In many real estate projects there will be incentives from the City, County, State, or Federal governments that will have a meaningful impact on a real estate equity investment. Understanding these various incentives is critical to properly modeling the projects and determining accurate project-level private equity real estate returns.
Property Tax Incentives
The most common incentive available deals with property taxes, which are levied at the City and/or County level of government. Tax Increment Finance, or TIF, has been around for decades. From a modeling perspective, there is really one primary distinction to understand: is the incentive a rebate, or an abatement? A rebate means the taxes must be paid in full, and then the taxing jurisdiction will rebate an amount back to the owner. An abatement means that the taxes are reduced, so the owner doesn’t pay the full tax levy.
If you are modeling a rebate, we recommend including the full property tax payment in the expense section of the model, especially if you are modeling cash flows on a monthly basis. You will have significant cash outflows when you pay the tax. Then at some later time you will receive the rebate and recognize that as revenue. It may be tempting to simply model the net expense to the owner, but if others review your model or if you have to pick it back up a year later for some reason, it may be difficult to reconcile the actual cash outflows and inflows with how it was modeled (leaving a good “breadcrumb trail” is important in both fairy tales and LBO models).
If you are modeling an abatement, your only option is to calculate the estimated actual tax due and incorporate that into the expense section of your model. Many abatements step down over time, such as a 100% abatement in Year 1 (meaning $0 taxes due in Year 1), and a 10% reduction in the abatement each year. In other words, 100% abatement in Year 1, 90% in Year 2, and so on.
One best practice as you model property taxes, whether incentives are involved or not, is including an escalator on the annual tax bill. Your model may include a general expense escalator that applies to all expenses for the project, or you may make different assumptions about the rate of increase for different expense types. Historical experience for the property will often be your best guide, followed by experience in similar properties.
Here’s the Point
Property tax incentives are very common, and you may need to incorporate them into a model for a real estate equity investment in any strategy (Core, Core-Plus, Value-Add, Opportunistic). If you want your model to be accurate and reliable, you have to understand the amount of the incentive, how it is calculated, and the timing of when the incentive is realized. All three steps are critical to properly calculating private equity real estate returns.