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NOT FOR PUBLICATION WITHOUT THE APPROVAL OF THE TAX COURT COMMITTEE ON OPINIONS

TAX COURT OF NEW JERSEY 003088-95

PINE PLAZA ASSOCIATES, L.L.C. :

Plaintiff, :

v. :

HANOVER TOWNSHIP :

Defendant, :

3 Decided December 12, 1996

Michael I. Schneck for plaintiff (Brach, Eichler, Rosenberg, Silver, Bernstein, Hammer & Gladstone, attorneys)

John H. Dorsey for defendant (Dorsey and Fisher, attorneys)

KUSKIN, J.T.C.

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Plaintiff appealed the 1994 and 1995 local property tax assessments on the Pine Plaza Shopping Center, Hanover Township, designated on the Township Tax Map as Block 4001, Lot 12. For each of the years under appeal, the assessment on the property was a total of $6,170,600, allocated $1,586,700 to land and $4,583,900 to improvements. For tax year 1994 the applicable ratio under N.J.S.A. 54:1-35a (the Chapter 123 Ratio) was 51.47%. For tax year 1995, the Chapter 123 Ratio was 53.99%. * The property is a strip shopping center located on the eastbound lanes of Route 10, a major four lane divided highway. The center contains 110,848 square feet of first floor rentable space. The parties have stipulated that such space is divided as follows: supermarket - 39,700 square feet; large store - 10,523 square feet; small stores - 60,625 square feet. In addition, there is a basement area containing 4,000 square feet located below the supermarket and, as of the valuation dates of October 1, 1993 and October 1, 1994, used exclusively by the supermarket operator for office space. The shopping center, as originally constructed in or about 1965, contained approximately 30,000 square feet of first floor rentable space, with approximately 6,400 square feet of basement area. The initial tenants were a Foodtown Supermarket and a few satellites. On December 26, 1989, the Hanover Township Planning Board granted site plan approval for a major expansion of the center to its current size. The expansion, which included a renovation and enlargement of the Foodtown premises, was completed in 1991. Efforts to obtain new tenants commenced during construction of the expansion and continued thereafter. These efforts resulted in two new leases in 1990 (including a lease for 10,523 square feet to Hook-Superx), twelve new leases in 1991, two new leases in 1992, one new lease in 1993 and no new leases in 1994. During 1994, however, there was an expansion of one store in the shopping center and a new lease with the Foodtown Supermarket. The expansion of the center was financed by a $17,117,574 mortgage loan from Fleet Bank, plus a $4,000,000 second mortgage loan used for the renovation and enlargement of the supermarket (of which $600,000 was used to purchase tenant fixtures). Because of the debt load imposed by this mortgage financing and the low level of leasing activity, the center quickly encountered financial difficulties. By late 1992, Fleet Bank became involved in the management of the center and in leasing activities. On May 11, 1994, a subsidiary of the Bank acquired title to the

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premises by deed in lieu of foreclosure. On January 27, 1995, the plaintiff purchased the shopping center for $7,500,000. Neither appraiser relied upon the sale to plaintiff as a reliable indicator of value because the sale was of a "leased fee" with the price materially influenced by the approximately 30% vacancy at the shopping center. Since the completion of the expansion in 1991, the shopping center has suffered from a persistent vacancy rate in excess of 25%. The appraiser for the municipality testified that this vacancy resulted from a lack of competent aggressive management and cited, in support of his opinion, the decline in the number of new leases in 1992, 1993 and 1994 and the involvement of the mortgagee in the management and leasing of the shopping center beginning in late 1992. The appraiser for the plaintiff testified that, notwithstanding the involvement of the mortgagee, the shopping center had competent managing agents so that the decline in leasing activity was not attributable to any lack of managerial competence or aggressiveness. It is impossible to determine whether the fall-off in leasing activity was the result of the mortgagee's involvement or whether the mortgagee's involvement was the result of the fall- off in leasing activity. In general, however, I find that, as of the applicable valuation dates, the shopping center was negatively affected by the following factors: 1) the center is somewhat isolated, being located approximately two miles west of the booming retail development on Route 10 in the Township of East Hanover and approximately two miles east of a major shopping center in Morris Plains. The area immediately surrounding the center consists of small retail, small office and residential uses; 2) the shopping center buildings are approximately 500 feet from Route 10. As a result of this setback and the trees and road terrain in the immediate area of the center, the center has poor visibility. Except for an identifying pylon sign (discussed below), the center is generally not visible from Route 10 until a motor vehicle is close to the entrance; 3) the shopping center has a pylon sign near Route 10 which contains the name of the center and a clock. The sign does not, however, contain identification signs for any of the tenants, even Foodtown and Superx. The evidence did not establish whether plaintiff's predecessors in title made any efforts to obtain municipal approvals for the expansion or enlargement of such sign or for additional signs. Plaintiff made no such efforts for over 20 months after acquiring the center. Although local tenants have signed leases without the pylon sign identification signs they initially demanded, the unavailability of pylon signs has hampered leasing to national and regional chain stores which generally require identification signs on shopping center pylons. The shopping centers located in East Hanover provide at least

