Will Property Tax Adversely Affect Property Values?
With the upcoming implementation of Property Tax, several people have been wondering what effect, if any, the Property Tax will have on the market values of real estate properties. Bearing in mind that investors make up a significant portion of real estate market participants, there is a distinct possibility that the tax could have some effect on values.
When making investment decisions as to if to buy and what price to pay, investors place considerable weight on the Net Operating Income (NOI) of a property. The NOI of a property is arrived at by first estimating the rent a property could fetch on the open market. Assume for example that a property can rent for $25,000 per month ($300,000 per annum). From this figure, an investor will subtract a provision for voids (ie. when the property is vacant) and the average of the annual expenses (insurance, repairs, management, etc.) over the last 3 years which could total around $60,000.
The NOI of the property in this example would therefore be $240,000 ($300,000-$60,000) for which an investor, who requires a return of say 8% (fairly typical depending on the properly characteristics), would therefore be willing to pay $3,000,000 ($240,000 divided by 8%). The NOI would now have to be reduced by the new property tax expense of $13,500 (utilizing the property tax formula or a commercial property and assuming the rent matches the tax assessment). The adjusted NOI would now be $226,500 and using the investor’s required rate of 8% stated above, the investor would only be willing to pay $2,831,250 which is about 5.5% less than the previous amount. In the case of a residential property, the drop would be less while for an industrial property, the drop would be more.
However, while in this scenario it appears that the value of the property will drop, there are two other scenarios which could negate this. The first scenario if that the landlord/investor may try to pass on the new expense to the tenant by way of increasing the rent. If the tenant pays the increased rent, the NOI of the properly would remain the same and by extension, so too would the amount that the investor is willing to pay. The second scenario is that if the tenant does not agree to pay the increased rent, the investor may be forced to accept a lower rate of return (7.55%) on the property.
In summary, it would seem therefore that we can expect one of three scenarios:
- A small drop in property values
- A small increase in rents
- A reduction in the rate of return on real estate investments.
It is also possible that we could experience a merging of two or more of these scenarios. Only time will tell as to what will happen in the final analysis and will be determined by the market participants.