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Regency West Apartments LLC v. City of Racine

Supreme Court of Wisconsin

December 22, 2016

Regency West Apartments LLC, Plaintiff-Appellant-Petitioner,
v.
City of Racine, Defendant-Respondent.

          ORAL ARGUMENT: September 9, 2016

         Appeal of Source Circuit Court Racine County Gerald P. Ptacek Judge

         REVIEW of a decision of the Court of Appeals. Reversed and remanded.

          For the plaintiff-appellant-petitioner, there was a brief by Maureen A. McGinnity and Foley and Lardner LLP, Milwaukee, and oral argument by Maureen A. McGinnity

          For the defendant-respondent, there was a brief by Robert E. Hankel, and Robert E. Hankel, S.C., Mount Pleasant., John M. Bjelajac, and Bjelajac and Kallenbach, LLC, Racine and oral argument by Robert E. Hankel.

          PATIENCE DRAKE ROGGENSACK, C.J.

         ¶1 Regency West Apartments, LLC brought actions against the City of Racine in circuit court pursuant to Wis.Stat. § 74.37(3)(d) (2011-12)[1] to recover refunds from claimed excessive taxation for 2012 and 2013. We review a per curiam, unpublished decision of the court of appeals, [2] affirming an order of the Racine County Circuit Court[3] that dismissed Regency West's claims of excessive taxation.[4]

         ¶2 The City of Racine's appraisers valued Regency West's property at $4, 425, 000 as of January 1, 2012 and at $4, 169, 000 as of January 1, 2013 for purposes of tax assessment. Regency West claims both appraisals fail to comply with appraisal principles required by Wisconsin law, and that those appraisals resulted in excessive taxation.

         ¶3 Our discussion centers on whether Racine's appraisals of Regency West's property comply with Wisconsin law. Specifically, we review whether Racine employed the methodology required by Wis.Stat. § 70.32(1) for valuing federally subsidized property that is subject to I.R.C. § 42 restrictions;[5]whether Regency West has overcome the presumption of correctness set out in Wis.Stat. § 70.49; and whether Regency West proved the tax assessments for 2012 and 2013 were excessive.

         ¶4 We conclude that the valuation methodologies Racine used for the 2012 and 2013 assessments did not comply with Wisconsin law. Accordingly, we also conclude that Regency West has overcome the presumption of correctness for the 2012 and 2013 tax assessments, and that the circuit court and the court of appeals erred in concluding otherwise. And, finally, we conclude that Regency West has proved that Racine's tax assessments for 2012 and 2013 were excessive. Accordingly, we reverse and remand to the circuit court to calculate the amount of Regency West's refund.

         I. BACKGROUND

         ¶5 Regency West is the owner and developer of a property located in Racine, Wisconsin. Regency West constructed the property in 2010-11, with the first units placed in service September of 2011, and the project being fully leased in February of 2012.

         ¶6 The property has 9 two-story buildings consisting of 72 residential units, all of which are family units. All units are federally regulated housing pursuant to I.R.C. § 42. These federal regulations include income and rent restrictions. As part of the restrictions, the property is subject to a Land Use Restriction Agreement (LURA) that provides that for 30 years, 51 of the 72 units are restricted to tenants earning up to 50 percent of the median income in Racine County and 21 are restricted to tenants earning up to 60 percent of the median income in Racine County. The maximum rents that Regency West may charge are set by Wisconsin Housing and Economic Development Authority (WHEDA).

         ¶7 For purposes of assessing real estate taxes, Racine's appraisers valued Regency West's property at $4, 425, 000 as of January 1, 2012 and at $4, 169, 000 as of January 1, 2013. Regency West contested both tax assessments, claiming that the appraisals that underlie the tax assessments did not comply with Wisconsin law. Regency West did not challenge the 2012 assessment before the board of review because Racine did not timely deliver the assessment to Regency West. However, Regency West did challenge the 2013 assessment before the board of review. The board upheld that tax assessment.

         ¶8 The matter now before us is Regency West's refund action brought in circuit court pursuant to Wis.Stat. § 74.37(3)(d). Therefore, we review the record made in the circuit court and the circuit court's determination, not the determination of the assessor or the board of review. See Nankin v. Vill. of Shorewood, 2001 WI 92, ¶¶24-25, 245 Wis.2d 86, 630 N.W.2d 141.

