rent, and absorption.
Occupancy has come a long way from when it bottomed out two years ago at
81.99%. Current occupancy stands at 84.24%, which represents a 0.40-point
hike over the quarter, a 1.88-point gain over the year, and a full 2.25-point
increase over rock bottom from two years ago. The Class A market recorded the
highest occupancy at 87.02% over the second quarter. In comparison,
occupancy for Class B, C, & D space ranges from 79% to 82%. Absorption
figures are also very telling. Boosted by this quarter’s absorption of 890,680
square feet, absorption over the last year is at 3,117,897 square feet. This is the
strongest annual absorption figure in five years.

Average rental rates have once again climbed back up to levels not seen in a
couple of years. Current rents are at $18.44 per square foot (psf), representing a
$0.04 psf gain over the quarter and a $0.38 psf, or 2.1%, gain over the year.
Class B rents, which are at $17.17 psf, have risen the fastest. Over the last year
Class B rents have gained $0.46 psf (2.75%) compared to Class A which gained
$0.30 psf (1.44%), while Class C and D rents have remained relatively flat.
Not only is it evident the market is gaining strength through hard statistics, it is
also showing up in sales activity. Since the beginning of this year, Houston has
already registered 29 sales of multitenant office properties. Thirteen of the
buildings that traded hands are classified as A, with another 11 of the sales being
Class B properties. These properties were likely targets as they are currently
outperforming market averages, with average occupancy at 90% and average
rents at $20.46 psf.

Some of the more notable deals that have occurred this year include Brookfield
Properties Corp. in partnership with Blackstone Group’s buyout of Trizec
Properties, who owned seven high-profile properties in Houston’s Central
Business District, including Continental Centers I & II; One, Two, and Three
Allen Center; 500 Jefferson Building; and the Kellog, Brown, & Root Tower.
Also of significance was Thomas Properties Group, Inc.’s purchase of four
BMC Software buildings in the Westchase area. Recent sales information is a
clear indicator that investors are once again interested in the high quality
products Houston has to offer at a relatively affordable price compared to coastal
markets. And when combined with the increasing health of the market, it is likely
that investors’ interest will only continue to rise.

Metro Occupancy Overview

Overall occupancy picked up 0.40 points over the quarter to 84.24%. Occupancy is an impressive 1.88 points higher than it was at this time 12 months ago, and is at its highest level in two years. Classes A and C made the largest strides over the quarter,
gaining 0.51 and 0.59 points, respectively, with Class B posting modest quarterly gains.
Class A reported a 0.51-point increase in occupancy over the quarter and a 2.75-point
increase over the year to 87.02%, which is the highest it has been since the second quarter of 2003. Occupancies in the three largest sectors, Galleria, Central Business District, and Westchase, stand at 86.93%, 84.38%, and 89.88%, respectively.
Class B posted a quarterly gain of 0.26 points and an annual gain of 1.25 points to bring occupancy up to 82.29%. The Northwest sector posted the lowest occupancy at 67.00%, while the Northeast 1 sector led the market with occupancy at 96.56%.
Class C occupancy recorded the largest increase of all categories over the last quarter with a gain of 0.59 points to 81.89%. Over the year, occupancy is up 0.89 points. Southwest 2 and The Woodlands/Conroe posted the area.s strongest occupancy levels at 95.62% and 94.29%, respectively. Greenspoint/Northbelt posted the weakest occupancy level just under 75%.
Class D was the only class to register a quarterly drop in occupancy and continues to post the lowest occupancy of all classes. Occupancy in the Class D market declined 0.11 points over the quarter to 79.29%. In spite of the loss, average occupancy remains 1.24 points above last year.s level.

Metro Rent Overview

Overall rental rates recorded their fourth consecutive quarterly gain, increasing $0.04 psf over the 2^nd Quarter of 2006 to $18.44 psf. The increase was fueled by the Class B market, which was the only class to post a quarterly gain in rents. Rents in both
Class A and D declined over the quarter, while rents in the Class C market remained flat.
Class A rents dropped $0.23 psf over the quarter. However, at $21.15 psf, rents remain $0.30 psf higher than last year.s level. Rents were highest in The Woodlands/Conroe and Katy Freeway West sectors at $22.59 psf and 22.27 psf, and lowest in
Kingwood at $12.00 psf.
Class B posted the largest quarterly increase in rents, up $0.23 to $17.17 psf. Class B also posted the largest 12-month gain in average rental rates, increasing $0.46 psf. Major contributors to the strong rental rates are the Medical Center and Midtown/Allen Parkway where rents average $22.04 and $18.59 psf, respectively.
Class C rents held steady over the last quarter at $13.77 psf, and are up $0.12 psf over the last year. Rents ranged from $12.00 psf in the Southwest 1 & 2 and Northeast 2 sectors to $16.25 psf in Greenway Plaza.
Class D rents, at $11.27 psf, registered a $0.15 psf quarterly decline, and a $0.23 psf annual decline. Class D was the only
class to post both a quarterly and annual decline in rents. The highest Class D rents were found in Katy Freeway East at $13.58 psf, while the lowest rents were found in the Southeast at $9.86 psf.

Metro Absorption Overview

Fueled by positive figures in the Class A, B, & C markets, overall quarterly absorption reached 890,680 SF. The Galleria enjoyed the largest quarterly gain, with 357,390 SF absorbed. Overall annual absorption is beyond 3 million SF, a milestone of health in this market where annual absorption just two years ago registered -2.4 million SF.
Class A had another strong showing, absorbing 446,892 SF over the quarter, the most of all classes. Absorption over the year is now totals over 2.3 million SF. Demand for office space was greatest in the Galleria and Sugar Land/First Colony, where quarterly absorption was 259,555 SF and 119,902 SF, respectively.
The Class B market rebounded this quarter, absorbing 180,732 SF. Annual absorption stands at 314,900 SF. The positive turn over the last quarter was largely driven by the Westchase sector, which posted absorption of 89,310 SF. The Clear Lake sector recorded the greatest loss this quarter with absorption of -19,189 SF.
The Class C market posted yet another quarter of positive absorption, with 269,726 SF absorbed. Positive absorption over the last three quarters has boosted 12-month absorption up to 378,684 SF. The Southeast market outperformed all other sectors with 160,401 SF absorbed, while the North Loop/Northwest Freeway trailed the market with -27,851 SF absorbed.
Class D absorbed -6,670 SF over the quarter. Despite the loss, annual absorption remains in the black with 72,129 SF absorbed. The Clear Lake sector posted the largest loss with -5,927 SF absorbed, followed by Foutainview/Gessner with negative absorption of 5,465 SF.

Traditional, Multitenant Office Inventory by Class

There are a total of 1,282 operating traditional, multitenant office properties in the Houston area market with total net rentable square feet of 157,458,306. Approximately 44.79% of the total office space is Class A, 36.81% of the total office space is Class B, 14.82% of the total office space is Class C, and 3.58% of the total
office space is Class D.

Job Growth

The civilian labor force unemployment rate in the tencounty Houston MSA increased to 5.6%, while the total number of nonagricultural wage and salary jobs increased to 2,411,800 in June 2006, according to the Texas Workforce Commission. This month.s total is 59,400 jobs more than at this time last year. Of the nonagricultural employers, Professional & Business Services gained 20,300 jobs over the previous 12 months; Natural Resources, Mining, & Construction gained 10,100 jobs; Education & Health Services is up 8,000 jobs; Trade, Transportation, & Utilities added 7,700 jobs; manufacturing added 4,800 jobs; Financial Activities gained 4,300 jobs; Other Services gained 2,700 jobs; Government employment increased by 2,000 jobs; and Leisure & Hospitality added 600 jobs. The only industry to lose jobs over the year was the
Information sector with -1,100 jobs.

http://www.poconnor.com/file_repository/Houston-Office-Performance-2Q2006.pdf

Homestead exemptions reduce the taxable value of your home, typically by 20%. For example, if your home is assessed (for property taxes) at $150,000, and you qualify for a $30,000 exemption (20%), you will pay taxes on the home as if it was worth $120,000. This would reduce your property taxes by $450 per year, based on a 3% tax rate.

