Comparing apples and printers

Why the No-New-Revenue property tax regime shifts the burden to residential property owners

Mar 30, 2021

As I've gotten older, I've become less and less a fan of the debating style where you just talk past your adversary. You know the drill, right? Each side has its talking points, and they just get repeated ad nauseum regardless of the questions raised or statements made by the other side. If you've watched any cable news since Crossfire debuted on CNN, you've seen this over and over. And with the Texas Legislature back in session, our biennal state pasttime of arguing over property tax reform has given us a new opportunity to engage in this kind of "debate."

Several years ago, I decided to stop focusing on trying to score my debate points, to land that devastating one-liner that will surely convince the other person that he or she is wrong and I am (obviously) right. Instead, I’ve tried to focus on finding that one bit of common ground: That one point of divergence where our principles split and ultimately lead to differing policy positions.

To do that, you have to ask lots of questions and listen to the answers. In the property tax debate, if you listen long enough you’ll find that bit of common ground - that Core Issue - is the fact that residential tax bills continue to increase despite the Legislature's efforts to prevent it.

If the problem is rapidly growing tax bills, it might make sense (on the surface) to make the entire process more transparent and place artificial limits at various points in the system. And aside from tinkering here and there on the edges as favors for various special interests, that's pretty much what we've done.

The Truth-in-Taxation-cum-No-New-Revenue regime is intended to make the appraisal and rate setting process more transparent. Caps on appraisal growth and tax rates set by localities are intended to restrict how much tax bills can grow each year.

Unfortunately, our good intentions were laden with unintended consequences, and the Core Issue is still hanging around. Residential tax bills continue to grow, blame gets placed on cities and local governments, and the Legislature asserts more power over them. Lather, rinse, repeat.

It's time to end that cycle and have a real conversation about our property tax system. One divorced from the heated rhetoric and finger pointing that typically dominates this debate. Creating a fair and equitable system of wealth taxation is extremely hard, regardless of how differently individuals may define the terms "fair" and "equitable." The nuances of real life are always going to be difficult to capture in the arcane language of the law.

In an effort to protect homeowners, we've harmed them. It wasn’t intentional, but we do need to talk about the underlying problems so that they can be fixed (and the State’s meddling can hopefully start to decrease over time).

This issue of the Roundup is part of an ongoing look into the problems with property taxes in Texas, which are legion. Like many things in life, this is a complex issue. There is no monocausal explanation for what’s wrong. However, like many of you, we are wary of the perpetual attempts to "reform" property taxes by the Legislature. And if local governments can't find a way to tell the story properly, we won't be able to fix these underlying issues. Be sure to follow our podcast for more discussion of this issue in the weeks and months ahead.

Let’s get real (but hopefully not personal)

OK, enough with the property tax puns. For those that are less familiar with property taxes in Texas, here’s a 30,000 foot overview.

What are property taxes?

Property taxes are an ad valorem tax - a millage rate based on the value of various types of property - assessed on the owners of said property.

Who sets the values?

The responsibility for appraising property falls to the Central Appraisal Districts (CADs), and there is one for each county. State law specifies how different types of properties are to be appraised.

Residential properties are to be valued “solely on the basis of the property’s value as a residence homestead, regardless of whether the residential use of the property by the owner is considered to be the highest and best use of the property.” In other words, even if a property is ripe for redevelopment, and may be worth a lot more as a dirt patch than a house, it has to be appraised as a house.

When you consider the abundance of information related to home values, including MLS listings and third-party estimates from companies like Zillow and Trulia, this should be a relatively straightforward process with a variety of checks and balances in place to ensure reasonably accurate appraisals.

Commercial valuations, however, are a bit more… subjective. Appraisal districts can choose from a variety of methods, including cost, income, and market data comparison. Each methodology presents opportunities for judgement calls in ways that residential appraisals simply do not. We’ll dig into these appraisal methods a bit more later in this issue.

Values are assigned as of January 1 of each year. Preliminary appraisals are released at the end of May, and certified values in late July.

Property owners are allowed to protest their valuations through an arbitration process.

Who sets the millage rates?