         ¶9 Trial testimony turned on various methods of real estate appraisal by which the value of Regency West could be determined. The City presented testimony from its assessor, Janet Scites, as well as the Chief Assessor for the City of Racine, Ray Anderson. Scites testified that for 2012 she applied a direct capitalization of income approach, using "mass appraisal techniques."[6] With a direct capitalization of income approach to valuation, an appraiser computes the property's net operating income (income less expenses or NOI) and divides it by the applicable capitalization rate (ratio between NOI of comparable properties and their sale prices).[7]

         ¶10 One of Regency West's construction lenders provided estimates of potential gross income and expenses to Racine for use in the 2012 valuation. However, Racine's assessor said that the expense projections in that report were too high. Accordingly, Scites applied a 40 percent estimated expense ratio that she believed was reflective of other Section 42 properties. She testified that she did so "to stabilize expenses."

         ¶11 Racine's assessor used a 6 percent capitalization rate derived from market-rate properties, not from the market for Section 42 properties.[8] To this, Scites added the 2.5 percent property tax rate, for a loaded capitalization rate of 8.5 percent.[9] Racine's appraisers divided the NOI they calculated based on "stabilized expenses" by an 8.5 percent capitalization rate thereby yielding a value of $4, 425, 000 for 2012.

         ¶12 With respect to the 2013 assessment, Racine valued Regency West's property at $4, 169, 000 as of January 1, 2013. The City's assessors used the comparable sales approach, rather than the income approach, to appraise the property. They relied on the sales of three properties, which they claimed were reasonably comparable properties.

         ¶13 One of the properties, Lake Oakes, had few Section 42 housing units; most were market-rate units. The other two properties the City's assessors relied on, Woodside Village/Albert House and McMynn Tower, had no Section 42 units. Each of those developments was either entirely HUD § 8 housing or HUD § 8 housing with a small number of commercial units.[10]The assessor did not adjust for differences in government restrictions on the different types of federally regulated housing when appraising Regency West's property. Instead, Scites testified that she considered the restrictions for Section 8 and Section 42 properties to be sufficiently similar.

         ¶14 Racine also presented the testimony of two outside appraisers, Peter Weissenfluh and Dan Furdek. The outside appraisers used four appraisal methods for both their 2012 and 2013 assessments. First, Weissenfluh and Furdek used the comparable sales approach. The appraisers relied on a combination of Section 42 and Section 8 properties, and Furdek testified that he believed the restrictions on the properties were irrelevant as long as the rental income from the properties was the same. Next, they used two variations of the income approach: the direct capitalization method and the discounted cash flow method. Finally, they used the cost approach. Each of Furdek and Weissenfluh's valuations resulted in higher valuations than Racine's.

         ¶15 In contrast, Regency West argued that it had overcome the presumption of correctness afforded the City's tax assessment for two reasons. First, the City had failed to comply with the Wisconsin Property Assessment Manual (WPAM)[11] in its appraisals of Regency West's property as Wis.Stat. § 70.32(1) requires. Second, Regency West presented sufficient contrary evidence that Racine's appraisals were excessive. In that regard, Regency West presented testimony from Michael Lerner and, its appraiser, Scott McLaughlin. Michael Lerner has vast experience working with Section 42 housing whereas Scott McLaughlin specializes in appraising subsidized housing. Relying solely on the income approach, which he explained was consistent with WPAM, McLaughlin appraised the property at $2, 700, 000 for 2012 and $2, 730, 000 for 2013.

         ¶16 At the conclusion of the trial, the circuit court dismissed Regency West's excessive tax claims for both years. The circuit court concluded that Regency West had failed to overcome Wis.Stat. § 70.49's presumption of correctness given to the 2012 and 2013 tax assessments.

         ¶17 The circuit court found that Racine did not do an individual valuation of Regency West's property for 2012, but instead, it "applied mass appraisal techniques." The court found that Scites "estimated expenses based upon her experience and used a capitalization rate of 8.5%." The court then concluded that "[d]ue to the number of assessments needed to be done (7, 500), the City used mass appraisal techniques, [which was] an appraisal method approved by the Property Assessment Manual for commercial property" in arriving at $4, 425, 000 as the property's value in 2012.

         ¶18 The court of appeals affirmed the circuit court's dismissal of Regency West's complaint. With respect to the 2013 assessment, the court rejected Regency West's argument that Section 42 and Section 8 properties are not reasonably comparable for purposes of the comparative sales approach. The court reasoned that both types of subsidized housing are found within the same section of the WPAM, and Racine's assessors had opined that the rents from all the properties were essentially the same. With respect to the 2013 assessment, the court concluded that reliance on market-rate properties for the NOI was immaterial because Racine used the comparative sales approach for that valuation; and for 2012, reliance on a market-rate NOI was reasonable because Regency West was newly constructed and did not have actual expenses to consider.

