Real estate markets are extremely sensitive to tax policy. Changes to either transfer taxes or property taxes can seriously impact valuations, so the serious investor must be familiar with at least the basics. Transfer taxes are what we pay when transactions occur, and are typically based on a percentage of the sales price. Property taxes are annually recurring charged as a percentage of assessed property value.
Higher taxes mean lower property values. Simple, right? The National Association of Realtors (NAR) released a study this May quantifying the impacts of changes in both transfer and property taxes. It turns out that increasing transfer taxes increases the cost of buying and hence drives potential buyers out of the market. For instance, in California it is estimated that about 80,000 would-be buyers are crowded out of the market by every 1% increase in transfer taxes.
Property taxes show a bleaker picture and tend to influence prices even more. In Los Angeles County property taxes are 1.25% of assessed value, charged every year. Consider that 1.25% of the mediate home price (of $425K in 3/08) is $5.4K, which ends up being about 18% of after-tax median income (taken from the U.S. Census Bureau's QuickFacts, 2004 median income for LA County). Increasing this tax rate even slightly can render home ownership impossible for a large segment of the population.
Since property taxes translate directly into cost of ownership, they must effect market value. The way to compute the impact of an incremental adjustment to property tax rates is to apply a discount rate (the buyer's weighted average cost of capital, i.e. cost of debt plus equity) to the stream of negative cash flows (annual taxes) and compute its present value. Deduct this from current market values and voila, you've arrived at the magic value politicians will never cite when telling you childrens' futures depend on such and such tax increase. NAR's report arrived at a $13,000 decrement in property value for every $1,000 tax increase. Given current median home prices that translates into a 3% drop in property values for every 23 basis point (0.23%) increase in property taxes.
When times are good, the economy and asset values are soaring, no one seems to care about government spending hikes. All sorts of noble causes are championed by our noble politicians - everything from education at all costs, to healthcare for everyone - but when the economy turns sour and home prices plummet the inevitable consequence is government deficit. To cover deficits governments must increase taxes now or borrow and increase later. This only further hampers economic recovery. From an investor's perspective, it's imperative to understand how government cycles of spend, tax, fall-into-deficit, and tax more impact your bottom line. Keep up to date with your state's and local municipality's fiscal condition and anticipate changes to tax policies. Staying ahead of the tax game will give you a sharp advantage over your investor peers, and put you well in front of the pack as far as regular home buyers are concerned.
About the Author:
Rob Viglione is a author, hedge fund manager, and real estate broker. He has founded Viglione & Partners Assurance Group, L.P., SoCal Real Estate Advisors, Inc., and founded The Freedom Factory.
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