WHAT’S THE DEAL WITH ALL THE OP/EX?Q4 2015 Special Report

AQUILA Q4 2015 SPECIAL REPORT

The beginning of the calendar year generally is the time landlords adjust their properties’ budgets. Operat-ing expenses (op/ex) are a key component of this fine-tuning, which includes variables such as property taxes, utility costs, janitorial costs, etc. When looking at the appendix of this report (pages 46 – 62), you will notice an almost universal increase in each building’s operating expenses when compared to their previous quarters’ values (84 up arrows, 7 down arrows), which makes sense because utility rates have been raised over the years, labor rates have increased for maintenance and services, and inflation, in general, makes things cost more.

What’s staggering, however, is the amount by which these operating expenses have increased. When analyzing all of our competitive set buildings¹ since 2007, the average operating expenses per building increased more this year than any other by a long-shot: an astounding $1.18 more than their 2015 values.

So, why is there this suddenly drastic spike in operating expenses? For this quarter’s special report, we delve deeper into one of the primary underlying components of operating expenses: property taxes.

The Travis County Appraisal District (TCAD) has been under some scrutiny lately in regards to its appraisal methods of commercial properties. The City of Austin filed a lawsuit against the appraisal district in the Fall of 2015 stating that they value commercial and vacant land properties well below market values, thereby placing the majority of the tax burden on homeowners². In a 2015 study done by The University of Texas at Austin, it was found in a sample of 417 transactions done between 2012 and 2014 that the average undervaluation by TCAD of the commercial properties sold was 47% of their fair market value³. One of the primary causes of this discrepancy is the fact that Texas is one of only five states to not mandate the disclosure of sales price data for commercial properties. This has undoubtedly caused some eyebrows to raise—including our own—to observe how TCAD sought to alleviate this problem in 2015 and 2016, and the effects it has on property owners as well as tenants.

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Changes in Operating Expenses

Average Year Over Year Change in Op/Ex per Building Average Op/Ex

Photo by Mara Buchi

“In this world nothingcan be said to be certain,

except death and [op/ex].”-Ben Franklin

AQUILA Q4 2015 SPECIAL REPORT

METHODOLOGY:

For our study, we took a random sample of thirty buildings across the three primary Austin submarkets (CBD, Northwest and Southwest) whose op/ex numbers we track each quarter, and whose op/ex values changed from the previous quarter, to ensure that the op/ex values are updated and currently reflective of their 2016 values. For these thirty build-ings, we then found their appraised values and tax rate for each year from 2011-2015 (TCAD only lists appraisals going back five years, and has not yet released 2016 appraised values). From these values, we were able to calculate the percentage of operating expenses that is comprised of property taxes for that year using the following formula:

Where “Op/Ex” is the value charged by landlords for operating expenses per square foot of rentable area. We then averaged the following values for each year across all thirty buildings: Op/Ex ($/sf), Assessed Value ($/sf), and Taxes as % of Op/Ex. We were left with the following summary (see Table 1).

To compare these values against one another, we plotted them as percent changes over time with 2011 being the reference point (see Graph 1).

RESULTS:

From Graph 1 the most notable takeaways are:

• Dramatic increases in both the Average Assessed Value and Av-erage Taxes as % of Op/Ex from 2014 to 2015 relative to previous years, despite the fact that the ac-tual tax rates decreased over this same time period

• Dramatic increase in Average Op/Ex from 2015 to 2016 relative to previous years

What does this mean? Primarily, it shows that TCAD has indeed stepped up their appraisal values of commercial properties drastical-ly since coming under pressure by the city of Austin, as seen in the

Taxes as % of Op/Ex

Appraised Value × Tax RateNet Rentable Area

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Percent Changes - Since 2011

Average Op/Ex Average Assessed Value $/SF Average Taxes as % of Op/Ex

Year Average Op/Ex

Average Assessed Value ($/SF)

Average Tax Rate

Average Taxes as % of Op/Ex

2011 $11.79 $158.45 2.36% 31.36%

2012 $11.78 $180.41 2.39% 36.34%

2013 $12.15 $193.54 2.45% 38.74%

2014 $12.88 $219.65 2.36% 40.11%

2015 $13.89 $278.26 2.30% 45.81%

2016 $15.71 N/A N/A N/A

Table 1

Graph 1

AQUILA Q4 2015 SPECIAL REPORT

WHAT DOES THIS MEAN FOR YOU?

Landlords: While we do not expect 2016 appraisal values to decrease from their 2015 values by any means, we believe that the spike experienced in 2015 will help curb the increases in 2016 values as TCAD’s appraisal methods bring commercial properties’ appraisal values nearer to actual fair market values. However, you might drive prospec-tive tenants away with too high of operating expenses in the future if nothing is done to lower the non-tax portion of your op/ex. If money is invested now in equipment that require less maintenance and consume less energy, you will be able to dampen the rate of increase for your operating expenses, thereby making your properties more competitive and attractive to prospective tenants.

Tenants: Don’t let the sticker shock of drastically higher 2016 operating expenses scare you! This spike likely rep-resents a very short-term trend, and while operating expenses will probably not get any cheaper in the near future, they should not continue to grow at the rate they did this year as TCAD’s commercial property appraisals approach true fair market values. Therefore, it would behoove you to factor in these increases into your 2017 budget. Furthermore, if you are a tenant out in the market looking for new space, you can use this year’s high operating expenses as a tool to negotiate for a lower base rental rate. For example, being that operating expenses jumped several dollars per square foot for buildings downtown, that submarket may be an unviable option now. Point to this spike in operating expenses as what has made the space out of your budget, and negotiate the base rental rate down to an affordable level.

¹Competitive set buildings are considered Class A office buildings located in, or near the core of downtown, and newer suburban office buildings that typically have structured parking and amenities such as conference rooms, workout facilities and/or delis.

²City of Austin v. Travis Central Appraisal District Et Al. 126th Judicial District Court of Travis County, Texas. 18 Sept. 2015.

³Gau, George W., Ph.D. An Analysis of TCAD's Commercial Valuations For City of Austin. 11 Mar. 2015.

nearly 80% increase in appraised value per square foot over four years, with nearly half of that increase occurring in the last year. Secondly, Average Taxes as % of Op/Ex increased drastically in 2015, whereas Average Op/Ex remained on a relatively steady incline over the same. This shows that landlords were not quite prepared to pass the cost of the higher property taxes onto their tenants. They seem to have made up for this discrepancy in the new op/ex figures, though, as the dramatic spike in Average Op/Ex occurs in 2016.

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The information contained herein has been obtained from sources believed reliable. AQUILA Commercial, LLC makes no guaranties or warranties as to the accuracy thereof. The presentation of the property is submitted subject to the possibility of errors, omissions, change of price, rental or other conditions, prior sale, lease or financing, or withdrawal without notice. Included projections, opinions, assumptions or estimates, are for example only, and may not represent current or future performance of the property. Information is for guidance only and does not constitute all or any part of a contract.