To qualify for homestead exemption, a home must meet the definition of a residence homestead:

• The home’s owner must be an individual (for example: not a corporation or other business entity) and use the home as his or her principal residence on January 1 of the tax year. An individual can own the home directly or through a qualifying trust.
• A homestead can be a separate structure, condominium or a mobile home located on owned or leased land, as long as the individual living in the home owns it.
• A homestead can include up to 20 acres, if the land is used as a yard or for another purpose related to the residential use of the homestead.

The application for residential homestead exemption, found at www.cutmytaxes.com, should be filed with the county appraisal district between January 1 and April 30 of the tax year — up to one year after taxes are due. During the year, if you turn 65 or become disabled, you must apply for the 65 or older or disabled exemption no later than one year from the qualification date. Once you receive the exemption, you do not need to reapply unless the chief appraiser sends you a new application. In that case, you must file the new application.

Patrick O’Connor, a designated member of the Appraisal Institute, is president of O’Connor & Associates. The firm, in business since 1974, specializes in real estate appraisals, research, and state and federal tax reduction services nationwide. With offices in Houston, Dallas, Los Angeles and Newport Beach, the firm employs more than 130 people. Patrick O’Connor is frequently acknowledged by national publications as a respected source of information on real estate. Visit www.cutmytaxes.com.

Reviewing CDU and grade of your home

Review the appraisal district’s description of grade and CDU (condition, desirability and utility) for your house. Grade is a qualitative evaluation of the construction materials and level of craftsmanship used to build your house. Most appraisal districts have about eight to 15 different grades to describe homes of varying quality. Entry-level appraisers typically make the initial estimate of grade. The appraisal district’s estimate of grade for houses within a subdivision often varies for homes that are essentially identical. This can occur when two or more appraisers are evaluating the grade of properties within a subdivision. The CDU or condition factor is highly unreliable. However, the appraisal district uses this as a key factor in valuing your property. The appraisal district, in most areas, believes it actually knows the quality and condition of improvements in homes that are 20-to-80-years-old, even though they have not been in the house since it was initially built. (The appraisal district’s staff typically measures and visits homes while still in the construction process. This is why it is likely they were in your home when it was initially built, if the appraisal district existed at that point and time.) If you can document that either the grade or CDU for your home is not accurate, the appraisal district will probably correct them and revise your value.

Review amenities

Review the appraisal district’s information regarding amenities - year built and year remodeled. If you are not sure the year your house was built, it is often stamped into the lid on the toilet tank. Review the year your home was renovated. Some appraisal districts still consider renovations performed between 20 to 40 years ago, even though the contributory value of a renovation may only last for five to 10 years. Some owners become concerned about appealing if they have amenities not described on the appraisal district records. For example, if you have a swimming pool not listed on the appraisal district records you may wonder if you should be concerned about appealing. (If you file an appeal, will the appraisal district come inspect your house? Most likely not.) Appraisal districts handle a large volume of appeals during the property tax appeal season. Therefore, they are not able to visit properties simply because the owner files an appeal.

Documenting meaningful deferred maintenance.

While many homes have cracks in the driveway, it is not likely to be an effective factor in a property tax appeal hearing. However, the appraisal district staff and ARB will consider factors such as rotten wood, peeling paint, roof leaks, foundation problems, settlement and other similar problems. Obtaining a bid of the cost to correct the problems is the most effective way to utilize this information in a property tax appeal hearing.

Developing a market value appeal

Comparable sales are the cornerstone of a market value appeal for a home. The exception may be a new house where cost is an important factor. Sources of comparable sales data can be found in the House Bill 201 package obtained from the appraisal district and MLS sites.

New-home discounts

Recently purchased homes in subdivisions where builders are active, or near subdivisions where builders are still active, often sell for 5% to 15% less than their initial purchase price. This is because homeowners would rather purchase a brand-new home with fresh paint and carpet than a slightly used home. To put this in perspective regarding the implication for property tax protest: if you purchased your home for $200,000 two years ago, and are currently assessed for $200,000, you are over-assessed! Researching data for recently sold homes sold by the initial owner (versus the builder) will document this discount.

Livable versus sellable

One of the first steps to selling a home is interviewing Realtors. During this process, homeowners will ask their Realtor, “what do we need to do to sell our home?” The costs of preparing a home for sale are substantial. Realtors will typically encourage homeowners to replace carpet, tile and other flooring, interior paint and exterior paint, and landscaping as appropriate. Realtors will also request that any deferred maintenance such as roofs, foundation problems, rotten wood, HVAC, electrical problems, offensive pet and smoke odors, and plumbing problems be addressed. Depending on the condition of your home, you should consider the livable versus sellable factor when preparing for your property tax appeal hearing. The vast majority of homes sold have cosmetic upgrades performed and deferred maintenance corrected before the property is sold.

Livable versus sellable for a two-year-old home

A discount may be appropriate for the cost to prepare a home for sale and for the differential for new homes versus slightly used homes (in areas where builders are active). While this may seem like double dipping, Realtors would likely advise someone who has a two-year-old home to perform cosmetic repairs so the home looks sharp and shows well before it is marketed.

Presentation of sales data

Prepare a summary with information on the subject property at the top of the chart and data for two to five comparable sales below it. Array relevant fields such as address, account number, year built, square feet, sales price, sale date, sales price per square foot and improvement price per square foot. (Some appraisal districts focus more on the sales price per square foot for improvements versus the overall sales price per square foot. You can calculate the improvement price per square foot by deducting the appraisal district’s assessed value for the land from the total sale price. The resulting value is the sales price for the improvements. Calculate the sales price per square foot of improvements by dividing the sales price for improvements by the size of the house).

Unequal appraisal

Unequal appraisal is an effective tool in appealing property taxes annually to minimize your property taxes. For many owners, it is not practical to appeal based on market value since the value determined by the appraisal district is less than the actual market value. Although addressing livable versus sellable does help in these cases, using unequal appraisal provides most owners another basis for appeal. Section 41.43 of the Texas Property Tax Code provides the basis for appealing on unequal appraisal and reads as follows: “a protest on the ground of unequal appraisal of property shall be determined in favor of the protesting party unless the appraisal district establishes that… the appraised value of the property is equal to or less than the median appraised value of a reasonable number of comparable properties appropriately adjusted.”

Important components of an unequal appraisal appeal include a reasonable number of comparable properties that are appropriately adjusted. Comparable properties are generally considered to be properties that are similar with regard to the quality and quantity of improvements. A reasonable number of comparables are often considered to be between two and 10. If there’s only one comparable that supports reduction, you are likely to be equitably assessed. In most cases, we prefer to have more than just one assessment comparable. However, some improvements are atypical and there are a limited number of comparables. For example, there are not a large number of bowling alleys that were built in the last five years in northwest Dallas. Neither are there a large number of 4,000 square-foot homes in an area where most homes range in size from 2,000 square feet to 2,500 square feet. For homes, you should focus on properties within the same subdivision, provided comparable properties are available within the subdivision. When appealing your home, it is probably not necessary to make appropriate adjustments. Most appraisal review boards will consider evidence regarding unequal appraisal based on reviewing the assessment comparables.

Review and analyze the information on unequal appraisal the appraisal district provided in the House Bill 201 package. You may want to research the assessment comparables chosen by the appraisal district to see whether they are comparable based on size, location, year built and quality.

Prepare your own unequal appraisal analysis based on researching assessment comparables on the appraisal district’s web site. If the appraisal district does not have a web site, send a request for information or visit the appraisal district to obtain the assessed value for similar homes. Select assessment comparables and summarize the data in a table. If you believe it is appropriate and feel comfortable doing so, make adjustments to address the differences between the subject property and the assessment comparables.

Do appraisal districts and appraisal review boards follow the law regarding unequal appraisal?

Unfortunately, many appraisal districts believe they are immune from following this law. This also applies to the laws, which provide owners the right to House Bill 201 information, a scheduled hearing, burden of proof, unequal appraisal and an independent ARB. More often than not, the appraiser at the informal hearing will not consider information regarding unequal appraisal. However, it is likely the appraiser will offer a reduction in assessed value to resolve the appeal so it does not have to be addressed at the ARB hearing. While unequal appraisal is clearly intended to be a basis for appeal, this law is fairly new. A combination of time, legislation and litigation will resolve these problems.