Local taxing entities receive appraisal rolls from CADs showing how much taxable value has been identified. It is based on these reports that annual budgets can be finalized. These entities are responsible for setting the rate at which those properties are taxed. They can assess taxes for operations as well as for debt service.

Local taxing entities include cities, school districts, counties, and special districts (Municipal Utility Districts, Hospital Districts, Library Districts, Community College Districts, and many, many, more).

Then what?

Property owners are then sent their tax bill, which is due by the end of the following January. Delinquent accounts are assessed penalties and interest.

How has property tax reform complicated this process?

That’s a great question, thanks for asking. Let’s look at two factors of reform that we mentioned earlier, appraisal and revenue caps.

Appraisal Caps

Appraisals for residence homesteads (Property Tax Code 23.23) cannot grow by more than 10% from the previous year, not including new improvements made to the property. This means that in booming markets, a gap can grow between the appraised value and the market value that the CAD actually believes your property holds. When the housing bubble burst in the late aughts, this caused a wave of confusion among homeowners whose home was decreasing in value while their tax appraisals continued to increase.

In other words, the core responsibility of accurately appraising properties is paramount for our CADs unless those values are growing too fast. The mixed signals being sent are, unfortunately, not isolated to residential appraisals.

Revenue Caps

On the other end of the spectrum are revenue caps (or tax rate caps if you prefer). The goal behind these is to limit the growth in actual revenue that local governments can collect from property taxes. In the past, this was called Truth-in-Taxation. Today it’s called the No-New-Revenue tax rate, but the mechanisms are largely the same.

To prevent revenue from growing to quickly, taxing entities are required to calculate the rate at which properties on both the current and previous year’s appraisal roll should be taxed, taking into account their new values, to generate the same amount of revenue. Here’s an extremely simplified diagram:

When property values are generally increasing, the No-New-Revenue Rate (which we’ll call the NNRR for short; it was previously called the Effective Rate), would be lower than the nominal rate the taxing entity assessed the previous year. When property values are decreasing, the NNRR would be higher than the nominal rate.

What seems like a simple calculation is actually quite complex, largely because cities (and local governments generally) are complex. Special considerations are given for any number of circumstances, including cities that have adopted a sales-tax-for-property-tax-reduction, cities that have divested portions of their operations to other entities, and rate shifting from debt to operations or operations to debt, just to name a few.

Suffice it to say that the NNRR formula is extremely complicated, and at times I wonder how confident anyone actually feels that the rate they calculated and published is correct (or if there is even a “correct” number).

Once the NNRR is calculated, the Voter-Approval Tax Rate (VATR) is calculated. The VATR is a certain percentage above the NNRR (the rate varies based on locality type). If the locality adopts a tax rate above the VATR, the locality is required to hold a special election requesting voter approval for the higher rate.

Under Truth-in-Taxation, this was called the Rollback Rate, and adopting a rate higher than the Rollback Rate triggered the ability for the people to petition for an election, but an election was not required. The old Rollback Rate was 8% above the Effective Rate. The new VATR is 3.5% greater than the NNRR for Texas cities.

Since we’re talking about Truth-in-Taxation and its successor, the No-New-Revenue Rate, it’s worth mentioning that these are also transparency reforms in addition to revenue restriction reforms. However, anyone who has had to write and/or decipher the public notices that these regulations require can tell you that it’s anything but transparent. In fact, it’s often so confusing that those of us who have to write them each year often can’t figure out what exactly the notices are trying to tell us. But the transparency aspect is not particularly relevant to problems we’re discussing, so we’ll leave it at that for now.

And yet, residential tax bills keep going up…

Despite these reforms (we do use that term loosely), homeowners are still seeing their tax bills go up. And they can increase even if their city lowered their tax rate to the NNRR. Property values are rapidly increasing across the state, driven up in part by the surge in demand from new residents and increases in the cost of materials.

But shouldn’t they be protected by the revenue caps? Why are some seeing increases of 8-10% in their tax bill when revenue isn’t supposed to increase by more than 3.5%?

The thing about averages…

If you have your head in an oven and your feet in a freezer, on average you’re feeling pretty OK. But in reality, you’re not doing so well are you?

