Taxes and Real Estate
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.
Intuition suggests that the higher you tax something the lower its price becomes. The same is true of real estate. The National Association of Realtors (NAR) released a study in May of this year quantifying how much property values decline with discrete increases in tax rates. One example from their analysis is that for every 1% increase in the transfer tax rate there are 80,000 potential buyers driven from the market in California, alone.
Property taxes are the largest recurring cost of home ownership, other than the cost of acquisition. These taxes are recurring and changes in rates can effectively render homeownership impossible for large parts of the population. As an example, consider that in LA County tax rates are 1.25% of property value. With median home prices of $435K and median incomes of $43K, this seemingly small 1.25% translates into roughly 18% of after-tax income! A small change in this rate can be devastating to a family living on the margin.
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.
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