         ¶19 Consequently, the court of appeals concluded that Regency West had not overcome the presumption of correctness accorded to tax assessments by Wis.Stat. § 70.49 and, therefore, Regency West was unable to show that its 2012 and 2013 tax assessments were excessive.

         ¶20 We granted Regency West's petition for review and now reverse.

         II. DISCUSSION

         A. Standard of Review

         ¶21 This is a refund action commenced under Wis.Stat. § 74.37(3)(d). It permits "an aggrieved person to recover that amount of general property tax imposed because the assessment of property was excessive." Wis.Stat. § 74.37(1). A claim for excessive assessment is a "new trial, not a certiorari action." Trailwood Ventures, LLC v. Vill. of Kronenwetter, 2009 WI.App. 18, ¶6, 315 Wis.2d 791, 762 N.W.2d 841');">762 N.W.2d 841. Therefore, "we review the record made before the circuit court, not the board of review." Adams Outdoor Advert., Ltd. v. City of Madison, 2006 WI 104, ¶24, 294 Wis.2d 441, 717 N.W.2d 803 (citing Nankin, 245 Wis.2d 86, ¶25).

         ¶22 As we review the record made in the circuit court, we interpret and apply Wis.Stat. § 70.32 to determine whether Racine's appraisals for 2012 and 2013 followed the statute's directives. We also interpret Wis.Stat. § 70.49(2) to determine whether Regency West has overcome the presumption of correctness that attached to Racine's tax assessments. Statutory interpretation and application present questions of law that we independently review, while benefitting from the analyses of the court of appeals and the circuit court. Oneida Cty. Dep't of Soc. Servs. v. Nicole W., 2007 WI 30, ¶9, 299 Wis.2d 637, 728 N.W.2d 652; see also Soo Line R.R. Co. v. DOR, 97 Wis.2d 56, 59-60, 292 N.W.2d 869 (1980).

         B. General Appraisal Principles

         ¶23 "The power to determine the appropriate methodology for valuing property for taxation purposes lies with the legislature." Walgreen Co. v. City of Madison, 2008 WI 80, ¶19, 311 Wis.2d 158, 752 N.W.2d 687. Wisconsin Stat. § 70.32(1) provides that "property shall be valued by the assessor in the manner specified in the Wisconsin property assessment manual." "The Manual, in turn, provides that '[t]he goal of the assessor is to estimate the market value of a full interest in the property, subject only to governmental restrictions. All the rights, privileges, and benefits of the real estate are included in this value. This is also called the market value of a fee simple interest in the property.'" Walgreen, 311 Wis.2d 158, ¶20 (quoting 1 Wisconsin Property Assessment Manual (2007) at 7- 4).

         ¶24 The objective of an appraisal is to determine "the full value" that an owner would receive at a "private sale." Wis.Stat. § 70.32(1). For purposes of determining full value, property is separated into seven classifications based on use. Wis.Stat. § 70.32(2). Regency West is residential property. § 70.32(2)(a)1.

         ¶25 Wisconsin Stat. § 70.32(1) provides the methodological framework that appraisers must follow when appraising property. It delineates a three-tier approach:

In determining the value, the assessor shall consider recent arm's-length sales of the property to be assessed if according to professionally acceptable appraisal practices those sales conform to recent arm's-length sales of reasonably comparable property; recent arm's-length sales of reasonably comparable property; and all factors that, according to professionally acceptable appraisal practices, affect the value of the property to be assessed.

Wis. Stat. § 70.32(1); see also State ex rel. Markarian v. City of Cudahy, 45 Wis.2d 683, 686, 173 N.W.2d 627 (1970).

         ¶26 "An assessor has an obligation to follow the three tier assessment analysis." Adams, 294 Wis.2d 441, ¶47. Nevertheless, this hierarchy of appraisal methods does not permit an assessor to use an appraisal method when insufficient data exist to perform an accurate valuation under that method. To the contrary, an assessor must not appraise a property using unreliable data. Metro. Holding Co. v. Bd. of Review of City of Milwaukee, 173 Wis.2d 626, 631-32, 495 N.W.2d 314 (1993).

