The Case for Value in Use

 Most property tax assessments rely on a value in exchange model. For example, Ontario's Assessment Act defines current value (the basis for Ontario property tax) as:

"in relation to land, the amount of money the fee simple, if unencumbered, would realize if sold at arm’s length by a willing seller to a willing buyer; (“valeur actuelle”)"

The result of this is a growing body of case law that elevates sales transactions to the level of absolute truth. A quick search of the terms "sale of the subject property" and "best indicator" yields over 200 separate decisions from Ontario's Assessment Review Board alone. The logic behind such a choice seems iron-clad. If current value is defined as the money generated in an arm's length sale, then any arm's length sale must be the current value.

 Of course, we can readily see the danger in this sort of syllogism if we examine it for a moment. Reasoning with a parallel structure would be "all dogs are mammals, therefore all mammals are dogs." One cannot simply apply simple statements backwards and forwards without considering the implications.

So what of real estate sales? Are there sales which are not current value, in the same sense there are mammals which are not dogs? Of course there are. The very definition of current value implies such when it references "arm's length" sales. Sales between related parties clearly do not represent current value, at least under the definition. If you sell land to your uncle, the assumption is that it is not current value; you likely gave your uncle a deal. Now, this might not be true - maybe you don't like your uncle, or maybe you really need the money and can't afford to give him a deal. Maybe your uncle is a money launderer, and he has paid you above market for the land, and he is going to sell it off to someone else in his conspiracy.

The point is - with non-arm's length transactions, you just never know. The sale price could be below, at, or above the actual "current value." What does this have to do with value in use? Let's turn to that.

 

Value in Use vs Highest and Best Use

In recent years many taxpayers in active markets (such as the Greater Toronto Area) have been hit with assessments based on potential uses. The way it usually goes is this:

1.       A property is sold for a much higher value than expected, apparently because it will be redeveloped to some higher and better use.

2.       The assessor revalues the sold property by hitting the sale price.

3.       This creates an inequity with the neighbors.

4.       The neighboring properties have their assessments increased as well. If the first property is worth so much money, surely the similar adjacent land is also.

Did you see the logical error? It is much more subtle when broken into four steps. It occurred in step 4 - "If the first property is worth so much." Who says it is worth that much? A buyer and a seller. But surely a buyer and a seller could be found who would have arrived at an altogether different value.

Now at this point, many tax assessors will object to introducing speculation into the process. "We have to rely on the data before us," they will proclaim. The problem being, the data before them is often limited, and it is often selected with a strong confirmation bias. Sales which work in the opposite direction, in which sellers part with a property for less than expected, are routinely discounted as "distress sales" and coded out. Why is the distress of the seller relevant but not the desperation of the buyer?

 

What Motivates a Buyer?

The thought processes of buyers are key to understanding any transaction, but yet are seldom discussed in the literature. The general principles of appraisal deal with them, but they are often only considered in the most crude and simplistic way. For example, the sales and cost approaches to value rely on the principle of substitution, that nobody would pay more for a given property than the value of a similar substitute. This sounds like a good justification for raising an assessment because the neighbors land sold. After all, surely the buyer was motivated normally, and looked for an alternate property.

Lets consider the issue, but with simple chattels. I won't pay more for a TV at one store than it sells for at the neighboring store. But what if I am in a small town, and it would be a long drive to get a better deal? Or what if the best price is on Amazon, but I want the TV today? Then I might overpay. In truth, two properties are seldom identical, rendering the principle of substitution much harder to apply than it at first seems.

 A fascinating, yet very technical, discussion of investor behavior is found in the paper "On the Statistical Differences between Binary Forecasts and Real World Payoffs" by Nassim Nicholas Taleb, author of The Black Swan and Skin in the Game[i]. A big part of Taleb's general thesis, and part of this paper, is the idea that a wise investor makes investments where the downside risk is limited, but the upside risk is not.

This is the premise of shows like "Shark Tank" and "Dragon's Den," where wealthy investors put up what are (to them) relatively small amounts of cash for an ownership stake in a start-up business. If the business flops, they are out a hundred thousand dollars, nothing to a billionaire. But if the business thrives, they could end up owning a large part of a multi-billion dollar enterprise. If you could go back to 1994 and offer Jeff Bezos $100,000 for a third of Amazon, would you do it? If you had the money would you pay $1,000,000 for 1%. Of course you would, and it would be the best investment you ever made. That does not mean that it was worth $100,000,000 in 1995, when it was run out of his garage.