The thing about averages is they don’t always tell the story accurately. Outliers can skew it in smaller data sets, and they don’t necessarily tell you how any specific datapoint is doing.

But more importantly, averages are not terribly useful when you are averaging fundamentally different things. And in Texas, residential properties are fundamentally different than all other property types when it comes to property taxes.

Because the No-New-Revenue system treats all properties the same, and lumps them together to calculate the No-New-Revenue Rate, it has had an outsized impact on residential taxpayers. Why? Because appraisals for residential properties are appreciating more quickly than other property types.

The correlation between residential property value growth and the growth in values of commercial, mineral, and personal properties is about the same as the correlation between unicorns and leprechauns. Which is to say, there isn’t really much correlation. As a result, the No-New-Revenue program actually benefits non-residential properties at the expense of homeowners.

Let’s look at an example of why treating them the same for the purposes of calculating an effective rate will shift the overall burden over time to residential properties.

In this table, you’ll see both residential and commercial values starting at the same total. Residential values grow more quickly (10% year) compared to commercial (3% per year), which is reflective of what we’re seeing and what we know about how these properties appreciate for different reasons and at different rates.

With the continued adoption of a No-New-Revenue Rate, the total tax rate has fallen by 18%, but residential property owners are paying 9.8% more in gross taxes, while commercial properties are paying around 9.8% less. The taxing entity is receiving the same nominal amount of money (of course, with lower purchasing power due to inflation), but the residential property owners are now paying a larger share (55% compared to 45%).

The burden shifting works the same way even if the city adopts the Voter-Approval Tax Rate (3.5% above the No-New-Revenue Rate). Residential burden still increases to 55% of total revenue. The only difference in this scenario is that total revenue for residential properties increases by 22% while commercial properties end up paying about the same nominal amount.

In short, using the average of disparate things to calculate the No-New-Revenue rate will necessarily shift the burden to the types of property that are growing more quickly. We don’t think that was the point of the current regime, but that’s the effect of it.

About those commercial appraisal methods

We spoke briefly about the more subjective nature of commercial appraisals earlier, and it’s important to note that there’s a legitimate reason for this: commercial properties don’t appreciate in value in the same way that residential properties do. Everyone needs a place to live, whether it’s a house, apartment, duplex, or what-have-you. The factors that drive residential property values (population growth, zoning restrictions, quality of schools, materials pricing, etc.) coupled with the ability to get reliable pricing information makes residential appraisals more straightforward for appraisal districts.

Commercial properties are much different. The market for commercial properties varies greatly (how many users need a 180,000 square foot tilt-wall warehouse, after all?), as do the types (big box retail, inline storefront, office space, mixed-use downtown buildings, etc.). Texas law allows for appraisal districts to use one of several appraisal methods depending on the specific property in question.

The cost method utilizes data from “generally accepted sources” and allows adjustments for physical, functional, or economic obsolescence. The income method allows appraisal districts to analyze comparable rent data or potential earnings capacity of a property to estimate gross income potential for the purposes of appraising a property. And the market data comparison method allows using data from comparable sales within the past 2-3 years (depending on the size of the county) to set values.

Appraisal districts have the ability to choose which method to use depending on the specifics of the property. While this allows them to take into account different types of commercial uses, it highlights the fact that commercial valuations are fundamentally different than residential valuations, and it raises the very valid question of why we accept that they’re different on the one hand but treat them as if they’re the same on the other.

The “dark” side of commercial appraisals

Some commercial property owners have attempted to add a de facto fourth option based on the so-called Dark Store Theory. Since this is not exactly an approved appraisal method (outside of litigation and settlement), we wanted to highlight it separately from the methods mentioned above.

This theory, which is wielded with particular skill by single-tenant, owner-occupied big box stores, argues that certain commercial properties should be appraised based on their value as if they were not in operation, or “dark,” due to the fact that the buildings would be difficult to sell to subsequent buyers.

This Dark Store Theory is contradictory to the general methods of appraisals outlined in State law, which require properties to be appraised based on their current use, not a subjective assessment of what a future user might do with them or whether the current owner would be able to sell the buildings if they decided to leave.