         ¶27 Under the first tier of appraisal methods set out in Wis.Stat. § 70.32(1), an appraiser should rely on recent arm's-length sales of the subject property to determine the property's value. This approach is universally considered the most reliable method of appraising property. Markarian, 45 Wis.2d at 686. However, both parties agree that this method is not at issue in the present case because there were no sales of the subject property to consider.

         ¶28 Under the second tier of appraisal methods, an appraiser values a property by considering recent, arm's-length sales of "reasonably comparable" properties. Id.; 1 Wisconsin Property Assessment Manual at 9-45. The WPAM defines "reasonably comparable" properties as those properties that represent the "subject property in age, condition, use, type of construction, location, design, physical features and economic characteristics." 1 Wisconsin Property Assessment Manual at 7-22.

         ¶29 Moreover, "if there has been no arms-length sale and there are no reasonably comparable sales [] an assessor [may] use any of the third-tier assessment methodologies." Adams, 294 Wis.2d 441, ¶34. "The income approach, which seeks to capture the amount of income the property will generate over its useful life, and the cost approach, which seeks to measure the cost to replace the property, both fit into this analytic framework." Id., ¶35.

         ¶30 However, when valuing subsidized housing, the WPAM suggests that the "Cost Approach is the least reliable valuation method" because of "the difficulty in estimating external obsolescence." 1 Wisconsin Property Assessment Manual at 9-45. Accordingly, an assessor should apply the cost approach when evaluating subsidized housing only when other approaches are not available.[12]

         ¶31 Because an appraiser must consider all aspects of the subject property that may affect its value, appraisers must consider whether a property's value is affected by its classification as residential property subject to Section 42 subsidized housing restrictions. See Metro. Holding, 173 Wis.2d at 631-32.

         ¶32 The income approach is often the most reliable method for assessing subsidized housing. 1 Wisconsin Property Assessment Manual at 9-45 ("The income approach may be the most useful method for valuing subsidized housing . . . ."). The income approach is superior when applied to subsidized housing "due to the conditions of the agreement and the limited availability of data." Id.

         ¶33 The WPAM recognizes dissimilarities between subsidized properties and market-rate properties. It instructs that federally regulated properties are to be treated "as a separate market and distinct from conventional (market level) projects." 1 Wisconsin Property Assessment Manual at 9-42. Specifically, federally regulated properties have "operational constraints (regulations) and risk factors that are different from a market rate property." Id. As such, appraisals that fail to account for differences between those properties and market-rate properties contravene the WPAM and Wis.Stat. § 70.32. Metro. Holding, 173 Wis.2d at 630-32.

         ¶34 The WPAM provides that to be "reasonably comparable, " other properties must have "similar restrictions" to the subject property. 1 Wisconsin Property Assessment Manual at 9-45 ("To be considered [reasonably] comparable, the recent arm's-length sales should have restrictions similar to the subject property."). With these foundational principles in mind, we turn to the 2012 and 2013 appraisals that underlie the tax assessments for Regency West's property. C. Regency West's Property 1. 2012 tax assessment

         ¶35 Regency West placed its first units in service September of 2011, and the project was fully leased in February of 2012. Both Racine and Regency West valued the subject property as of January 1, 2012, using the income approach. However, they did not apply it in the same way. First, Racine did not do an individualized appraisal of Regency West's property, but instead, employed "mass appraisal techniques" because its appraisers had 7, 500 properties to value in 2012. Regency West's appraisal was based on the subject property. Second, Racine did not consider the projected expenses and income for the subject property when calculating its NOI. Regency West used projected expenses and income for the subject property. Third, Racine employed a capitalization rate based on market-rate properties; Regency West applied a capitalization rate derived from a Section 42 housing market.

         ¶36 In calculating Regency West's NOI for 2012 under its mass appraisal technique, the City's appraiser used market-rate vacancy and market-rate expenses instead of the vacancy and expense projections that were specific to the subject property. This approach fails to account for the vast differences in federally regulated housing discussed above and distorts the actual value of Regency West's property.