You have now completed three analyses regarding the tax assessment for your home:

1. Errors in the appraisal district’s data,

2. Market value, and

3. Unequal appraisal.

Review the advantages and disadvantages of each analysis to determine what information is most effective for your property tax appeal. Also determine what O’Connor & Associate’s terms as a target value and ARB value. The target value is the opening negotiating position you will request when you start the negotiation. The ARB value is the highest value you will accept at the informal hearing.
Patrick O’Connor, a designated member of the Appraisal Institute, is president of O’Connor & Associates. The firm, in business since 1974, specializes in real estate appraisals, research, and state and federal tax reduction services nationwide. With offices in Houston, Dallas, Los Angeles and Newport Beach, the firm employs more than 130 people. Patrick O’Connor is frequently acknowledged by national publications as a respected source of information on real estate. Visit www.cutmytaxes.com.

Assessment Evaluation of Restaurants

By Patrick O’Connor, MAI
Many restaurant owners have been shocked to learn that they are unable to sell or lease their restaurant property for an amount equal to its tax assessment value. The market value of a recently built restaurant is usually less than its construction cost. When an owner attempts to set a sales price or lease rate, he is unable to recoup his costs. Excess property taxes result from improper use of the cost approach to market value.

The cost approach is an excellent valuation methodology for some types of new properties. It works better for properties that can be utilized by a large number of users without alteration as opposed to special-use properties. Apartment complexes are an example of properties where multiple users can use the same property with few, if any, alterations. Restaurants are a category where extensive renovations are typically required to convert a restaurant from use by one operator to use by another operator. This is particularly true where chain restaurants are involved. For example, how much would it cost to convert a restaurant built for McDonald’s to be used by Pizza Hut?

Randy Dishongh, of the Mason Jar Restaurant Group, recently purchased a 8,250 square foot restaurant that has been used by another operator and altered for use by his firm. It cost $400,000 ($48.48 per square foot0 to convert the restaurant. Phil Kensinger, of Kensinger & Company, recently purchased an 8,000 square foot restaurant that cost $300,000 ($37.50 per square foot) to convert his tenant’s requirements. Kensinger reports, “improvement in a restaurant built-to-suit often has little or no value to a successor tenant.”

Part of the business value developed by restaurants is dependent upon a distinctive architecture that is recognizable to restaurant patrons, who believe they can expect a reliable quality of food and service for a set price at this establishment. It is important to restaurant operators that all operating units have this recognizable architecture. It is the primary reason large restaurant operators such as McDonald’s, Pizza Hut, and Whataburger have distinctive restaurant design with distinctive signage.

Signage is a good example of one of the high-cost conversion items. McDonald’s golden arches are distinctive and well serve the purpose of announcing to its patrons the presence of the McDonald’s restaurant. However, they are not easily converted for use by another restaurant, perhaps not even with extensive conversion costs. The same is true for changing the elevation (exterior appearance), interior layouts and redoing the interior finish.

The unique architecture of chain restaurant facilities makes it difficult to convert a facility built for one chain to use by another chain. It costs less to convert them from use by a major chain to a local nonchain operator. Examples of national chains with distinctive architecture include: McDonald’s, Pizza Hut, Burger King, Taco Bell, Long John Silvers, Pizza Inn, Jack in the Box and Whataburger.

Definitions Determine Methodology
The first steps in determining the proper valuation methodology includes, reviewing a series of definitions, determining how they apply to restaurants, and reviewing the laws that apply in your jurisdiction. However, continual refinement is essential to the growth of the appraisal profession. A current economic definition of market value is stated as follows:

The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress. (The Appraisal of Real Estate, 20th ed., published in 1992 by The Appraisal Institute)
The following definition has been agreed upon by agencies that regulate federal financial institutions in the United States, including the Resolution Trust Corporation (RTC):

The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price in not affected by undue stimulus. Implicit in this definition is the consummation of a sale of a specified date and the passing of title from seller to buyer under conditions whereby:

1. buyer and seller are typically motivated

2. both parties are well informed or well advised, and acting in what they consider their best interests

3. a reasonable time is allowed for exposure in the open market

4. payment is made in terms of cash in the United States or in terms of financial arrangements comparable thereto

5. the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale. (USPAP, 1992 edition)¹

Use Value. The value a specific property has for a specific use.²

Investment Value. The specific value of an investment to a particular investor or class of investors based on individual investment requirements; distinguished from market value, which is impersonal and detached. See also market value.³

Liquidation Value. The most probable price which a specified interest in real property is likely to bring under all of the following conditions:

1. Consummation of a sale will occur within a severely limited future marketing period specified by the client.

2. Actual market conditions are those obtained currently for the property interest appraised.

3. The buyer is acting prudently and knowledgeably.

4. The seller is under extreme compulsion to sell.

5. The buyer is typically motivated.

6. The buyer is acting in what he or she considers his or her best interests.

7. A limited marketing effort and time will be allowed for the completion of a sale.

8. Payment will be made in cash in U.S. dollars or in terms of financial arrangements comparable thereto.

9. The price represents the normal consideration for the property sold, unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

This definition can be modified to provide for valuation with specified financing terms. (The above definition, proposed by The Appraisal Institute Special Task Force on Value Definitions, was adopted by The Appraisal Institute Board of Directors, July 1993.) See also disposition value; distress sale; forced price; and market value.⁴

How to Apply Market Value to Restaurants
The balance of this article is focused on determining and evaluating market value for a restaurant. Market value is the type of valuation performed in Texas. Value in use, or use in value, is the value a property has to a specific user as opposed to the value in the open market. Investment value is the value an investment has for a specific class of investors. In restaurant valuations, the investment value of a restaurant with a long-term guaranteed by a high credit tenant may be dramatically different from market value of the property without the long-term lease and guarantee. Liquidation value is distinguished from market value primarily by a brief marketing period. The valuation methodology discussed herein pertains to market value instead of value in use, investment value or liquidation value. The market value of the restaurant real estate should be distinguished from the sale of a going-concern. When an operating restaurant is sold it may involve the sale of real estate, FF&E (furniture, fixture, and equipment), business value, and inventory. The following are definitions for real estate, business value and going-concern value.

Real Estate. Physical land and appurtenances attached to the land, e.g., structures. An identified parcel of tract of land, including improvements, if any. See also real property.⁵

Business Value. A value enhancement that results from items of intangible personal property such as marketing and management skills, an assembled work force, working capital, trade names, franchises, patents, trademarks, contracts, leases, and operating agreements. See also going concern value.⁶

Going-concern Value. The value created by a proven property operation; considered as a separate entity to be valued with a specific business establishment; also called going value. See also business value.⁷

When a restaurant is sold, a bulk price for these four classes of assets (real estate, FF&E, business value and inventory) will typically be negotiated. During the business negotiation, each party may give some thought to the different items but is typically focusing more on the net cash flow generated by the restaurant and the market value of that income stream. When the attorneys and accountants become involved, it will be necessary to allocate the purchase price to real estate, FF&E, business value and inventory. Federal income tax ramifications may affect the allocation between these items. Many investors will attempt to maximize depreciation for federal tax purposes. This will involve maximizing the allocation to building values, FF&E, and inventory. Investors typically attempt to minimize the value allocated to land and business value.

When confirming comparable sales, it is essential to determine which of these elements are involved. The final set of definitions to be reviewed is fee simple estate and leased fee estate:

Fee simple estate. Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.₈

Leased fee estate. An ownership interest held by a landlord with the rights of use and occupancy conveyed by lease to others. The rights of the lessor (the leased fee owner) and the leased fee are specified by contract terms contained within the lease.⁹

There are three primary distinctions between fee simple estate and leased fee estate for the purposes of our analysis: 1) contract rent paid versus market rent which could be achieved, 2) the term of the lease, and 3) the strength of the lease guarantor. A tenant may agree to pay an above market rental rate to induce a landlord to invest capital to build a restaurant that has a distinctive architecture necessary to operate his business and maintain a brand image. McDonald’s could not maintain their brand image if they simply leased restaurants built by others, which were not successful locations for the first operator. A diverse set of restaurant elevations would diffuse the brand image developed by their advertising.

The primary reason that some of the restaurant rental rates are at an above market level is the cost of converting a restaurant from use by one operator to use by another restaurant operator. Many restaurant operators view the landlord’s capital expenditure of tenant improvements as a loan being repaid over the life of a lease. According to Randy Dishongh, of the Mason Jar Restaurant Group, “landlords expect to receive tenant improvement costs returned over the leased term along with a 10% to 12% return on funds advanced.” Discussions with other restaurants, investors and operators indicate that the yield on tenant improvements may range from 10% to 20%, depending on the level of expenditures, their uniqueness and the financial strength of the lessee.

