Dena Cohen, Partner

In order to turn a profit, commercial landlords need to recover their operating expenses. In New York City, one of an owner’s largest expenses is the property’s real estate taxes, which can be passed along to tenants as additional rent in either a modified gross lease or a net lease. In a modified gross lease, the landlord’s expenses for the initial year, known as the base year, are included in the base rent, and the tenant pays its share of future increases. In a net lease, the tenant pays a lower base rent but is charged a pro-rated share of the landlord’s operating expenses, including real estate taxes.

All tenants need to closely study a property’s real estate tax status in order to project the cost of the lease and predict escalations. But tenants contemplating or negotiating an office, retail or industrial lease in a newly constructed, vacant or underutilized property need to pay particular attention to the nuances of base year taxes. That’s because the real estate taxes for these buildings are quite a bit less than real estate taxes for normalized buildings — a fact that often goes unconsidered during lease negotiations. But as the property stabilizes, the real estate taxes may sharply increase. To protect against these inflated tax increases, a tenant must first understand how real estate taxes are determined in New York City.

Background — Assessing New York City Real Estate Taxes

New York City real estate taxes are assessed by the New York City Department of Finance (“DOF”), which keeps a real estate tax fiscal year from July 1 to June 30 of the following year.

The method DOF uses to calculate estate taxes every year is complicated. DOF determines real estate taxes as a percentage of each property’s market value. For commercial real estate, the market value is based principally on the property’s net operating income, which is then capitalized by a factor to arrive at the market value. DOF obtains the property’s net operating income from a statement called the real property income and expense statement (“RPIE”), which property owners are required to file each year. It then factors in capital improvements made to the property, and in most cases calculates the assessed value as 45 percent of the property’s market value.

Why Understanding Base Year Taxes is Crucial

When tenants lease space in newly constructed, vacant or unstable properties, the taxes are often said to be “artificially low,” because DOF’s market value determination doesn’t include all of the income that can be derived from the property. One example of this is a tenant leasing office space in a building that’s still under construction. In this precompletion situation, the income and market value, and consequently the real estate taxes, would be far less than that of an existing office building that is near full occupancy.

However, the under construction building’s market value will increase as it leases up with rent-paying tenants. With income going from zero to normalized levels the building’s value increases significantly and so will its real estate taxes. Similarly, tenants that lease space in underutilized properties with major capital improvements on the horizon will likely experience similar property tax escalations over their base year. Even if a tenant occupies only a small portion of the property, a large increase in the taxes will result in that tenant paying a good deal more in rent than it anticipated. The bottom line is, tenants with leases that commence before, during and even after construction, capital improvements or lease up are underway, will likely experience a large and unanticipated increase in their real estate tax obligation, which will continue for the life of the lease.

Complications in Predicting Base Year Taxes

Tenants in these situations will typically see their taxes phase in over a five-year period. This mitigates some of the exposure but the increases are still painful. Even if a tenant occupies only a small portion of the property, a sharp tax increase will result in the tenant paying a good deal more in rent than it anticipated. To mitigate the potential for large increases, tenants should ideally strive for a base year in which the property is “fully assessed,” meaning that the income from the property is stabilized and major construction is completed. However, due to the complex nature of assessing the value of New York City real estate, it isn’t possible to precisely predict when a property will be fully assessed. To further complicate the situation, New York City real property is assessed for tax purposes based on its condition on the “taxable status date,” which falls on Jan. 5 every year. The assessed value on the taxable status date is the basis for determining the property’s real estate taxes for the next succeeding tax year beginning on July 1. Therefore, the real estate taxes in a given tax year aren’t a reflection of a property’s status on July 1, but are a window into the property six months earlier.

Calculating Base Year Taxes — Two Approaches

Various methods have been used to approximate real estate taxes during base years for properties that have not yet stabilized, all of which require the help of an experienced tax certiorari attorney. One approach is to scour comparable properties to find an agreed upon floor for base year real estate taxes. This works best in single tenant buildings, since there is less room for variations. Another method is to select a later base year with or without an interim payment based on historical increases. This can be helpful when there is insufficient information to even estimate normalized real estate taxes. Both of these methods lack precision and involve a fair amount of guess work, but they can enhance predictability.

Lease Negotiation Considerations

When considering a lease, tenants should closely examine whether the property is in transition, under construction or being repurposed. Armed with the facts, a tenant will be able to address its concerns regarding anomalous real estate tax escalations, and depending on the outcome of its negotiations, weigh the risks of potentially high tax escalations against any possible upside. For instance, the potential uncertainty that comes with an unclear base year tax assessment can be offset by other considerations, such as below market rents or government incentives that cover a tenant’s real estate or other tax obligations.

The nuances of base year taxes and the potential for sharp rent escalations can shock even the most experienced tenants. By understanding the facts before they come to the negotiating table, tenants can more effectively manage the base year process, and avoid unpleasant surprises.