         ¶37 An appraiser must not value federally regulated housing as if it were market-rate property. Doing so causes the assessor to "pretend" that the subject property is not hindered by federal restrictions. Metro. Holding, 173 Wis.2d at 631; see also 1 Wisconsin Property Assessment Manual at 9-45 ("Any income approach used must consider all the impacts of the subsidy program."). The restrictions and underlying agreements implicit in federally regulated housing will affect the property's value. See Bloomer Hous. Ltd. P'ship v. City of Bloomer, 2002 WI.App. 252, ¶31, 257 Wis.2d 883, 653 N.W.2d 309 ("An assessor must consider the effects of the restrictions on subsidized housing."); Walworth Affordable Hous., LLC v. Vill. of Walworth, 229 Wis.2d 797, 802-03, 601 N.W.2d 325 (Ct. App. 1999) (reasoning that because the subject "property is encumbered with income and rental restrictions resulting from the [Federal Housing Tax Credits], these restrictions must be considered in the property's valuation."). As discussed above, the WPAM recognizes these differences and directs that assessors are not to treat federally regulated housing as if it were market-rate housing for purposes of determining property values. 1 Wisconsin Property Assessment Manual at 9-42 ("Subsidized housing properties operate differently than conventional (market-rate) properties.").

         ¶38 Our decision in Metropolitan Holding unambiguously requires assessors to use income and expenses for the subject property when valuing subsidized housing under the income approach. Metro. Holding, 173 Wis.2d at 634 (remanding the "case with instructions that [t]he Board order the city assessor to assess Layton Garden using the capitalization of income approach based on actual income and expenses").

         ¶39 In Metropolitan Holding, the plaintiff, Layton Garden, argued that its property was valued artificially high because the City of Milwaukee had relied on market-rate expenses when determining the property's NOI. Id. at 630. We agreed with Layton Garden and overturned the City of Milwaukee's tax assessment based on that valuation. Id. We reasoned that by employing market-rate rents and market-rate expenses, the city assessor "pretended that Layton Garden was not hindered by the HUD restrictions and valued the property at the amount the property would bring in an arm's-length transaction if Metropolitan were able to charge market rents." Id. at 631; see also Mineral Point Valley Ltd. P'ship v. City of Mineral Point Bd. of Review, 2004 WI.App. 158, ¶11, 275 Wis.2d 784, 686 N.W.2d 697 (concluding that the assessor must value properties individually, not based on hypothetical income and expenses (citing Metro. Holding, 173 Wis.2d at 629)).

         ¶40 Wisconsin Stat. § 70.32(1) requires assessors to value property based on "the best information that the assessor can practicably obtain." Here, there was available to Racine's assessor projected expenses and income for this newly opened property. However, Racine chose not employ that information and chose instead to calculate the NOI for its income-based valuation through mass appraisal techniques that were not particularized to Regency West's property. We conclude that in that regard, Racine did not comply with the directive of § 70.32(1) because it did not use the "best information" that was available to its assessor.

         ¶41 In contrast to the City's approach, Regency West used income and expenses specifically projected for the subject property when it calculated the NOI for its income-based valuation. These projected expenses are the best information that could practicably be obtained. We conclude that for this newly opened property, the use of projected expenses complies with the mandate of Wis.Stat. § 70.32(1).

         ¶42 In addition to calculating a NOI for the subject property, an income-based valuation requires determining the applicable capitalization rate. Therefore, we consider whether appraisers, when valuing federally regulated properties, may derive the capitalization rate from market-rate properties. We conclude that they may not.

         ¶43 The capitalization rate expresses the rate of return an investor would expect to receive from an investment in the subject property. 1 Wisconsin Property Assessment Manual at 9-21. The determination of the applicable capitalization rate is a critical element in determining the value of a property because a small change in capitalization rate will create a significant change in a property's value. This is so because the value of a subject property is determined by dividing its NOI by the applicable capitalization rate, which rate is expressed as a percentage. Id. Therefore, a larger percentage will yield a smaller total value for the property.

         ¶44 When determining the applicable capitalization rate, assessors must consider factors that appreciably alter the value of the property. Otherwise, the capitalization rate will not truly represent the risk an investor is undertaking when investing in the property.

         ¶45 "Capitalization rates from the marketplace are usually derived from the sale of market-rate projects." Id. at 9-45. Such capitalization rates "do not reflect the unique characteristics of subsidized housing. In some cases there can be more risk in subsidized housing, in other cases there is less." Id. The WPAM further explains, "Rent levels are often regulated and annual increases may be difficult to obtain. In many cases the proportion of debt to equity is different in subsidized projects than in market rate projects. With some types of projects the amount of annual equity return is limited (called a limited dividend)." Id. Additionally, for some types of federally regulated housing, "equity investors primarily look to other sources beyond the cash flow of the property for their required return on investment." Id.

         ¶46 Appraisers who fail to consider property classified as federally regulated housing and the restrictions attendant thereto when deriving capitalization rates are overlooking major characteristics of such property. After all, a property's classification as federally regulated housing may substantially ...


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