Although 10% to 20% may seem like a high rate of return for a real estate investor, an equity investor in a restaurant business would expect a higher level of return for this capital. Therefore, it is prudent for the real estate operator to in effect borrow the tenant improvement costs from the landlord and repay them with an above market rent as compared to raising additional equity.

Choosing the Correct Approach to Valuation
The final step in our analysis is to review the three traditional approaches to valuation: cost, sales comparison and income. The cost approach involves adding the market value of the land to depreciated value of the improvements. The subjective portion is determining depreciation of the improvements in a market value appraisal. Deducting the cost to change the exterior elevation, interior layout, interior finish and signage is one approach to determining depreciation resulting from the unique requirements of each restaurant operator. Other items, which might be considered, are the leasing commission paid to a third-party leasing agent and rent loss until the property is leased.

These costs can be considerable. Another approach to determining total depreciation in a restaurant is to analyze recent sales and allocate the sale price between land and improvements. If the replacement cost of the improvements is estimated and physical depreciation is deducted, the balance of the depreciation may be a good indicator of the depreciation due to the cost of conversion.

None of the traditional forms of depreciation describe precisely depreciation due to conversion of a restaurant. According to the Appraisal Real Estate, 11th ed., published by The Appraisal Institute, “Functional obsolescence is caused by a flaw in the structure, materials, or design that diminishes the function, utilities and value of the improvement.” Curable functional obsolescence is defined as follows: “An element of accrued depreciation; a curable defect caused by a flaw in the structure, materials or design.” A second approach would be to treat the costs of conversion leasing and rent loss in the same manner as deferred maintenance since it is a necessary expense to prepare the restaurant for a new restaurant operator.

The sales comparison approach is a direct and easily understood valuation tool. With restaurants, due to the number of elements of value (real estate, business value, FF&E and inventory) involved in a sale, the sales comparison approach requires more detailed research to prepare an accurate valuation. It is critical to perform detailed research to separate the value of the real estate, business value, FF&E, and inventory when reviewing comparable sales. Since the allocation of these items is often made by lawyers and accountants to maximize federal income tax depreciation, it may not be reasonable to use the allocation established by the buyer and seller in preparing a real estate appraisal. Since adequate information may not be available to properly allocate value for the real estate when a going-concern restaurant is sold, it may be appropriate to use this information as a comparable sale. Further, the time involved to estimate the business value, inventory, real estate and furniture, fixture and equipment values may be a more detailed and complex analysis than the appraisal of the subject restaurant.

Selecting appropriate sales, which involve only real estate, is the most important step in preparing the sales comparison approach. It is often practical to separate the other elements of a going-concern restaurant sale from the real estate value. Sale of a restaurant building where a restaurant is no longer being operated reflects the true value of the real estate provided adequate time to market the property is available.

Improper application of the income approach can result in an unreasonable value. The most common pitfall when valuing a restaurant for tax purposes in Texas is to consider the contract rent being paid as market rent. This contract rent in most cases involves compensation for tenant improvements. This repayment of the cost of tenant improvements is often a significant portion of the contract rent.

The second major item, which sometimes distorts the valuation of the fee simple estate when a restaurant is leased, is the effect of the long-term lease to a creditworthy tenant. When valuing the fee simple estate when a restaurant is leased is the effect of the long-term lease to a creditworthy tenant. When valuing the fee simple estate, the appraiser should use market rent, market vacancy, market expenses and a market capitalization rate. If local practice involves valuing the fee simple estate, the income using capitalization rate for a creditworthy tenant.

Conclusion
The most important step in correctly valuing restaurants for tax purposes is determining which type of value should be utilized. There are significant differences between the market value, value in use and investment value for the same property. There are often significant differences between the market value of the leased fee estate and the fee simple estate. Calculations of the appropriate value can then be performed using relevant data. However, controversy over proper valuation of restaurants will likely be an active topic of discussion well into the future.

Patrick O’Connor, a designated member of the Appraisal Institute, is president of O’Connor & Associates. The firm, in business since 1974, specializes in real estate appraisals, research, and state and federal tax reduction services nationwide. With offices in Houston, Dallas, Los Angeles and Newport Beach, the firm employs more than 130 people. Patrick O’Connor is frequently acknowledged by national publications as a respected source of information on real estate. Visit www.cutmytaxes.com.

Fortunately, the property tax appeal process in Texas provides owners multiple opportunities to appeal. Handled either directly by the owner or by a property tax consultant, this process should involve an intense effort to annually appeal and minimize property taxes. Reducing the largest line item expense has a significant effect in reducing the owner’s overall operating expenses. While it is not possible to entirely escape the burden of paying property taxes, it is possible to reduce taxes sharply, often by 25% to 50%.

Why some owners don’t appeal

Some property owners don’t appeal because they either don’t understand the process, or don’t understand that there is a good probability of achieving meaningful reductions in property taxes. Some owners believe that since the market value of their property exceeds the assessed value, then it is not possible to appeal and reduce the property taxes. Although appeals on unequal appraisal are relatively new, there is a clear-cut way to appeal property taxes at the administrative hearing level based on unequal appraisal. Unequal appraisal occurs when property is assessed inconsistently with neighboring properties or comparable properties. Also, some owners are reluctant to hire a property tax consultant, even though many consultants will work on a contingent fee basis, in which there is no cost to the owner unless property taxes for the current year are reduced.

Overview of appeal process

The following are the primary steps in the annual process for appealing property taxes:

• Request notice of accessed value
• File an appeal
• Prepare for hearing
• Review market value appeal
• Review unequal appraisal appeal
• Set negotiating perimeters
• Administrative hearings
• Decide whether binding arbitration or judicial appeals are warranted
• Pay taxes timely

Requesting a notice of assessed value

Property owners have the option of requesting a notice of assessed value for their property annually. Section 25.19g of the Texas Property Tax Code provides the owner the option to request a written notice of the assessed value from the chief appraiser. Owners benefit from requesting and receiving a written notice of assessed value for each property because it ensures they have an opportunity to review the assessed value. This notice should be sent on an annual basis. The appraisal district does not have to send a notice of assessed value if the value increases by less than $1,000. However, if an owner was not satisfied with a prior year’s value and the value remained the same, the appraisal district probably will not send a notice of the assessed value for the current year. In this situation, the owner might forget to protest since a notice of assessed value for the property was not received.

How to file and appeal

On or before May 31st of each year, the property owner should file an appeal for each property. However, while many owners are comfortable with an assessed value, in many cases there is a basis for appealing. Two options for appealing include:
1. unequal appraisal, and
2. market value based on data the appraisal district provides to the owner before the hearing.
You can appeal by completing the protest form provided by the appraisal district and indicating both excessive value (market value) and unequal appraisal as the basis for appeal. In addition, the property owner can simply send a notice that identifies the property, and indicates dissatisfaction with some determination of the appraisal office. The notice does not need to be on an official form, although the comptroller does provide a form for the convenience of property owners. (You can access the protest form at www.cutmytaxes.com .)

House Bill 201 - helpful information

House Bill 201 is the industry jargon for a property owner’s option to request information the appraisal district will use at the hearing, and to receive a copy 14 days before the hearing. The name House Bill 201 is derived from the bill used to enact the law. The details for House Bill 201 are located in sections 41.461 and 41.67d of the Texas Property Tax Code. When filing a protest, the property owner should additionally request in writing that the appraisal district provide a copy of any information the appraisal district plans to introduce at the hearing. The appraisal district will typically require the property owner to come to the appraisal district office to pick up the information and charge a nominal fee, typically $0.10 per page. While the cost for House Bill 201 requests are quite low (typically $0.50 to $2.00 per property for residential and commercial) the information is invaluable in preparing for the hearing. In addition, filing a House Bill 201 request is important because it limits the information the appraisal district can present at the hearing to what was provided to the property owner two weeks before the hearing.