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some tenant identification signs on their pylon signs; 4) the construction of the expanded center contemplated store units of approximately 1,500 square feet. Such units are combinable but are not suitable for so called "big box" or "power" stores because of inadequate ceiling heights. No one of the foregoing factors was, in itself, sufficient to place the shopping center at a significant disadvantage as compared to competitive centers located to the east on Route 10 in East Hanover and to the west on Route 10 in Morris Plains. The combination of such factors, however, had a material negative impact on the center, its attractiveness to tenants and the rents which it could command. Both appraisers agreed that the highest and best use of the subject property was for continued use as a strip shopping center, and I accept their opinions on this issue. Both appraisers utilized an income approach to valuation. The appraiser for the municipality also used a cost approach but only as a check on his income approach and not as an independent basis for his valuation determination. I find that, for this income producing property, the income approach is the appropriate valuation method, Appraisal Institute, The Appraisal of Real Estate 449 (11th ed. 1996), and I will determine the value of the center using only this approach. I accept the opinion of both appraisers that, in determining value, I should utilize the same rents, vacancy and collection loss allowance, and expenses for both 1994 and 1995, with only the capitalization rate changing from year to year. The first step in the income approach is to determine economic rent for the rentable area at the shopping center. Both appraisers agreed, and I so find, that, for a shopping center such as the subject property, rents should be determined on a net basis with the tenants being responsible for payment of real estate taxes, insurance, and operating expenses. As to the large store area, containing 10,523 square feet, the parties stipulated that the economic rent, as of the applicable valuation dates, was $14.50 per square foot net. As to the supermarket, the plaintiff's appraiser determined an economic net rent of $13.50 per square foot and the defendant's appraiser determined $13.65 per square foot. The actual rent contained in the May 15, 1994 modification and revision of the supermarket lease was $13.65 per square foot. Three of the four comparable supermarket leases used by the taxpayer's appraiser (two of which were also used by the municipality's appraiser) reflected, after adjustment by taxpayer's appraiser, rent in excess of $13.65 per square foot. The fourth comparable is

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located in Berkeley Heights, in a different county and a significant distance from the subject property. Furthermore, the rent in such lease was established in the context of an assignment by the tenant, Grand Union, of its ground lease for a shopping center, and a leaseback to Grand Union of new supermarket premises to be constructed by it at the shopping center with reimbursement by the landlord of a specified amount for construction costs. I give little weight to this comparable and to the two comparables utilized by the municipality's expert located in Passaic and Somerset counties, respectively. I find that $13.65 per square foot, net, is the proper economic rent for the supermarket. As noted above, the supermarket administrative offices are located in 4,000 square feet of basement space. The supermarket lease is silent as to any separate rental for this space. The taxpayer's expert testified that such space is not independently rentable and must be used as part of the supermarket. The expert for the municipality testified that the space has outside access, is suitable for leasing independently of the supermarket, and warrants an economic rent of $8.50 per square foot, net. This amount is equal to one-half of the economic rent which he determined for satellite space (see discussion below). The appraiser made no separate analysis of rental comparables for this space. He based his use of one-half of satellite space rent on his analysis of a shopping center or centers in Wayne, New Jersey. 3 I find that this 4,000 square feet of office space cannot be separately leased. The space has direct access to the parking lot, but the access door is more in the nature of a fire exit required for code compliance than an attractive entrance to office space. Even if I found this space could be separately leased, I could not, because of a lack of reliable evidence, find the appropriate rent to be attributed to the space. Accordingly, I find that the 4,000 square feet of office space should be deemed incorporated in the economic rent of $13.65 per square foot for the 39,700 square feet of first floor supermarket space. The remaining, and most significant, issue as to economic rent relates to the satellite store space. The appraiser for the taxpayer determined an economic net rent of $15.50 per square foot, and the appraiser for the municipality $17 per square foot. The appraiser for the taxpayer relied upon four comparable leases only two of which are located in shopping centers similar to the subject. One such comparable reflected an unadjusted rent of $18.05 per square foot which the appraiser adjusted to$16.25 per square foot. The other reflected an unadjusted rent of $13.30 per square foot which he adjusted to $13.96 per square foot. Taxpayer's appraiser also relied upon the leases and rents at the subject shopping center. He noted that most of the tenants with contract rents ranging from $20 to $23 per square foot were paying only $8 to $15 per square foot. Certain of the tenants unilaterally reduced their rent payments without the consent or agreement of the landlord, while

