Trouble Ahead With DC Real Estate Taxes

Tax_Customer_Svrus-300x195In the 2015 tax year the District of Columbia will implement a new assessment method that will substantially increase real estate taxes for most office properties. This method relies on comparable sales instead of evaluating net cash flow. The result is that assessments are expected to rise such that $10.1 billion will be added to the commercial tax rolls, a 12.6% increase. This, ironically, at a time that the office vacancy rate is near its historical peak and the market is suffering from stagnant (if declining) federal demand.

This new valuation policy is also troubling because it ignores specific lease characteristics that may dramatically affect real property value. GSA-leased properties, particularly, could be disadvantaged by D.C.’s new assessments because the sales comparison approach fails to recognize the unique features and risks of federal leases, namely rolling termination rights, flat rents, atypical operating cost reimbursement and the likelihood of short-term extensions or downsizing (though the current assessment approach probably doesn’t account for this nuance either).

The threat to owners of GSA-leased properties is that, where leases are renewed with a replacing or succeeding lease (and not merely extended), a new tax base must be established. The “Real Estate Tax Base” is defined in the boilerplate GSA lease as the “the unadjusted [i.e. unabated] Real Estate Taxes for the first full Tax Year following the commencement of the Lease term.” Therefore, leases commencing between October 1, 2013 and September 30, 2014 will establish the actual taxes incurred in the 2015 tax year as the Real Estate Tax Base.

Given the huge pile-up of lease expirations this is no small issue. More than 3.3 MSF of GSA leases expire in the District of Columbia in the 2014 tax year. Though many of these leases will simply be extended (with no change to the original tax base) there is opportunity for a substantial number of new leases to be established under the 2015 base.

Any lease commencing between October 1, 2013 and September 30, 2014 runs the risk of a higher than anticipated tax base. Lessors will undoubtedly appeal the tax increase but appeals are determined and awarded retroactively. The problem is that, while the GSA lease asserts that savings from successful appeals must be passed through to the Government, it doesn’t specifically state that the Real Estate Tax Base will be reduced retroactively due to a successful tax appeal. Going forward, lessors would be wise to add some clarifying language to their leases.

Perhaps the bigger problem is for lessors of properties with prospectus leases because OMB has been slow to increase the full service rent cap. Rising taxes will put the squeeze on NOI and, for many downtown and CBD lessors, the prospectus cap already feels tight. Rising taxes are trouble for GSA too because, where the tax base has already been established, GSA will be responsible for reimbursement of the expected increases caused by D.C.’s new assessment method. Assuming, for example, typical taxes of $7.50 per square foot and an expected assessment uptick of 12.6%, GSA could incur nearly $23 million in additional tax reimbursements next year.

In the short run, GSA and its lessors will bear the brunt of these tax increases. In the long run the District of Columbia will. Both GSA and Congress have become increasingly vocal in their intent to reduce reliance on “costly leased space”. Given that the primary cost differentiator between federal leased and owned property is real estate taxes (the federal government doesn’t pay taxes on its owned buildings), the District of Columbia’s efforts to increase taxes on office properties will ultimately damage the core of its office tax base The federal government pays rent on 24 million square feet in the city.