Preparing for the Hearing

Start by reviewing the appraisal district’s information for your property for accuracy. If the appraisal district overstates either the quality or quantity of improvements, this will justify a deduction. The next step is to review the information on market value and unequal appraisal provided by the appraisal district in the House Bill 201 package. If the subject property is an income property, review the appraisal district’s income analysis versus your actual income and expense statements. Consider the following areas as opportunities to rebut the appraisal district’s analysis:

• Gross potential income
• Vacancy rate
• Total effective gross income, including other income
• Operating expenses
• Amount of replacement reserves
• Net operating income
• Capitalization rate
• Final market value

Many property owners and consultants start with the actual income and expense data, and use one or two of the assumptions provided by the appraisal district. However, they primarily utilize information from the actual income and expenses in preparing their own income analysis and estimate of market value for the subject property.

When comparable sales are the primary issue in determining market value, start by reviewing the comparable sales data provided by the appraisal district versus the assessed value for your property. Convert the sales prices from the appraisal district to either a per square foot or per unit basis. Then compare the sales to the per square foot or per unit assessment for your property. Sales can be helpful during the hearing.

The cost approach is not typically used in the property tax hearings except for brand new or relatively new properties. If your property is new, the appraisal district will probably want to review the cost information and you probably won’t want to show it to them. In many cases, the actual cost of a property is higher than the estimate provided by the appraisal district. If this is the case, you will likely want to appeal on unequal appraisal instead of on market value. No matter how good your argument or how passionately it is expressed, the appraisal district staff and Appraisal Review Board (ARB) members tend to believe that cost equals value for new properties.

Deferred Maintenance and Functional Obsolescence

Another issue that is important for the market value appeal, and to some extent for a unequal appraisal appeal, is information on deferred maintenance and functional obsolescence. Deferred maintenance could include items such as:

• rotten wood
• peeling paint
• roof replacement
• substantial repair
• landscaping updating and other similar items

Most appraisal districts give minimal consideration to requests for adjustments based on deferred maintenance, unless the property owner provides repair costs from independent contractors. There are some exceptions where a cooperative informal appraiser or sympathetic ARB will take an owner’s estimate of deferred maintenance and make adjustments based on those costs. Most appraisers and ARB members are much more inclined to make adjustments if third-party cost estimates are provided. In addition, the appraisers and many ARB members are inclined to only deduct a portion of the total cost using the argument, “we’ve been giving a replacement reserve allowance for this item for the past years and it’d be double-dipping to deduct the whole value off it in the current year.” While this is an incorrect appraisal argument, it does tend to be the practice at many appraisal districts. The reality is, the cost of curing deferred maintenance is deducted from the offer by a prospective buyer.

Examples of functional obsolescence would be a three-bedroom apartment unit that only has one bathroom, or a two-bedroom apartment that does not have washer/dryer connections in an area where those connections are common. Another example would be an apartment that has a window air conditioner in an area where central HVAC is typical and expected.

Unequal appraisal analysis

The Texas Property Tax Code, section 41.43(b)(3), provides for appraising or appealing on unequal appraisal including ratio studies and “a reasonable number of comparable properties appropriately adjusted.” Virtually all unequal appraisal appeals involve a reasonable number of comparables that are appropriately adjusted. Comparables are similar properties.

This is primarily because of the difficulty and cost of performing a ratio study. Historically, the position of many appraisal districts was that the property owner needed to get a fee appraisal for each comparable property and compare the market value estimated by the appraiser to the assessed value. The cost of getting multiple appraisals made this process financially impractical. Compiling a reasonable number of comparables appropriately adjusted is simple and straightforward. The first step is to choose a reasonable number of comparables. Usually four to five comparables is the typical number used at a property tax hearing, but in some cases, property owners choose ten to thirty. In some cases, there may only be one to four comparable properties that merit consideration. Most unequal appraisal presentations include three to ten comparables. The number of reasonable comparables depends on the location, type, size and age of the property. For example, there would be fewer five-year-old bowling alleys in the northern part of Harris County compared to recently built apartment complexes.

After choosing a reasonable number of comparables, array them in a table format, including fields of data such as account number, net rentable area, year built, street address, assessed value and assessed value per square foot.

The next step is to determine whether or not to make appropriate adjustments. For the administrative hearing, if you have truly comparable properties, most boards (appraisal review board or ARB) won’t be concerned with you not making adjustments. If you make adjustments, those would typically be based on factors such as differences in size and age compared to the subject property.

You should also review the information in the appraisal district’s House Bill 201 packet on an unequal appraisal. In many cases, the appraisal districts unequal appraisal analysis will document a reduction in your assessed value! If the appraisal districts unequal appraisal analysis documents a reduction, either the informal appraiser or the ARB should make the adjustment in assessed value for you. Having the opportunity to get an assessed value reduced automatically based on the appraisal districts unequal appraisal analysis is one of the reasons to appeal every property every year.

Completing Hearing Preparation

After reviewing the appraisal district’s information on your property, the House Bill 201 package, and your market value and unequal appraisal analyses, determine the strengths and weaknesses of each approach and decide which basis of appeal provides the best opportunity for a meaningful reduction. Although appeals on unequal appraisal have clearly been the law of the land since 2003, some appraisal districts and review boards have chosen to disregard the option for unequal appraisal put forth by the Texas Legislature. Although there is litigation underway which should resolve this issue within the next year, it would be prudent to visit someone who is knowledgeable in local property tax appeals to determine whether the county appraisal district and ARB in your area are considering appeals on unequal appraisal.

Set Negotiating Perimeters

After reviewing the information, it is important to set the highest level of assessed value you will accept at the informal hearing because after you accept an assessed value, the appeal process will be complete for the year and you will not be able to appeal further.

Administrative Hearing Process

The two steps to the administrative hearing process are the informal hearing and the appraisal review board hearing.

The Informal Hearing
The following procedure and rules are typical at the informal hearing:

• Meet with an appraiser representing the appraisal district. You should be polite and prepared at this meeting. While many property owners are frustrated and angry at the high level of real estate taxes, the appraisal district appraiser does not control the tax rate set by various entities nor the policy regarding property taxes in the area or the state. The appraisal district appraiser is trying to execute his job in a professional manner and appreciates it when property owners work with him on that basis.
• Provide the appraiser information on your property and he will review that information and information he has available.
• The appraiser will likely make an offer to settle the assessed value of your property fairly quickly. You can either accept the value or negotiate further. Either way, you should know within ten to twenty minutes whether the appraiser will offer an acceptable value. If the value is acceptable, conclude the negotiation by agreeing to the value for the current year. If the value offered is not acceptable, ask to go forward with an ARB hearing.

Appraisal Review Board Hearing (ARB)
The ARB hearing panel consists of three impartial citizens selected and paid by the appraisal district. The age of most ARB members ranges from fifty to eighty. There is an unfortunate bias in the system since the ARB members are selected and paid by the appraisal district, but most ARB members are reasonable people who want to make appropriate decisions.

Like the appraisal district appraiser, the ARB does not set tax rates or tax policy. The members are also not responsible for the effectiveness of local government. It is unlikely to help your case if you complain to the ARB members about either the high level of property taxes or the poor quality of some aspect of local government.

The ARB will expect you to make your presentation in about three to ten minutes. They will typically wait patiently while you make your presentation and may have questions after you conclude. An appraiser from the appraisal district, who may or may not be the same person who attended the informal hearing, will represent the appraisal district at the ARB hearing. The appraiser will comment on the evidence you presented and will often present other information the appraisal district has available. If you requested a House Bill 201 package for your property, it substantially limits the evidence the appraisal district appraiser can offer at the hearing. The ARB members may have questions after the appraisers presentation. Then the property owner will be given a final opportunity to rebut evidence presented by the appraisal district appraiser and quickly summarize the evidence. The ARB members strongly prefer you not repeat your entire presentation at this point.

After hearing the evidence, the ARB members will confer and make a decision. This decision is not subject to negotiation and they will not revise the decision if further evidence is presented. When this decision is announced, the hearing is effectively over. The ARB will send a letter two to four weeks later summarizing their decision and notifying the owner of a 45 day limitation from the date receipt of the ARB decision to either request binding arbitration or file a judicial appeal.

Binding Arbitration or Judicial Appeal

Beginning September 2005, owners of properties with an assessed value of $1 million or less may file a request for binding arbitration. The owner must file with the appraisal district no more than 45 days after receipt of the notice of the ARB’s decision. The binding arbitration option is interesting because it includes a loser pays provision. The appraisal district pays for the arbitrator’s fee if the final value is closer to the owner’s opinion of value, and the owner pays for the binding arbitration if the final decision is closer to the appraisal district’s opinion of value. Binding arbitration was passed to provide an alternative to judicial appeals, which can be expensive to prosecute.