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others may have obtained the landlord's consent. Plaintiff presented no written agreements evidencing such consent except as to one store at the center for which rent was reduced to $15.05 per square foot as of October 1, 1994 in connection with expansion of the store. Finally, taxpayer's appraiser considered three post-assessing dates leases at the subject center, one dated May 1, 1995 at $14.85 per square foot, one dated October 1, 1995 at $14.95 per square foot and one dated November 1, 1995 at $13.43 per square foot. The municipality's expert relied primarily on the contract rents for the subject property. He ignored the subsequent undocumented rent reductions because he did not, and could not, determine that they represented negotiated agreements between the tenants and the landlord. The expert also considered five comparable leases, all different from the comparables used by the taxpayer's expert, and made very few adjustments. He made no adjustments to four of these leases which indicated net rents of $16, $21, $17.59 and $18.69 respectively. As to his fifth comparable, he adjusted the contract rent of $18 per square foot to $16.20 per square foot. Of these comparable leases, three are located in strip shopping centers, two of which are comparable in size to the subject property. One such comparable is located in a shopping center in Morris Plains and indicated a rent of $16 per square foot (the taxpayer's expert utilized a comparable lease from the same shopping center with a per square foot rent of $18.05 adjusted to $16.25). The other such comparable is located in an East Hanover shopping center and, after adjustments, indicated a rent of $16.20 per square foot. The expert for the municipality also considered post-assessing dates leases at the subject property. Specifically, he noted a lease dated August 1, 1996 which, after adjustment for the tenant contribution to the cost of the tenant improvements, indicated a rent of $15.99 per square foot. The expert was aware of the post-assessing dates leases considered by the taxpayer's expert, but noted a post-assessing dates lease at the shopping center dated November 1, 1995 at $18.43 per square foot and another dated February 1, 1996 at $18.52 per square foot. Year-by-year review of the leases at the center indicates that, during 1991, leases for satellite space were entered into at per square foot net rents of $10.28, $12, $12.80, $16.43, $17.10, $18, $19.14, $21.76, $22.83, $23.08, $24.73 and $25.06. In 1992 leases were entered into at per square foot net rents of $17.29 and $17.87. In 1993, there was a lease at $18 per square foot net. In 1994, the rent for one store was reduced to $15.05 per square foot net. In 1995, there were new leases at per square foot net rents of $12.81, $14.85, $14.95, $18.43 and $18.52. In 1996 there was one lease at $15.99 per square foot net. I find that the leases in 1992 at net rents above $20 per square foot are not

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reflective of the rental value of the satellite space in the shopping center as of the valuation dates of October 1, 1993 and October 1, 1994, nor is the 1992 lease at $10.28 per square foot. The remaining rents range from $12 to $19.14 per square foot. Based upon this range and my analysis of the comparable leases, I find that the proper economic net rent for the 60,625 square feet of satellite space at the subject shopping center is $16 per square foot. The next step in the income analysis is the determination of a vacancy and collection loss allowance. The taxpayer's appraiser used a 20% allowance consisting of 15% for vacancy and 5% for collection loss. The expert for the municipality used a 5% allowance including both vacancy and collection loss. Both appraisers considered the vacancy levels in other shopping centers. These shopping centers, at specific points in time, demonstrated vacancy rates from 0% to approximately 7%. Such rates could easily vary from time to time. For example, one of the shopping centers considered by the taxpayer's appraiser had vacancy rates on two different dates of 3.99% and 11.38%, respectively. The municipality's appraiser, in addition to considering vacancy rates at other shopping centers, also relied upon a study by Brunelli & Co., Inc. of vacancy rates on Route 10 for each of the years 1993 through 1995. These rates were 5.8% for 1993, 3.3% for 1994 and 5.4% for 1995. The expert, however, apparently did not note or give any significance to the following language from the text of the Brunelli report relating to Route 10 vacancies: 3 With Rt. 10 having the second largest inventory of retail footage in the state's Northern tier, the 5.4% rate is no cause for alarm. Some areas, such as East Hanover and the Ledgewood Circle, remain extremely tight. On the other hand, several long standing problem properties will probably remain that way. [Emphasis supplied].

