Tax Court Shuns Traditional Survey Derived Capitalization Rate Determinations and Champions Reliance Upon The Band of Investment Technique Instead

In a recently decided case 3 University Plaza SPE, LLC v. City of Hackensack 5002-2014, 1670-2015, 3553-2016, 1163-2017, 3768-2018, 12891-2019 – 3 University Plaza SPE LLC, et al. v. Hackensack City (njcourts.gov) concerning a large 225,000 square foot class A office building, the Tax Court addressed the valuation community’s on-going debate as to whether certain reoccurring expenses (such as tenant improvement allowances and brokers’ commissions) should be treated as so called “above” or “below” the line adjustments when calculating the all-important net operating income of an asset. 

Due to the fact that the Income Approach to value is the well-recognized leading methodology employed when dealing with income-producing properties, the determination of a property’s stabilized net operating income is critical to arriving at an appropriate and supportable fair market value determination.

Because the 3 University Court concluded that these categories of expenses are “in the competitive market” “annually reoccurring” operating expense and “needed to stabilize occupancy and preserve the value” of the property, they must be treated as “above-the-line” adjustments affecting net operating income.  In addition, because the Tax Court recognized that the major industry surveys report capitalization rates based upon the survey participants’ treatment of tenant improvement allowance and brokers’ commission expenses as “below-the-line” adjustments, (therefore not impacting net operating income), these surveys (e.g., American Council of Life Insurers Investor Bulletin Tables and PwC Real Estate Investor Survey) cannot be relied upon in concluding appropriate capitalization rates for use in the Income Approach valuation method.

On the other hand, the Band of Investment technique for deriving capitalization rates is a method that relies upon market determinations of appropriate mortgage interest rates and equity dividend rates, neither of which are directly impacted by a property’s net operating income and the divergent treatment of tenant improvement allowance expenses or brokers’ commissions.  As such, the Court concluded that the Band of Investment technique “provides the most accurate and reliable method of deriving a capitalization rate because it is not polluted or impacted by questions of how potential survey recipients perceived hypothetical transactional questions or how a market perceives an annually reoccurring operating expense.”

As a result, the Tax Court’s holding in this case, although a trial level decision and not binding on other courts, does provide a well-reasoned analysis and approach that should serve to better guide the valuation community as to best practices when determining stabilized net operating income and fixing appropriate capitalization rates  — two integral components of the Income Approach to value.