Sometime in March, county appraisal districts across Texas have an epic party. There’s loud music, dancing, cake, party hats and party horns. Oh and they send out the new property tax appraisals to property owners.
Coincidentally, around the same time of the year, I receive numerous calls and text messages from clients. “Ouch”, “Getting killed over here” and “This is out of control” are some sentences that may be uttered.
I’m trying to make light of it, but truth be told ever increasing tax appraisals are no fun. They take a bigger bite out of your incoming rent and reduce your positive cashflow. On average, operating expenses account for 40% of incoming rent and property taxes account for 65% of operating expenses. Therefore, they’re the principal driver of those expenses. So when you have years like 2013-2015 where average property appraisals went up by 10-15% per year to track a similar appreciation in property value, the impact will be felt.
I wish I had a magic strategy that you could put to work and reduce your property taxes right away but unfortunately my supply of fairy dust is depleted. But I would like to offer some thoughts and tips on the subject.
Property appreciation and tax appraisal appreciation go hand in hand
Some real estate investors are focused primarily on cashflow while viewing appreciation as a welcome bonus. However, cashflow and appreciation don’t exist in a vacuum, they are interrelated and they impact each other. For instance, when property values rise (a welcome outcome for any investor) property tax appraisals rise and positive cashflow drops. But in fact, what’s happening is a transfer of returns from cash on cash return to appreciation return. For instance, let’s say you own an investment property where you have invested $40,000 and it produces $3500 per year in positive cashflow (8% return) in a year during which property values remain flat. So your total return for that year is the sum of return from cashflow (8%) and return from appreciation (0%). Now in the following year, your taxes go up by $100 per month so now your cashflow is reduced to $2300 per year (6% return) but property values rose 10% that year. While your cash on cash return dropped by 2% your total return increased by a factor of 7 due to appreciation returns. How? A 10 percent appreciation on a property in which you’ve invested just 20% of the value in capital translates to a 50% return on that capital due to 4:1 leverage. Therefore your total return for the year is 56%. The counter argument to this point is that appreciation returns don’t materialize until you sell the property and it’s well noted. But that’s not exactly accurate. For a long term investor whose goal is to built up a portfolio with a certain asset value, appreciation helps them get there faster. The main negative impact of rising property taxes and shrinking cashflow is that it might require more surplus injections from an investors surplus income to pay off mortgage debt at the same pace. But once the mortgage is paid off, the higher asset value due to the same appreciation (that caused reduced cashflow) leads to higher income at retirement.
Protest your tax appraisal every year
Once the property tax appraisal is sent out the property owner typically has 30 days after the receipt of the notice to file a protest. This can be done in three different ways: 1) File a protest online with the county appraisal district website (i.e Harris County http://hcad.org, Fort Bend http://fbcad.org) 2) Local investors can file a protest in person at the appraisal district office (their address is also on the website) or 3) File a protest using a property tax consultant. I have used this last option personally and have advised clients to use as well. The property tax consultant gets paid based on a percentage of the tax savings they’re able to provide (usually 30-35%). So if they aren’t able to secure any savings you don’t have to pay anything. And you can select the perpetual engagement option which means they automatically protest your tax values each year and you don’t have to remember it.
Full Disclosure: In recent years, county authorities have been very stringent and property tax savings have been small. However, if you don’t protest, tax savings will be exactly ZERO. Something is better than nothing
In long term investing, you sign up for the whole ride
One thing you sign up for when investing long term is for the whole ride – the peaks, the valleys and everything in between. There will be times like 2008-2011 where cashflow might be plentiful but appreciation absent. And other times like 2012-present where cashflow is getting squeezed but values are rising. We all have our preferences – some investors really go after cashflow and could care less about appreciation. They’d prefer that for the decade or two that they’re investing, things should stay constant like 2008-2011. Then there are investors who feel that if you built up enough net worth, income takes care of itself and they’ve been grinning these last few years. But the reality is in long term investing the only thing you can count on is change as we move and navigate through the cycle. The sooner you get used to and embrace that idea, the better. This year property prices have not risen like in recent years in response to the oil market struggles so property tax appraisals will likely reflect that reality as well.