Property Tax Post: Dark Stores, Property Tax and the Changing Face of the Retail Industry, Part Three

part 3

It’s that time again. And by that, I mean it’s time to delve back into our discussion of the so-called “dark store” controversy. In Part One of our three-part series, we offered insight into how this great debate erupted, while Part Two highlighted the position of big-box retailers. In this final installment, Part Three, we will continue to highlight the controversy surrounding built-to-suit retail property with a detailed look at taxing authorities’ position on the “dark store theory.”

With responses from Jack Van Coevering, Esq., of Foster Swift Collins & Smith P.C. and Kathryn Myers, Esq., the Assistant County Counselor for Johnson County, Kansas, this installment of our series covers the full spectrum of opinions about the “dark store theory,” demonstrating how truly divisive the issue has become. Myers, speaking in her individual capacity and not as a representative of Johnson County, the state of Kansas or any other organization, believes this dispute cannot be reconciled voluntarily and opines that “appellate decisions and/or legislation will resolve [the] issue.”

Our experts’ answers to the questions below illustrate why some may agree with Myers that without intervention by state courts or state legislatures, there is no end in sight for “dark store” litigation. It seems, as Van Coevering points out, the “mechanics” of valuing big-box or built-to-suit properties are the center of the controversy.

Check out their answers and opinions to get some insight on where they each stand on what Myers prefers to call the “as-if-vacant” controversy.

Bloomberg BNA: What standards and methods do most jurisdictions use to determine the value of built-to-suit commercial properties? Are there geographic limitations on where local taxing jurisdictions can look for comparable built-to suit properties? How might taxable value of these particular properties differ if comparable properties are operative and located in thriving areas, for example?

Van Coevering: Michigan statutes define “true cash value,” the state’s concept of market value, in part, as the “usual selling price” of the specific property “being the price that would be obtained in a private sale.” The Michigan Supreme Court has held that this definition requires all three standard methods of value to be used—comparable sales, cost-less-depreciation and capitalization of income. The court has also explained that the purpose of requiring all three standard methods of value is to provide checks on any single valuation method—that is, as the court has explained, to correlate, reconcile and weigh the analysis in each method to ensure all physical aspects of the property are accurately valued. When data in a particular approach is speculative, the court has required less speculative valuation methods be utilized. The Supreme Court has also found that the “usual selling price” is the same market price that would be used in the market or for all other purposes, such as sale, refinancing, etc. In Michigan, commercial properties are valued no differently than any other properties.

On those points, the "“dark store” theory disagrees. The theory is premised on a claim that any property owned by a national retailer (as opposed to locally owned commercial property) is unique and claims entitlement to an exclusive method of value for property of national retailers: comparable sales for owner-occupied properties and capitalized income for leased properties. To the extent the property is unique, it is because national retailers use anti-competitive deed restrictions to prohibit all commercial retailers—national and local—from purchasing the property. Second, the “dark store” theory openly advocates for an approach to value that is reserved for property tax appeals, whether or not the approach has currency with buyers and sellers or the national retailer. The result is a valuation approach that leaves out most of the process and testing in standard appraisal practice for an exclusive valuation method for national retailers. The national retailers argue that their anticompetitive business practice—deed restrictions—must be considered in valuing property.

The theory is “dark” not because the stores are vacant, but because deed restrictions and anti-competitive business practice make the stores non-conforming under zoning laws, dramatically hinder marketing and require substantial conversion or demolition of the property to a non-commercial use. The stores are “dark” for substantial periods before they can be sold. The theory itself is also “dark.” Much of the theory is built on over-generalized statements without proof, without substance, without the normal appraisal methodology used to test, correlate and substantiate values. The theory asserts, for example, that the standard cost approach methodology is conceptually improper; that “big-box” stores, while ubiquitously constructed, are nearly entirely functionally obsolete; that the stores are so obsolete that the property is worth less than vacant commercial land; and that the public service improvements have no value.

You have used the phrase “built-to-suit.” I consider that term to apply only to situations in which a developer builds property to a tenant’s specifications and then leases it to the tenant under a long-term lease, often at a lease rate that recovers development costs and is higher than the market rental rate. Examples might be Kohl’s, Walgreens and CVS. That situation presents issues in the capitalization of income method that may not exist in owner-occupied big-box stores, like Lowe’s, Home Depot, Walmart or Menard. By statute, Michigan presumes that actual rental income is not controlling. Different considerations of value apply to owner-occupied “big-box” stores than to “built-to-suit” junior box stores. “Built-to-suit” stores and “big-box” stores are nearly exclusively national retailers, and the “dark store” theory has little use to local businesses, regardless of the size of the retail store.

Bloomberg BNA: What kind of comparable properties do built-to-suit commercial retailers and similarly situated companies think should be used to value operating built-to-suit properties, and why do these entities believe this is an appropriate measure of market value?

Myers: The value of properties should not be based only on its sale price or its actual contract rent. Mass appraisal requires the use of market rents. This requires consideration of the rents for the other retail properties in the immediate location of the single-tenant property and similar locations. The single-tenant property should have a value that reflects the quality of its location, the quality of construction and its physical condition and that may be more, less or equal to its contract rent. The capitalization rate also should reflect these factors.