But the impacts are significant, and result in reductions in appraised values of 50-75%. The Comptroller reports that Lowe’s has been the main proponent of this in Texas, in some cases suing appraisal districts over the issue.

In Tarrant County, values for Lowe’s stores hover around $50/foot (see Keller, Lake Worth, Southlake, and White Settlement for example). Not only are the appraisals well below permitted construction costs for these buildings, they rarely change (none of the stores linked above have seen their total appraised value change since at least 2016). And curiously enough, they all end up around the same total value despite having wildly different compositions:

One might ask, how does a store in Keller have its improvements valued at $29.91 per square foot, while the same store of the exact same size just 16 miles away in in the Lake Worth area get valued (by the same appraisal district) at just $11.33 per foot? Indeed, that would be a good question.

What about Walmart?

Again, the total value per square foot hovers around $50 and the key predictor in both samples for what the improvements are valued at is land values. But it’s a small dataset, so let’s expand a bit.

A quick analysis of 41 Lowe’s from across the state shows quite a bit of variety in improvement values (ranging from $9-$53 per foot) while the vast majority of buildings are roughly the same size.

In Bexar County, the 5 stores we looked at averaged 136k square feet, but improvement values ranged anywhere from $17 to $53 per foot. However, all of the properties had total appraised values of between $10.1 million and $10.6 million, a curious happenstance if we ever did see one.

In other words, the more expensive the land is, the lower the appraised value of improvements, even for nearly identically sized stores. In areas where land is more valuable, the same building will be appraised for less. And not just a little less; it will be appraised low enough to make the total value more or less consistent across the county. There really isn’t a good logical explanation to have such variation in improvement values (for basically the same buildings) only to end up in basically the same result (around a $10.3 million total value).

We’ll continue to collect more data on the impact of Dark Store valuations. In the meantime, it’s worth filing away this practice and noting that this practice is being aggressively pursued by big box retailers across Texas.

It’s causing massive distortions in valuations, particularly when you compare single-use, owner-occupied box stores with power centers rented out to multiple retail tenants. In the latter case, the property owners have no reason to protest since higher tax bills simply get passed on to their tenants, who have no standing to protest the disparate treatment between them and Lowe’s or Walmart. This raises a number of equity issues that will have to be considered in future discussions.

Where does that leave us?

Texas homeowners have continued to see their property tax bills increase each year, despite efforts by the Texas Legislature to control their growth. Appraisal caps and revenue caps have been implemented - and increasingly tightened - as the primary method for solving this issue. But it’s not working, and no one can seem to figure out why.

Fortunately, the answer (or at least an answer) is right there for us to see.

Texas law tacitly admits that residential, commercial, and other types of property do not necessarily appreciate the same way. There’s little correlation between the value of a mineral lease and the home that sits above it, nor between the duplex on the corner and the big box store across the street. We allow central appraisal districts to take these intricacies into account (whether they are fully valuing commercial properties or not).

The No-New-Revenue system ignores that. We artificially limit the growth of property tax revenue by averaging all of our properties together, when we know that the factors that cause appreciation of residential properties are not necessarily correlated with factors that cause commercial appreciation.

In trying to restrict the growth of property tax revenue, we’ve created a system that slowly but surely shifts the burden to residential properties. We’re comparing apples and printers. Much like evaluating a National League pitcher by taking the average of his slugging percentage and WHIP, the system we’ve created not only makes very little sense, it isn’t measuring what we think it is.

As a result, the burden of property taxes will continue to increase on residential properties. The calls for additional “reform” efforts will continue to increase as well, which most likely means more Draconian measures will be layered on top of our current system, all without solving the underlying issue. Instead, we need real reform that acknowledges the differences in property appreciation from start to finish.

We hope you’ll continue to follow us as we dive more into this topic, whether on our podcast or in the pages of this newsletter, including future discussions of potential solutions to this problem. Many of our readers are still in public management roles, and may not be able to speak as freely about these issues as we can. If you’ve got something you want us to look into, please reach out. If you found this interesting, we’d love you to forward it to your friends and colleagues.

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