The subject property has experienced a vacancy rate in excess of 25% since the expansion of the shopping center in 1990-1991. I find that the financial difficulties of the shopping center had a negative impact on the coherence and aggressiveness of leasing efforts. The 15% vacancy allowance used by plaintiff's appraiser is not an appropriate long term stabilized vacancy rate because it is unduly influenced by the experience of the subject property during a period of financial turmoil. Five percent is also an inappropriate stabilized vacancy rate because it totally ignores the history of the subject property and is based on vacancy rates at highly successful centers which do not suffer from the negative factors set forth above. Considering (i) the history of the subject property, (ii) vacancy rates at other shopping centers which were considered by both appraisers, (iii) the negative factors affecting the subject property, and (iv) that "a vacancy allowance must be predicated on an estimate of the long-term quality and durability of the rental income stream,"

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University Plaza Realty Corp. v. City of Hackensack, 12 N.J. Tax 354, 369 (Tax 1992), aff'd 264 N.J. Super 353, certif. denied 134 N.J. 481 (1983), I find the appropriate vacancy allowance to be 10%. The Appraisal of Real Estate defines the vacancy and collection loss allowance as follows: Vacancy and collection loss is an allowance for reductions in potential income attributable to vacancies, tenant turnover, and non-payment of rent. Annual rent collections are typically less than annual potential gross income, so an allowance for vacancy and collection loss is usually included in the appraisal of income producing property. The allowance is usually estimated as a percentage of potential gross income, which varies depending on the type and characteristics of the physical property, the quality of its tenants, current and projected supply and demand relationships, and general and economic conditions.

[The Appraisal of Real Estate, supra, at 489.]

The appraiser for the municipality testified that he found no market evidence to support a separate collection loss allowance in addition to a vacancy allowance, that collection loss is attributable only to vacant space and that occasional non-payment or delayed payments of rent for occupied space do not result in a net loss of rental and thus do not warrant adding a separate factor to the vacancy percentage. I disagree and find that, for the subject shopping center, it is reasonable to include a factor for occasional non-payment of rent by tenants as well as rent interruptions resulting from the gap between the vacating of space by one tenant and the occupancy of space by a new tenant. I find such factor to be 2%. Accordingly, I find a total vacancy and collection loss allowance of 12% to be appropriate. The next step in the income approach analysis is a determination of operating expenses to be deducted from effective gross income (gross potential income reduced by the vacancy and collection loss allowance). Because the shopping center is being valued on a net lease basis, the categories of expenses payable by the landlord are limited. Both appraisers deducted expenses for management fees, leasing commissions and reserves. The appraiser for the taxpayer also deducted an expense for common area maintenance costs not reimbursed to the landlord by reason of vacant space or tenants in financial default, and an expense for a tenant improvement allowance. The appraiser for the municipality did not deduct such expenses but did deduct a miscellaneous expense. The taxpayer's appraiser used a management fee of 5% of effective gross income and the municipality's appraiser used 3% (5% less a deduction of 2% attributable to the administrative fee included in common area expense reimbursements from tenants). The municipality's appraiser testified, based on his review of the leases at the subject shopping center, that an administrative fee of 10% to 15% of other common area maintenance costs was standard in
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such leases. The taxpayer did not dispute this testimony. Only two such leases were offered into evidence. In one lease, the definition of common area maintenance costs includes an administrative fee of 15% of other common area costs. In the other, a post-assessing dates lease, the definition of common area maintenance costs includes a management fee which "shall be 4% of the annual gross rent of the shopping center." I conclude that there should be a deduction from the management fee for the administrative fee included in common area maintenance cost reimbursements. As discussed below, I find that $2.50 per square foot is the proper common area maintenance cost exclusive of an administrative fee. I can, therefore, determine the dollar amount of an administrative fee equal to 10% or 15% of this common area maintenance cost. The product of multiplying $2.50 per square foot by 110,848 square feet and then by 15% is $41,568. Reducing this amount by the 12% vacancy and collection loss determined above produces $36,580 or approximately 2.5% of the effective gross income determined using the economic rents and the vacancy and collection allowance set forth above. A 10% administrative fee is $27,712. Reducing this amount by 12% produces $24,387 or approximately 1.7% of such effective gross income. I find, therefore, that a reduction in the management fee from 5% to 3% is appropriate. Both appraisers deducted a leasing commission expense. The appraiser for the taxpayer used 3.75% of effective gross income and the appraiser for the municipality used 3% of effective gross income. The appraisers agreed that commissions are generally 5% of basic rent for new leases. The taxpayer's appraiser reduced the percentage to 3.75% because renewal commissions are not always payable. The municipality's appraiser reduced the percentage to 3% because renewal commissions are generally lower than 5% and the owner can avoid payment of any commission by direct leasing. I find no proof that owner leasing is a realistic prospect for the subject shopping center and, therefore, accept 3.75% of effective gross income as the proper deduction for leasing commissions. Both appraisers utilized 2% of effective gross income as the proper deduction for reserves, and I accept this percentage. As noted above, the taxpayer's appraiser deducted an expense for common area maintenance costs attributable to vacant space and space occupied by tenants in financial default. In determining this deduction, the appraiser noted that the common area maintenance costs for the subject shopping center, exclusive of any administrative fees were $2.83 per square foot for 1994 and $1.91 per square foot for 1995. Insurance costs were 47

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