CHAPTER III

THE PROPERTY TAX AND NEIGHBORHOOD ANALYSIS

There are basically two approaches to studying the impact of property taxation on housing supply. One approach is to examine the income statements of individual investors and the particular circumstances of individual properties. One might hypothesize, for instance, that owners of properties currently generating a negative cash flow are less likely to maintain or upgrade their properties than owners who face a positive cash flow. Changes in the property tax then would be significant insofar as they altered particular investors' operating statements.

The alternative view is that the cash flows of the investors who happen to be holding property at a given moment are insufficient to determine the effect of changes in the property tax on housing supply. Properties can always be transferred to other hands in response to profit incentives, and the price at which the transaction takes place may alter drastically the cash flow which a given property generates. In this view, the proper level of analysis is the neighborhood sub-market for housing, not the individual property or individual owner alone. The rest of this report emphasizes neighborhood analysis. However, the survey also accumulated a great amount of information on investors' income statements, and the age and condition of their properties. This chapter summarizes the structure-specific and investorspecific data obtained. Analysis of these data shows that it is possible to formulate some rules of thumb as to which kinds of properties are most likely to be profitable to upgrade, and which kind of owner is most likely to take advantage of the profit opportunities. But it must be emphasized that in general owners of rental stock undertake improvement of their property for one reason only, because it is profitable to do so.

Whether it is profitable to renovate a property, undertake cosmetic rehabilitation, or let a property run down depends not so much on characteristics of the property itself, as on the aggregate supply and demand for housing of different types in the market. For this reason, it is misleading to concentrate too much on individual properties. A structure-specific method of analysis implies that if a property is of a certain age, structure, and type, it will be profitable to improve it, regardless of market conditions. This approach ignores the demand for housing. For purposes of policy analysis, it is much more fruitful to analyze housing improvements, by looking at neighborhood sub-markets, wherein the basic demand and supply conditions are similar enough to justify generalizations as to the kind of investment strategy that will prove profitable. Renovation of a 140 year-old town house, with stained glass windows and oak floors may or may not be profitable, depending on neighborhood conditions and the demand for housing; but renovation of such a house in an upward transitional neighborhood, where professionals are moving into the neighborhood in great numbers, almost certainly will be profitable.

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Owner Characteristics, Structure Characteristics, and the Likelihood of Improvement

Table III.1 links the owner's investment decision with his cash flow. It is often hypothesized that owners are more likely to effect improvement of their property if they can finance the investment out of current cash flow. The rows of Table III.1 classify investors by the magnitude of their cash flow, per dwelling unit.

The columns present a breakdown of the rental stock 10 years of age or older by change in the quality level of housing services provided, over a five year period. The quality of housing services includes not only the physical quality of the building, but also the service level and management techniques provided by the owner. This measure is somewhat more subjective than one that only looks at rehabilitation, but it provides a comprehensive measure of quality. This measure recognizes that rehabilitation is only one possible element of upgrading a building; lack of rehabilitation may or may not be a sign of deterioration in quality.

This measure was formulated on the basis of comments by the owner about his investment strategy and the type of neighborhood sub-market he was investing in, by examining his five year history of maintenance and rehabilitation, and by visual inspection of his property.

As shown in Table III.1, the relationship between per unit cash flow and change in quality is weak. There is a tendency for quality to decline in buildings that are currently experiencing a negative cash flow, and a tendency for quality to increase in buildings with a positive cash flow. Yet, the only definitive conclusion that can be drawn from the relationship between operating expenses, rent receipts and building quality is that only in the circumstance when a dwelling unit generates a net cash flow of more than $300 per annum is it unlikely that the landlord would allow such a seemingly good investment to decline in quality. Otherwise, it is extremely difficult to predict the quality of a building solely from an examination of the owner's cash flow statement.

What is most noteworthy about the findings in Table III.1, and Table III.2 is the lack of any consistent relationship between the quality of a dwelling unit and the associated cash flow. There are many landlords in blighted neighborhoods, for example, whose properties are still generating a positive cash flow because they have cut back on maintenance and building services. Alternatively, the landlords in upward transitional or stable neighborhoods may be willing to upgrade their property despite existing negative cash flows because the future prospects for the area are good. It is unclear how quality and cash flow are interrelated. In order to understand this relationship, for instance, one has to ascertain whether the decline in dwelling quality has produced a decline in cash flow, or whether the weakness of the rental submarket forces the landlord to disinvest. For all investment decisions property owners give primary emphasis to their expectations about the future, since this determines how quality improvement or decline will affect the profitability of their investment.

As indicated in Table III.3, an examination of selected per unit expenditures does not provide a sufficient amount of information upon which to determine the rehabilitation

Change in quality refers to period 1966 to 1970.

All private market residential rental properties 10 years of age and older where cash
flow per unit could be determined.

Note:

Sample:

Source:

ADL Investor Interview Question 12.

The tables summarize information obtained from 228 owners regarding 420 individual properties in ten cities.

TABLE III.2

TOTAL EXPENSE AND CASH FLOW PER UNIT BY NEIGHBORHOOD, 1970

93-996 O-73-6

potential of individual properties or groups of properties. Within each neighborhood, debt service, property taxes and operating expenses vary significantly among dwelling units. In an upward transitional neighborhood where capital values are appreciating, for example, there are many investors who are willing to rehabilitate their properties; not because of the level of their present debt service, operating expenses or rent roll but on the basis of a belief in the future of their neighborhood. Demand for their properties may be increasing as higher-income residents move into the area. If there is an influx of higher income tenants who want to live in an upward transitional area, then property-owners are likely to upgrade their buildings even if their existing cash flow is small. What such investments reflect is an expectation about the stability of their cash flow over time. Property owners invest in the future; not in the present. And the future profitability of a rehabilitation investment depends upon the condition of the neighborhood even more than the condition of the individual property.

In contrast to Table III.3, Table III.4 presents the median change in selected per unit income and expense items during the 1966 and 1970 period for each of our neighborhood groups. Over a five year period trends in the submarkets provide a much better basis for determining the likelihood of significant rehabilitation. In the blighted areas, for example, it is apparent that investors face a continuing financial squeeze. Gross expenditures are rising faster than gross rents. If these trends continue then the profitability of additional investments is questionable.

Table III.5 portrays change in quality by owner investment strategy. It might be expected that investors involved in a long term strategy are more likely to maintain or upgrade their properties than those with a short term strategy. This assumption is not supported by the data.

However, those investors interested in capital appreciation were less likely to let the building quality decline than those primarily interested in rental income. Those investors in our sample primarily interested in the tax shelter advantages of real estate, were making few, if any, improvements to their buildings.

By far, the best maintenance record was achieved by those investors who bought their rental property primarily as a home. Fifty percent of these owners had increased the quality of their building in the period 1966 - 1970.

Further confirmation of the importance of owner occupancy is presented in Table III.6. The category "owner occupied" includes those whose investment strategy was primarily purchase of property as a home as well as owners who live in the property but had some other investment strategy, such as capital appreciation. Of the 68 owner occupied buildings only 10.3% experienced a decline in quality in the period 1966-1970. This compared with 22.3% for absentee owned buildings.

Table III.7 portrays change in quality by age of building. The table indicates that the