 Translate this into land. Imagine a farmer with a parcel of land near a major highway, several kilometers from a rapidly growing metro area. Our farmer has no interest in selling; he raised his family here, and loves this land. Then a vastly wealthy land speculator approaches him, offering him money beyond his wildest dreams. Why? Because the speculator believes that real estate allows for "fat tails" in rewards, that the city will continue to expand, and one day this land will be worth far more than he is offering. This does not prove that the land is worth the sale price, anymore than Amazon was worth $100,000,000 in 1994.

 

Value in Use (or Value for the Only Proven Use)

So how do we deal with this issue? Fortunately, nothing too novel is needed to resolve this dilemma. Good appraisal practice already equips us with the tools needed, without violating the Assessment Act.

First, note that I am not advocating what is traditionally called Value in Use. While this is appropriate (and legally required) for some properties in Ontario, such as farms and railway properties, it opens up a whole host of problems if generally applied. The factory which is long past its economic life, but which is still used because the owner hasn't got the cash flow or available options to move somewhere else comes to mind. It wouldn’t sell, couldn’t be rented, and nobody would rebuild it. In the case of properties such as complex industrials, a well applied cost approach, with carefully calculated obsolescence, is still the best bet.

What about our farmer though? Should his former neighbors now have their assessed value shoot through the roof just because a land speculator found the limit of the farmers sentimental attachment to his land? That would clearly be unreasonable. Good appraisal practice helps us in two ways.

First there is the often misapplied term "highest and best use" (HABU").  This term is often used to justify the increased assessment, but it rarely is a good justification. One requirement of highest and best use is that the proposed use be legal. If the current zoning doesn't allow for a use, it isn't legal. Full stop. The definition of Highest and Best Use starts with "The reasonably probably and legal use."[ii] Some have read that to mean that the use is "probably going to become legal," but that isn't what it says. The use must be legal today. (Arguably, it must have been legal on the valuation date, currently January 1, 2016 in Ontario.) A use can be legal and not probable. Seeing the basic logical error in "probably legal" would solve at least half of the problem. Removing the outright speculation from the process, and valuing based only on demonstrably probable and legal uses, would work, and is really what good appraisal practice demands.

The other appraisal practice which would help is applying more than one approach to value. Despite the Board's preference for sales comparison, and the frequency of the cost approach, most investors prefer an income approach. The reason is obvious - they want to make money. Most people (and all investors) like money. So, look at the field next to our farmer's now sold parcel. What would it rent for? Would its rent, and any reasonable cap rate, justify a value similar to what the land speculator paid? Of course not. So you are still developing a “value in exchange”, just one which recognizes the very real limits imposed on the property.

 What is in fact happening in the GTA is that 'additional rent' (the charges, such as property taxes, which are flowed through to the tenant) is now larger on some small offices and retail properties than is the base rent. This calculation should immediately tell the assessor something is wrong - when a 1.5% tax is more than the base rent going to the owner. That would essentially mean that the property would sell at a 1.5% capitalization rate. Yet for nearby properties on which the assessor applies the income approach, they use much higher cap rates. Do you see the problem? In their quest to avoid inequities, the assessors have created harder to justify inequities.

 

What's an Assessor to Do?

Implementing this sort of logic would be the easiest thing in the world for the assessors. They already have codes for non-market sales, non-arm's length sales, and estate sales. Simply start coding some sales as "speculative sales" and recognizing their non-market value nature.

The puzzling thing about this is that nobody wants the vastly increased assessments. It obviously hurts the taxpayer. Contrary to what many believe, the cities don't want these inflated assessments either - they don't actually generate additional tax dollars. Since these new values come out with a general reassessment, and the tax rate is calculated (in very rough and obviously oversimplified terms) by dividing the budget by the assessment, the vast increase in the value of a few properties serves to (slightly) reduce the overall tax rate. What does happen is some individual business owners get clobbered, and bad publicity abounds.

 

What Can a Property Owner Do?

The only solution available to the business owner affected by this sort of revaluation is to be vigilant about your assessment. Many don't realize what has happened to their value until the tax bill comes out, which is conveniently months after the appeal deadline. Watch your value, and if need be, appeal. As I have outlined above, the logic behind these 'alternate use' values put forth by MPAC is far from iron-clad. A well presented case by a qualified expert has convinced many a board member.

 

 

[i]https://www.academia.edu/38962327/On_the_Difference_between_Forecasting_and_Real_Life_Payoffs?email_work_card=title

 

[ii] The Appraisal of Real Estate – Third Canadian Edition, 12.1