Many owners pursue judicial appeals to further reduce property taxes. In 2005, O’Connor & Associates filed over 1,200 judicial appeals on behalf of property owners in the state of Texas. The judicial appeals can be expensive if the property owner and attorney don’t understand the process and have a plan in place to minimize the cost of legal and expert witness fees. Judicial appeals are typically successful. However, success requires cooperation from the property owner, such as providing responses to questions, documents and a deposition if requested. The judicial appeal is meaningful as an option to minimize property taxes since it reduces the base value. This is important because the appraisal district and ARB consider the base value in the subsequent year when setting the administrative hearing value.

Conclusion

Property owners can generate substantial reductions in property taxes by appealing annually. Consider appeals on both market value and unequal appraisal and obtain the House Bill 201 information when preparing for the appeal hearing. Property owners should consider all three levels of appeal: informal hearing, ARB hearing and judicial appeal/binding arbitration. While the ARB hearing and judicial appeal/binding arbitration can be an intimidating process, each is straightforward once you understand the mechanics.

Patrick O’Connor, MAI is president of O’Connor & Associates, 130-person firm in business since 1974. O’Connor & Associates is the largest tax consultant in Texas, handled more than 43,000 administrative appeals in 100 counties in 2005 and is currently coordinating over 2,000 judicial appeals. O’Connor & Associates also provides real estate appraisal, cost segregation and market research services.

/article.asp?id=46″>http://www.poconnor.com>/article.asp?id=46

Several years ago a definitive court case ruled that tangible personal property included in an acquisition or in overall costs should be depreciated as personal property for asset recovery, using the old Investment Tax Credit principles to classify personal property.

This meant that owners of improved properties could distinguish between real property and personal property to depreciate component costs over varying useful lives. Basically, instead of depreciating an entire commercial property over 39 years, or residential roperty (single-family rentals or multifamily) over 27.5 years, certain components are correctly identified as depreciating in much less time. For about 135 items, useful life periods can be 5, 7 or 15 years. This is known as cost segregation.

The result of increasing depreciation is lower taxable income (which would have been taxed at 35%) and more income taxed at the capital gains rate (15%) when the property is sold. Furthermore, it works for any type of improved property.

Until recently, primarily large accounting firms or engineering firms implemented cost segregation studies, addressing large and newly built properties and sometimes outsourcing the analysis.

Prices for those analytical reports, usually in the $10,000 to $40,000 range, were out of reach for owners of small properties, especially those holding less-than-new assets. Unfortunately, those owners representing the largest segment of real estate investors in the country were mostly overlooked by previous providers of cost segregation services.

Now a revolutionary paradigm shift is opening the door to very significant savings for owners of small properties. Much of the change is based upon introducing the efficiencies of highly knowledgeable real estate appraisers who often apply industry-accepted cost estimation techniques before determining remaining asset life. By not “over-engineering” the staffing or production process, professional fees are lower. Yet, results can usually meet or exceed those of far more expensive reports. This approach has been successfully field-tested by IRS auditors.

Changes that appraisers are introducing to cost segregation analysis and reporting are addressing: 1) the size of the property being analyzed, 2) the age of the property, and 3) an affordable price point. O’Connor & Associates, a nationwide real estate service firm, is taking advantage of such techniques to effect these beneficial changes:

1. Owners of property with an improvement basis as low as $500,000 can benefit from cost segregation. This compares to the limited properties worth $5 to $10 million and above that previously benefited.

2. Existing properties built or purchased after 1986 offer significant savings in year-one of cost segregation, even without producing original cost documents. Capturing non-segregated depreciation from prior years is perfectly allowable by the IRS. This compares to firms previously applying the methodology only to new construction.

3. Fees are no longer prohibitive. To prepare an analysis and report for many small properties, prices are low enough to generate at least 3 times the report cost in the first year. This compares to the traditional fees ranging from $10,000 to $20,000 and up for comparable size properties.

It is wise to keep the owner’s CPA or tax preparer abreast throughout the process. For older properties, the CPA may need to complete a Form 3115 to submit with the tax return so the owner can realize savings on items not previously depreciated - without filing an amended return.

Income producing properties worth as little as $500,000 can achieve a 3:1 payback ratio of tax savings over the modest price of a cost segregation report. If owned for 3 or more years, the typical payback ratio is 10:1.

Patrick O’Connor, MAI, is president of O’Connor & Associates. The firm, in business since 1974, specializes in state and federal tax reduction services, real estate appraisals and research and consulting nationwide. With offices in Houston, Dallas, Los Angeles and Newport Beach, the firm employs more than 130 people. Patrick O’Connor is frequently acknowledged by national publications as a respected source of information on real estate trends. Visit /costsegregation

http://www.poconnor.com/article.asp?id=38

Austin Market occupancy dropped 0.07 points over the month, however at 93.39%, occupancy remains 2.10 points higher than in April of 2005. Average rents are currently at $0.930 psf and are $0.002 psf higher than last month and last year’s figures. Absorption dipped into the red this month, as -109 units were absorbed. Annual absorption stands at 3,589 units.

Dallas/Fort Worth Market occupancy is up 0.03 points over the month to 90.35%, and is 1.70 points above last year’s level. Although average rents have remained flat over the last few months at $0.867 psf, they are $0.003 psf higher than the rate seen at this time last year. Monthly absorption of 641 units brings annual absorption up to 13,575 units.

Houston Market occupancy fell 0.27 points to 90.73% over the month. Overall occupancy remains 4.29 points higher than April 2005’s level. Rental rates inched up $0.003 psf over the month and are up $0.027 psf over the year to $0.824 psf, while monthly absorption was -323 units. Absorption over the last twelve months is at 24,542 units.

San Antonio occupancy, at 91.69%, gained 0.08 points over the month and 0.47 points over the year. Rental rates are up slightly over the month, $0.001 psf, to $0.817 psf, which is $0.012 psf higher than last year’s figure. This is the third consecutive month of positive absorption, as 237 units were absorbed in April. Annual absorption totals 3,473 units.

In the News
O’Connor & Associates now offers online Apartment market data in all four major Texas markets: Austin, Dallas/Fort Worth, Houston, and San Antonio. Need Rent Comps, enhanced market reports, construction pipeline, sales activity, ownership or management contact information? Just give us a call: 1-800-856-REAL

While most accountants are familiar with the approach, some are hesitant to recommend it without a documented analysis of correct depreciation amounts. The numerous intricacies of IRS designated building components make it difficult for some accounting professionals to be cognizant of all applicable items on a specific property. CPAs recognize that in order for the client to fully benefit, it is usually necessary to seek a real estate specialist to provide an independent report supporting the owner’s depreciation schedule.

Although it is vastly under-utilized, cost segregation is no wildly speculative accounting tool. In fact, the American Institute of Certified Public Accountants’ National Journal of Accountancy has published numerous articles in support of cost segregation.

Cost segregation identifies applicable components and establishes the value and correct time line for depreciation. Under typical circumstances, depreciation is spread out over as long as 39 years. However, cost segregation applies depreciation to parts of the property in 5-,7- and 15-year increments. This acceleration in depreciation time reduces the income subject to federal taxes. This method does not dictate alternative minimum tax issues.

Professionals Prepare Detailed Reports
To perform a cost segregation analysis, initially the building’s cost basis for construction, renovation and repairs is reviewed. A technician goes on site to take detailed measurements and observe the quality and condition of the property. After the site visit, he or she calculates the value of the property using widely accepted pricing resources and local economic conditions.

A cost segregation study produces a professional document that is backed by careful research. The results are summarized in a detailed report, documenting the amount of 5-,7- and 15-year property that qualifies for short-life depreciation.

Real estate appraisers or engineering firms typically have the knowledge to perform the detailed cost segregation studies, frequently at the recommendation of the owner’s tax preparer. Preparing the study requires expertise in evaluating real estate and complete command of the regulations that detail these depreciation options. Internal Revenue Code regulations outline approximately 130 categories of property, which qualify for shorter lives.

Cost segregation regulations contain a lot of variables that are not necessarily intuitive. The 5-year property includes items such as carpet and vinyl flooring. Seven-year property may reflect signs and parking lot striping. Fifteen-year property encompasses paving and landscaping.

