(This archived article was published in 2012. More recent data is found in the articles section of our web site).
The lack of commercial property transactions in the aftermath of the recession often makes it difficult to find comparable sales. Sometimes an appraiser may have no choice but to expand the geographic area researched into neighboring tax jurisdictions. Great care must be taken, however, because valuations that do not adequately reflect the potential impact that tax rate differences have on prices may widely miss the mark. We did the math on the composite tax rates for approximately 3,600 different taxing districts (tax codes) in Cook County. While we expected to see much variation in tax rates from town to town, we were frankly surprised at the magnitude of the impact these differences could potentially have on property prices. In addition, because it is often the case that effective tax rates are lower in the stronger market areas where more transactions are occurring, the natural tendency for appraisers to drift into such areas in search of comparable sales may result in a systematic bias toward overvaluation. It is generally accepted that communities with lower taxes can have a competitive advantage. The Appraisal of Real Estate
notes that "… a warehouse in a municipality with low property tax rates may have a higher value than a comparable warehouse in a neighboring community with higher tax rates…"The difference in value attributable to the tax rates would be reflected either as a location adjustment, or as an adjustment for economic characteristics. Intuitively, it makes sense that lower tax rates would result in higher prices. For example, in appraising around the O'Hare International Airport area, which lies at the border of the counties of Cook and DuPage, appraisers have long recognized that DuPage County tends to have a more favorable tax structure than Cook County. This makes appraisers reluctant to use comparable sales from DuPage County when valuing a property in Cook County, and if they do, they will usually make a location adjustment. But what about properties located in different towns within Cook County itself? How well appreciated is it, for example, that the difference in tax rates between the City of Chicago and neighboring Franklin Park (both in Cook County) is twice as large as the difference between Chicago and Bensenville, in different counties? Would the need for an adjustment of such scale be as readily recognized? To be sure, if property owners receive better services because they pay higher taxes, the tax effect on value is reduced; nevertheless, if all other factors such as location and the quantity and quality of public services are equivalent, then research has shown that higher taxes tend to lower property prices. In a 2006 article, McDonald and Yurova report on research into 419 industrial building transactions in the O'Hare area, which occurred in the time period from 2001-2004. The authors found that after controlling for other influential factors such as building size, land area, truck docks, ceiling heights, etc., a property tax differential averaging 263 basis points was associated with properties in Cook County selling for 16.2% less than comparable properties in DuPage County. Roughly, that equates to a 6.06% drop in sale price for every 100 basis point (1 percentage point) increase in effective tax rate. Although their research focused on industrial properties, it is reasonable to expect that it would apply to other commercial properties as well, whether, office, retail or industrial. After all, property taxes are usually among the highest commercial real estate operating expenses and weigh significantly in a buyer's purchase price decision. Owners cannot force the burden entirely onto tenants because the tenants would demand lower rents to keep overall occupancy costs competitive with neighboring jurisdictions. Under the assumption that the gross rents and other operating expenses, excluding real estate taxes, are similar the difference in the tax loaded capitalization rate provides an apt proxy for an adjustment for location or economic characteristics. (The tax loaded capitalization rate is the sum of a property's cap rate and its effective tax rate, which, when applied to net operating income before real estate taxes, yields an estimate of property value in situations where taxes are not known or are dependent on a property's value). Here is how this might this look in the O'Hare area when we do the math to a property being valued in Des Plaines as an example. The subject has a 2012 composite tax rate of 8.477%. When multiplied by the current assessment rate of 25% and the state equalization factor of 2.8056, the resulting tax load is 5.946%. Adding a market derived cap rate of 9.5% renders a tax loaded cap rate is 15.446%. A sale in Bensenville, in Addison Township in DuPage County would have a tax rate of 8.298%. When multiplied by the current assessment rate of 33.33% and the state equalization factor of 1.0000 for DuPage, the resulting tax load is 2.766%. Adding a market derived cap rate of 9.5% yields a tax loaded cap rate of 12.266%. Then [(12.266/15.466)-1] = -21%. All things being equal, the sale in DuPage County is superior to the subject by virtue of its lower tax burden and would require a -21% adjustment for location or economic characteristics. Incidentally, this adjustment is very close to what McDonald and Yurova found in 2006. Applying the same logic to cities and towns in Cook County in the vicinity of the airport reveals these comparisons:
Composite Tax Rate
Subject (Des Plaines)
Elk Grove Village
Bensenville (DuPage County)
In some cases, such as neighboring Park Ridge, the adjustment is insignificant. In others, such as Franklin Park, Northlake, Schiller Park, it is surprisingly large. The higher tax burden in these areas suggests that sale price would have to be adjusted upward by 11% to 21% to put them at par with Des Plaines. Also noteworthy is that there may be significant variation in tax rates within the same municipality. Due to the scarcity of sales in the current economic environment, an appraiser may be forced to extend the geographic area researched in order to capture a transaction and in so doing, may be drawn to a stronger location. If not appropriately adjusted, this may result in overvaluation. Valuations in the south suburbs are especially susceptible because it is here where some of the highest effective tax rates in the region are found and where transaction data is particularly scarce. The inclination would be to extend the geographic area researched outward, even into the southern fringe of the City of Chicago, with its generally much lower tax rate. So, all things being equal, a comparable sale in Chicago, having a composite tax rate of 6.14, when compared to a property appraised in Richton Park, with a 15.214 tax rate, would require a -31% adjustment. It is not well appreciated that, the differentials in effective tax rates between jurisdictions within Cook County can be greater than across county lines. The range of composite tax rates for 2012 across all of Cook County is extreme—from 6.396 in Chicago and 6.579 in Northfield for example to 28.787 in Park Forest and 31.872 in Ford Heights. The adjustment a Chicago comparable would require relative to the Ford Heights property would be -56%! Communities in weaker markets may become mired in a vicious downward cycle. As realty values fall, tax rates are bumped up to keep pace with local government's fiscal needs. Owners have less money to devote to upkeep and property values fall further to disinvestment; and taxes have to be raised up again. The area becomes less attractive to businesses and investors lower demand and contributing further to disinvestment. This means that there are fewer property transactions in higher tax areas. Assessments based on transactions occurring in stronger markets could result in overvaluation for ad valorem tax purposes, perpetuating the cycle. Our research shows the importance for increased awareness by appraisers, lenders and users of appraisals, of the effect that differences in tax rates can have on properties within the same county; the potential impact can be profound, even for districts that are side-by-side.  Appraisal Institute. The Appraisal of Real Estate
. 13th ed. Chicago, 2008: 341.  McDonald, John F., PhD, and Yuliya Yurova, "Are Property Taxes Capitalized in the Selling Price of Industrial Real Estate?" The Appraisal Journal
, Summer 2006, p 250-256.