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 staple of revenue for local governments, and tend to be the largest non-acquisition cost of ownership. These vary by locality, but in Los Angeles County are 1.25% of assessed property value, charged annually. This translates into hefty recurring bills, especially for new buyers. For instance, 1.25% of $435,000 (the Apr ‘08 median home price in Los Angeles County) is $5,438. Per the U.S. Census Bureau’s QuickFacts, 2004 median income for the County was $43,518. Because of the sickly confusing amalgamation of local, sales, state, and federal taxes, let’s just assume a rough 30% net tax on income, which adjusts the median take-home income down to $30,463. On this basis, an inocuous-looking 1.25% property tax translates into 18% of after-tax median income. Granted, income figures were taken from 2004 data and may need upward adjustment, but given modest increases in take home pay over the last four years this is not likely significant.
Financiers undrestand that as you increase the cost of ownership you decrease value. Using discounted cash flow methodologies NAR was able to estimate that for every $1,000 increase in taxes there is a $13K decrease in home values. For properties valued at the median, this means a 3% drop in value for every 0.23% increase in the property tax rate.
These simple examples illustrate how important it is to understand the influence tax policy has on property values. This doesn’t even touch on the signficance of depreciation or mortgage interest deduction, which have enormous implications for valuations. To at least understand these basics and to keep a watchful eye on policy developments will gives a tremendous long-term advantage to the serious real estate investor.