Many CPAs Recommend Cost Segregation
Most property owners instinctively believe their CPAs are performing cost segregation for them, but research has suggested that this tool is used only 5% - 10% of the time. CPAs and other tax preparers may not routinely perform the study because it involves real estate appraisal methodology and specialized knowledge outside the scope of a typical tax practice. Even though cost segregation may be unfamiliar territory to some accounting professionals, it is highly praised by many accountants.

“Cost segregation is a powerful and necessary part of accurately calculating depreciation for real property,” comments CPA Bill Bandy of Blakely and Bandy, a Houston-based accounting firm. “A properly prepared study is invaluable to me as a CPA because it provides reliable support for preparing the depreciation schedule and reducing my client’s taxes.” Recent changes in tax regulations make cost segregation more attractive and allow it to be implemented years after the completion of a real estate purchase.

How Does It Work?
Historically, most depreciation schedules are split between land and long-life property. Long-life property depreciates over 27.5 years for apartments and 39 years for most commercial properties. A cost segregation study can typically allocate 20% to 40% of the improvement basis to short-life categories, and sometimes more.

High-income owners typically pay a 35% federal tax rate on ordinary income and a 15% rate on capital gains. The mechanics of reporting the gain on a sale usually allocate most of the gain to capital gains, which is taxed at 15%.

A cost segregation study actually reduces the amount of long-life property, which is recaptured at 25% by allocating more of the basis to the 5-,7- and 15-year property. If cost segregation is utilized from inception until a gain on the property is recognized, it can reduce the federal tax rate from 35% to 15% for most investors. The exceptions are C corporations, which pay the same tax rate for either ordinary income or capital gains.

How Much Can It Save?
The annual tax savings through cost segregation can be significant. The following table summarizes actual first-year tax savings generated in cost segregation reports prepared by O’Connor & Associates, a national real estate consulting firm.

A recent client of the firm realized a payback ratio for the first year savings at 4:1 and the payback ratio for the first five years at 20:1.

Who Prepares Cost Segregation Studies Today?
Appraisal and engineering firms, Big Four firms and spin-offs of Big Four firms are the primary providers of cost segregation studies. Some accounting firms offer the service but frequently outsource the actual report preparation to an appraisal or engineering firm. With the introduction of new providers, the price gap has widened between very low cost analytical studies and much higher large firm rates.

Do All Properties Benefit From Cost Segregation?
Cost segregation is typically effective and financially feasible for properties that have an improvement basis of $500,000 or higher.
Properties with a great deal of site-improvement, including landscaping
and parking, generate great results.

Cost segregation can be performed for properties anywhere in the United States. It is effective for apartments, office, retail, industrial, self-storage and many special use properties.

“Clients expect us to seek out and utilize tools which will minimize their federal taxes,” says CPA Sheldon J. Donner of Donner Weiser & Associates, P.C., an Atlanta-based CPA and consulting firm. “Cost segregation is an appropriate, conservative and cost effective tool to substantially reduce federal and state income taxes. Our clients have been extremely pleased with the results.”

When Should I Obtain A Cost Segregation Report?
“We routinely obtain a cost segregation study after purchasing an investment property,” said Jeff Harris, chief financial officer of Boxer Properties, a national property investment firm. It typically makes sense to obtain a cost segregation report the year a property is purchased or built. Property owners who purchased or constructed property after 1986,often can benefit substantially by recouping previously under-reported depreciation without filing amended tax returns.

Call Larry Brewster at 1-800-856-REAL(7325) for more details.

About the Author
Patrick O’Connor, MAI is president of O’Connor & Associates. The firm, in business since 1974, specializes in nationwide real estate appraisals, research, and state and federal tax reduction services. O’Connor is frequently acknowledged by national publications as a respected source of information on real estate trends.

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Perhaps one explanation for this change is the blurring line (at least in the minds of some consumers) between discount stores and more traditional retailers. A new upscale Wal-Mart Supercenter in the Dallas suburb of Plano aims to attract those consumers who can be convinced that the term “upscale Wal-Mart” is not an oxymoron, and who are none too pleased to toss sushi in their cart alongside their diapers and economysize
mouthwash. However, considering the popularity of non-“upscale” discount retailers, it appears that the new brand loyalty is price loyalty – simply buy from whoever gives you the absolute lowest price.

Is a price-obsessed public a good thing? On the one hand, few would react negatively to competition in the retail business. And we do get some great deals these days for many everyday items, but many would argue that the money we save is negligible. Will consumers’ current attitudes toward retailers last for the long term? Perhaps one day soon, the public will have a change of heart, and those retailers that do not focus
strictly on price will enjoy a resurgence. Then again, perhaps they won’t, and it will be just a matter of time before Wal-Mart leases the vacant Galleria space.

ABSORPTION
The Houston retail market took a step back over the last quarter, posting a negative 429,215 square feet (SF) of absorption, marking the first quarter of negative absorption in 12 quarters. Still-robust construction combined with substantial move-outs, most notably Mervyn’s, contributed to the negative figures. Annual absorption remains positive at over 1.5 million SF. Over the first quarter, every category except Strip Centers posted negative absorption,
with Regional Malls struggling the most.

Regional Malls had their softest quarter in several years, posting -469,464 SF of absorption. Annual absorption remains in the red, at -615,188 SF. Much of the negative absorption was due to Mervyn’s vacating large spaces in several regional malls, including First Colony Mall in the Far Southwest sector and The Woodlands Mall in the Far North sector. Demand for space in Community Centers further weakened, posting its second straight
quarter of negative absorption, at -22,088 SF. Annual absorption totals 788,570 SF, despite losses over the last two quarters. The Far Southeast sector brought down the market with - 114,920 SF absorbed. Neighborhood Centers struggled over the first quarter as well, absorbing -84,260 SF. Annual absorption currently stands at 922,988 SF. The Near West sector showed strong
demand with 33,805 SF absorbed, while the Inner Loop sector absorbed -65,993 SF. Strip Centers continued their strong performance, absorbing 146,597 SF over the quarter. This marks the 14th straight quarter of positive absorption for Strip Centers. The Far North sector was the largest contributor to the gain with 47,696 SF, while the weakest demand was recorded in the Near West sector with -10,472 SF absorbed.

OCCUPANCY
Retail occupancy fell substantially over the first quarter, losing 0.61 points and falling below 86% for the first time in two years. Average occupancy, at 85.95%, is at its lowest level in two years. Every market sector posted a decrease in occupancy, with Regional Malls taking the biggest hit, losing more than 2 points.

Regional Mall occupancy plummeted over the quarter, largely due to Mervyn’s move-outs in several area malls. Average occupancy lost 2.03 points to reach 86.76%, and now stands 2.64 points below levels at this time last year. The single mall in the Far Southwest sector, First Colony Mall, suffered a drop in occupancy of nearly 8 points, and now stands at 90.10%.
Community Center occupancy dipped 0.08 points over the quarter to 86.87%, its second straight decrease. However, occupancy has increased 1.52 points since this time last year. The highest occupancy is found in the South sector at 95.87%, while the lowest is reported by the Near North sector at 67.78%.
Neighborhood Centers recorded an occupancy decrease of 0.32 points to 85.40% over the last quarter, bringing the total decrease over the year to 0.44 points. None of the 13 sectors reports an occupancy currently above 90%; the Far North sector has the lowest occupancy at 78.75%. Occupancy levels at Strip Centers continued on a steady decline, decreasing 0.78 points
over the quarter to 84.70%. Other than a slight increase in the 1st quarter of 2005, occupancy has decreased every quarter for two years. The South sector continues to post the highest occupancy, at 93.12%, while the lowest occupancy is found in the Far West sector, at 77.07%.

RENTAL RATES
Despite lackluster performance in absorption and occupancy over the last quarter, rental rates continued to increase, posting a $0.01 per square foot (psf) gain. At $1.59 psf, rents are $0.04 higher than levels at this time last year and are at the highest level on record. The highest rents continue to be found in close-in parts of the city, while large amounts of newly constructed centers are driving up rents in some suburban areas.