It is questionable that retailers believe the as-if-vacant methodology they promote. For these retailers, the end game is always to lower property taxes, and how the game is played is inconsequential. The methodology does not comport with real property law or generally accepted appraisal practice, but there is a minority group of stakeholders who earn their incomes promoting the methodology. The only authoritative text that I have seen accepted by the courts on appraisal practice, The Appraisal of Real Estate, 14th ed., does not equate “fee simple absolute” as “vacant.” Additionally, the International Association of Assessors does not interpret fee simple to mean “as-if-vacant,” but instead, teaches the same methodology as in the AI—that “fee simple” means at market rent in a stabilized condition (market vacancy and collection loss). A handful of articles assert the idea that “fee simple” means “as-if-vacant,” but the articles are not authoritative nor generally accepted.

The A investment class retailer [an A investment class retailer refers to a big-box or similarly situated commercial retailer] asserts that the difference in value is because the assessor is valuing the creditworthiness of the tenant. No! It is the value of the real property. Part of determining market is to determine who the most likely buyer is.

The quality of the real property and the tenant drive the market selection. Investment class A single user/tenant sells in this national market. Its market will change over time. By the end of its useful life to the original user, the market likely to be entirely different. It will no longer be a class A investment attractive but rather class C or D investment attractive and ready for a different use, such as a warehouse [Class C or D investors are potential buyers intending the property to be used in a manner differing from the A investment class buyer’s use due to changes in the market]. This is the problem. The A investment class tenant wants to have a market value that is the same as the C or D investment class property.[1] It defies common sense, it is not an accepted appraisal practice and it arouses a heated reaction.

A single-tenant property that sits empty on the market indicates either 1) the location is not that good at least not for the original tenant and/or 2) the property may have deed restrictions that artificially change the property’s highest and best use. This empty property is not truly comparable to a thriving property and reduces the value of the thriving property. Valuing a big-box or built-to-suit properties this way also violates uniformity.

Bloomberg BNA: Some opine that valuation methods that take use by a built-to-suit commercial property owner into consideration have fueled “dark store” litigation. How can the value to the present user reflect what the value of the property might be in an open market? How is a property’s market value different if an occupant’s present use is considered in determining market value? Are there states that currently take this into consideration when valuing built-to-suit commercial properties and are there instances where courts have upheld this method of valuation?

Van Coevering: The value to the user is not relevant to the valuation of property. However, the property’s current existing use is a starting point to determine the market for the property, i.e., is there demand for the property, will the property have to be substantially converted to some other use and what will those costs of conversion be? In short, the premise for valuation is the property’s highest and best use (the reasonably probable and financially feasible use that results in the highest value). Any state following standard appraisal principles and practices would begin with the property’s current use to determine whether there is a market for that use. To argue that there is no market for a recently built big-box store that is located in a commercial corridor of other similarly-structured big-box stores, which continue to be built across the United States, is not supported by standard appraisal practice.

A completely user-neutral method of value is the cost-less-depreciation approach, which develops a market-based cost value for a similar structure of optimal utility, without any unique characteristic reflective of a particular user. This is exactly the approach that “dark store” theory complains is, per se, invalid.

There is a distinction between the consideration of existing use in determining how the market would regard the property (the highest and best use of the property) and the methods of valuation. The standard replacement cost approach values a “big-box,” is market-based and is not the actual costs used for any specific retailer. Though purchasers would relate a sales price to the cost to build a new building of optimal utility, “dark store” theory per se rejects that aspect of appraisal practice.

Myers: Appraisers must consider the use for which the improvement was designed. The user is not considered. There is an important difference between “value in use” and “use value.” Appraisers wrongly use the terms synonymously. “Value in use” is an obsolete term that is replaced with the term “investment value.” “Investment value” is the value a particular improvement has to the actual owner or user.

As explained above, a box can be used by the same or similar users. This is what is known as the use value, the economic concept of substitution.

Use value and market value can be the same. If highest and best use is the continued current use then use value and market value are the same. If the highest and best use is for a different use, than use value and fair market value will likely differ.

Appraisers tend to give the cost approach cursory reliance on the assertion that it is too difficult to estimate appreciation. That is not a valid excuse. It is no more difficult to estimate depreciation than it is to quantify adjustments in the sales comparison approach or a capitalization rate for the income approach. In fact, many courts will rely on the cost approach when there are issues with the other approaches, because sufficient and reliable data is lacking. This is especially true if the property type does not trade frequently in the market or is highly specialized. For built-to-suit properties, the cost approach is a very good indicator of value, as the cost to construct is the overriding feature of built-to-suit property, and these properties are well maintained so that depreciation is nominal over time compared to other property types. The cost approach also inherently values the fee simple estate in a stabilized condition, removing issues for these properties complained about in the sales comparison approach and the income approach.