Regional Mall rents increased $0.06 over the quarter to $3.04 psf, their highest level since the 3rd quarter of 2004. The Near West sector, which includes the Galleria and Memorial City Malls, continues to post the highest rents, followed by the Far North sector, which includes The Woodlands Mall. Community Center rents posted a modest increase of $0.01 over the quarter to $1.50 psf. The Near West sector reports the highest average rents at $2.19 psf, while the Near
Southeast and Near Northwest sectors have the lowest rents at $0.96 psf.
Neighborhood Center rents were unchanged over the quarter, and are up $0.02 over the year to $1.14 psf. The Near West sector boasts the highest rents at $1.53 psf, followed by the Inner Loop sector with average rents at $1.50 psf.
Strip Center rents continued their steady upward climb, increasing $0.01 over the quarter to $1.13 psf. Average rents are up $0.04 from this time last year. The Inner Loop and Near West sectors report the highest average rents at $1.59 psf, while the lowest rents are found in the Near Northwest sector at $0.76 psf.

MULTITENANT RETAIL SPACE BY CATEGORY
O’Connor & Associates divides multitenant retail space into four basic categories for purposes of analysis: Regional Malls, Community Centers, Neighborhood Centers, and Strip Centers. Based on the number of retail centers and square footage, Neighborhood Centers lead other categories with 48% of the overall Greater Houston retail inventory. The second largest category is Community Centers, accounting for 25% of the overall inventory.

Patrick O’Connor, MAI, is president of O’Connor & Associates. The firm, in business since 1974, specializes in state and federal tax reduction services, real estate appraisals and research and consulting nationwide. With offices in Houston, Dallas, Los Angeles and Newport Beach, the firm employs more than 130 people. Patrick O’Connor is frequently acknowledged by national publications as a respected source of information on real estate trends.

Cost Segregation Study Benefits
Benefits of a cost segregation study are substantial, immediate and enduring. Year 1 federal income tax savings are typically at least two times the cost of a cost segregation study. In many cases they are five to fifty times the cost of the study. The present value of federal income tax savings for a property held for ten years are typically at least ten times the cost of the study. In many cases, the present value of tax savings as much as 30 to 50 times the cost of the report. The cost segregation study is only required once. Its cost is not recurring, but the benefits are recurring during the term of property ownership. A cost segregation study can also materially reduce local property taxes by separating real and personal property for newly constructed properties.

Detailed Example
Preparing a cost segregation study requires only a limited time commitment from the owner, perhaps 10 to 15 minutes. This limited commitment of time results in substantial tax savings, which are both conservative in approach and well documented. Some owners believe their accountant is properly segregating components into the proper classifications. Many accountants cannot thoroughly research this highly specialized field to understand the myriad of items which can be segregated and are inadvertently overstating their client’s income tax liability. Furthermore, not obtaining a cost segregation study increases exposure in case of an audit since there is no clear audit trail. A cost segregation study prepared by an appraiser with expertise in land valuation, construction costs and market value clearly documents each of these items. Further, a cost segregation expert can almost certainly sharply increase allowable depreciation.

Who Benefits from a Cost Segregation Study
If you own real estate and pay federal income taxes or expect to during the ownership period for the property, you will benefit from the results of a cost segregation study. This is true whether the ownership to the real estate is titled in a corporation, limited partnership or limited liability corporation. For syndicators, a cost segregation study is appropriate if limited partners will receive material net taxable income during the holding period even if the general partner does not currently pay federal income taxes. The cost segregation study will increase depreciation shield, thereby decreasing and deferring federal income taxes for the investors.

Decreasing and Deferring Federal Taxes
Since a cost segregation study decreases and defers federal income taxes, let’s review the long-term impact of this deferral. When the property is sold, capital gains tax will be due if the owner does not enter into a 1031 exchange. However, capital gains tax rates are typically 20% - 25% for high net worth individuals, while the ordinary income tax rate is 35%. In addition, the deferral during the ownership period has material benefits because of the time value of money. All investors would much rather pay a 20% - 25% tax rate when an asset is sold as opposed to paying a 35% tax rate today.

When Should You Obtain A Cost Segregation Study
The best time to obtain a cost segregation study is when you build or purchase a property. Documentation is most readily available for performing a study and a contemporaneous property inspection can be performed to best document results. However, there are options to perform a cost segregation study for property which has been developed or purchased previously.

Elements of Preparing a Cost Segregation Study
The appraiser starts by gathering documents from the property owner and performing a site visit. As necessary, depending on the special-use property found during the site visit, the appraiser would confer with tax counsel and review relevant tax court decisions. For newly constructed properties, most of the costs detail can be obtained from construction draws or invoices from contractors. For existing properties, the appraiser performs a quantity take-off for 5-year, 7-year, and 15-year property and estimates replacement cost using recognized sources. The appraiser then values land, 5-year, 7- year, 15-year, 27.5-year and 39-year property based upon inspection, analysis and IRS regulations and court rulings.

Does this only apply to large owners?
Both large and small owners of income property or owner-occupied commercial property can benefit from a cost segregation study. Commercial properties with a cost basis of at least $200,000 will likely see a material benefit in excess of the cost from a cost segregation study. In fact, owners of single-family rental homes can probably achieve worthwhile benefits by obtaining a cost segregation study.

Qualifications to Consider when ordering a Cost Segregation Report
The ability to value land and real property are critical elements when engaging a tax reduction expert to perform a cost segregation study. In addition, it is essential they have a detailed understanding of rules for classifying 5-year, 7-year, 15-year, 27.5-year and 39-year property. The ability to justifiably increase short-life depreciation materially increases the benefits of a cost segregation study. While most accounting professionals have a rudimentary understanding of the 5-year, 7-year and 15-year property classifications, few have a detailed understanding of this highly specialized niche. Be certain the report provider has scrutinized both the federal income tax code and the meaningful tax court cases to allow you to maximize your depreciation and minimize your federal income tax liability.

Today, more apartment investors, especially those whose occupancy rates are challenged by the nation’s single-family housing, are taking a close look at every possible avenue to lower costs. That’s a frustrating task in the apartment business. One historically underused technique for saving money, in this case saving taxes, is to ensure that all depreciable items are reflected accurately on tax returns.

Those items are not limited to copiers, automobiles and heavy equipment. The list extends to a wide range of buildings and improvements. In fact, the IRS recognizes 130 items that depreciate over much shorter time periods than the standard depreciation of 27.5 years for an apartment community. Many of those items, such as parking surfaces, landscaping and even certain wall coverings, are present in large proportions on typical apartment communities.

A cost segregation analysis, when reflected on deprecation schedules, reduces taxable income now and also defers taxes on capital gain amounts until the community is sold. At that time, the recapture of taxes on the extra depreciation taken can occur at a much lower rate than the 35 percent max tax rate that was avoided with the extra losses.

Don’t forget the time value of money by deferring that inevitable tax by a few years. In light of the 130 IRS-identified “short life” items, this conservative tax-planning tool can help apartment owners allocate more costs to five-year, seven-year, 15-year and 27.5-year improvements versus the land value on apartment communities.

Apartment communities, according to IRS rules, depreciate over the course of 27.5 years. This is 10 years less than the depreciation estimated for office, retail and industrial properties, which equal quicker savings for apartment community owners. Items that are found in every apartment, such as carpet, linoleum, window treatments and appliances, are categorized as five-year items, meaning that they are typically replaced after five years of use.

Wide Range of Applications
Whether the community was recently purchased, has been owned for a while or is on the market to be sold, a cost segregation analysis can help at any stage of ownership by reducing federal income taxes and showing future depreciation. The optimum time to do this is preferably as soon as ownership is taken, whether the property was bought or built. Any commercial property built after Dec. 31, 1986, is eligible, and there are “catch-up provisions” to accommodate higher savings in the first year when a cost segregation study is completed for communities that have been owned for several years.

Communities of all sizes can benefit, from small communities of fewer than 10 apartments to communities that span several city blocks. If the property has an assessed value of at least $200,000, the cost segregation evaluation can almost always produce substantial federal income tax savings.

Preparing for a Study
A small amount of an owner’s time is required when working with a consulting firm that specializes in cost segregation. And it is advisable for the owner’s CPA or tax accountant to collaborate with the consultant, ensuring the most advantageous application for that owner’s particular financial circumstances.

The original purchase price of the apartment community is the cost basis, so owners receive savings on their initial investment, as well as on improvements. With research that is both quantitative (square footage of asphalt, pavement, ect., or quantities of wall or window coverings, ect.) and qualitative (judgment of remaining life) a specialized analysis and calculation is conducted before a report is issued. This report becomes the backup documentation for federal income tax returns.