Bloomberg BNA: “Dark store” litigation is a contentious issue because property tax revenues are a major source of funding for local governments. Due to the relatively high value of commercial property compared to residential property, a “dark store” valuation can have a significant impact on a taxing jurisdiction and who carries the majority of the tax burden. Is there a way to reconcile competing interests of residential and commercial property owners?

Van Coevering: No. The differences reflect the same dynamic that drives out local retailers. The dynamic reflects the fact that national retailers are not invested locally—in local education, health services, economic development, etc. “Dark store” theory is transparent: use a different method to value national retailer than would be used to value local retailers. For example, a deed restriction for a pharmacy building may mean an entire neighborhood no longer has a local pharmacy.

Myers: “As-if-vacant” is not contentious because it involves property tax. It is contentious because both sides are adamant in the methodologies they want to apply to arrive at value. Property owners want to pay less and have a personal motivation to reach the lowest value possible. The mantra that retailers want to be “good corporate taxpayers and pay their fair share” is demonstrably in conflict with the actions the corporation takes in tax appeals. No one can seriously state that a fully functional, well-maintained and fully occupied property has the same value as a vacant property.

On the other hand, assessors are accused of the opposite. They are accused of trying to push the value as high as possible. I do not know of any jurisdiction where the assessor or an employee is paid based on tax dollars saved or penalized based on tax dollars lost, which is not the case for tax representatives and attorneys that represent taxpayers. Most assessors are looking to get it right. There is no monetary incentive for the assessor, but there is a personal incentive to maintain a good reputation.

There is another reason why assessors would not want to push the envelope. Property values and the corresponding taxes paid are the basis for budgeting, and the budgeting assumes the historical receipts will reasonably reflect future receipts. If an assessor consistently and purposely overstates values, the budget process would be adversely affected. In Kansas, for instance, under these circumstances, the county who employs the appraiser is obligated to issue a refund, and it would also be required to pay interest on the refund from its general fund.

Reconciliation of these interests is not likely to be voluntary. The sides are too polarized. Appellate decisions and/or legislation will resolve the issue. While the nation and many states are pro-business laden, the voter bloc is residential homeowners. Residential homeowners, once they realize what is happening, are vocal and forceful.

Bloomberg BNA: E-commerce giants like might be setting up brick-and-mortar retail locations in some states, while established national retailers are struggling to keep the lights on. Considering this theory’s success, do you think we can expect to see state legislatures stepping in to prevent built-to-suit retail properties from being valued according to the “dark store” theory? If so, what might this legislation look like?

Van Coevering: Possibly. The problems are a well-funded national retailer lobby, a complicated appraisal problem and the nation’s most hated tax, the property tax. “Dark store” theory highlights a lingering problem with property tax: the lack of uniformity. Well-funded taxpayers that appeal an assessment obtain reductions that most taxpayers will not see.

Many states have general definitions of market value but ignore the mechanics of how to determine it. States have allowed the blank sheet to be filled by “experts” with their own twist on market value. States have forgotten that the same group of experts (retailer appraiser advocates) that contributed to the savings and loan debacle and gave us the Financial Institutions Reform, Recovery and Enforcement Act are the ones determining law in their states.

There is much value in legislation that explicitly details general appraisal practice such as the determination of highest and best use, the treatment of vacant properties and the use of the three standard approaches to value. The less “interpretation” given to appraiser advocates, the more will be given to states in uniform administration of their property tax laws.

Myers: If generally accepted appraisal practice is understood and applied, whether anyone truly understands what fee simple absolute actually is, the “as-if-vacant” concept would die. It has been tried by other property types and it was not very successful. It goes against common sense. If there is a loophole, as in Michigan, the loophole will be closed. In states where [it] has not taken hold, and frankly, outside Michigan and Indiana, it has not been all that successful, although Wisconsin may be at risk, the courts will shut it down.

Legislation that prohibits deed restrictions designed to protect a retailer and without any benefit otherwise would be a good start. These restrictions should be viewed as egregious and against public policy. The restrictions lead to the long-term vacant property. A vacant property falls into disrepair. The neighborhood gets a poor reputation and, eventually, it leads to blight.

Considering our experts’ responses this week compared to those of our expert last week, it’s no surprise that the jury is still out on the “dark store” or “as-if-vacant” controversy. As this series clearly illustrates, there are few topics concerning property tax that have garnered as much emotion as the controversy surrounding the valuation of big-box or built-to-suit commercial properties. We will continue to follow and report on developments in this area as things inevitably heat up.

Continue the discussion on Bloomberg BNA’s State Tax Group on LinkedIn: Do you think the “dark store” controversy can be resolved without court or legislative intervention? Can state courts and legislature streamline the mechanics of determining a big-box retailer’s market value?

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[1] New York uses the NNN (triple net lease) market as the source for rents after a tedious battle with Rite Aid. Rite Aid’s petition for review with the U.S. Supreme Court on equal protection grounds and the petition was denied. See, e.g., Rite Aid Corp. v Hayworth, 15 N.Y.S.3d 523, 130 A.D.3d 1510 (2015);Rite Aid Corp. v Huseby, 13 N.Y.S.3d 753, 130 A.D.3d 1518 (2015).