The general rationale offered by proponents of Philadelphia’s 10-year tax abatement for real estate improvements is that it promotes development that wouldn’t happen otherwise. It does this by increasing the final value (e.g. price) of the finished project by a margin large enough to cover Philadelphia’s generally high cost of construction. This higher-than-otherwise price results from the abatement conferring a significant tax advantage to the property (e.g. very low real estate taxes for 10 years) that increases its final market value.
But just how large is this advantage? And, how accurately do buyers and investors value it? This is important in order to promote the efficient administration and successful continuation of the program for several reasons.
The improvement/construction of these properties has contributed significantly to the city, with over $100 million in direct tax revenue to date and approximately half of that in each year since their abatements have expired.
First, if the value that the abatement confers is “excessively” large—in that it results in above-market returns to real estate investment—then the program is unnecessarily expensive to the taxpaying public and can be curtailed. Second, if developers, investors and buyers are not accurately pricing the value of the abatement into the sale and purchase of the finished product, then the program’s efficiency can be improved via either modifications to the program or by better educating the public on its benefits.
As noted in previous installments to this series, 10,404 residential properties have seen their abatements expire since the program’s original inception in 2000. All of these were abated and purchased in the 2000 to 2009 period. Of the original 10,404 dwellings that have since seen their abatements expire, only 3,530 have since subsequently sold. And, of these 3,530 units, only 1,175 met the conditions listed in the second installment to this series to be used for further empirical analysis. This constitutes only 11 percent of all previously abated units.
This article will endeavor to empirically calculate both the value and the price of the abatement for individual units, and then draw some larger policy-oriented inferences about the program based upon the results. The formal math behind this exercise is somewhat complicated. (See my full report for a detailed explanation.)
But we can show how this is done using an example from one of the 1,175 properties that meet the necessary conditions for this analysis: 503 Governor’s Court in the exclusive and historic townhome community of Naval Square. This is a Toll Brothers project located in the revitalized neighborhood of Gray’s Ferry at the edge of Center City. The dwelling is a 3.5 story brick townhome that has the legal status of being a condo, due to its location in a gated HOA community.
This unit was purchased in 2007 for $679,975. Since it was 100 percent new construction, the value of the structure was fully abated and the owner paid taxes only on the land. According to OPA’s property file from 2008, the total assessed value of the property was $540,000, with $15,900 of this being allocated to the value of its land. Because the structure was fully exempt, a whopping 97 percent of the property’s value was spared from taxation due to its abatement. The property’s tax bill in its first year was a mere $420. In the absence of the abatement, it would have been $14,280.
In 2016, the last year of the property’s abatement, its taxable value had risen to $564,300, with $56,430 (10 percent) being allocated to land. Its tax bill in this year was $790. Minus the abatement, it would have been $7,899.
The abatement’s value is computed by taking the present discounted value of the abated portion of the property’s annual tax bill in each year of the 10 years it was abated. In year one of the property’s abatement, the tax savings to the owner were: $14,280-$420=$13,860. In year 10 of the property’s abatement, the tax savings to the owner were: $7,899-$790=$7,109.
Adjusted for the time value of money, the owner of the unit was spared a total of just over $87,000 in taxes due to the property’s abatement status. So, in a perfectly rational world with complete foresight, the dwelling would have commanded an $87,000 premium in its first year of purchase due to the abatement. Conversely, absent the abatement, the property could be expected to sell for $87,000 less than what it actually sold for. This implies that the tax advantages conferred by the abatement constituted 13 percent of the property’s total market value. Note that this is very close to the average of 12 percent that was estimated by the City Controller’s recent report analyzing the value of Philadelphia’s abatements.
While it is reasonable to expect a buyer to pay a premium for a property with favorable tax treatment, it is equally unrealistic to expect them to be able to predict their future tax bills with complete accuracy, which would be required to accurately arrive at the $87,124 value. However, it is possible to be able to estimate what they thought their future tax bills would be by computing what the owner actually paid for the abatement.
In 2017, when all of their abatements had expired, these properties generated $44.8 million in tax revenues. With their 2018 assessed values, they are projected to generate $50.2 million in tax revenues.
To do this, a counterfactual purchase price was computed by discounting the property’s post-abatement sales price back to its original date of purchase, and then taking the difference between the actual purchase price and the counterfactual price as the abatement’s price. Since the property’s post-abatement sales price represents its market value once the abatement has expired, then adjusting this price for the general fluctuations in local real estate values over time yields the price that the property would have originally sold for if it did not have an abatement.
The previous article in this series estimated a repeat-sales property price index for Philadelphia using all paired sales between 2000 and 2017. The index is analogous to a “Dow Jones” index for Philadelphia’s housing: the percent change in the level of the index between any two periods reflects the average percent change in the value of local residential property values. A chart showing the index is below:
The value of the index in the year that the post-abated property sold (2017) is 239.58. The value of the index in the year that the same property was originally purchased (2007) is 168.64. To obtain the counterfactual price (P) of the property, the 2017 sale price is deflated using the value of the index as follows:
P = $775,000 x (168.64/239.58) = $545,511
This price is ~30 percent less than its subsequent sales price, which is exactly the same as the percent change in the level of the index between 2007 and 2017; i.e. average residential property prices in Philadelphia rose 30 percent from 2007 to 2017. So, to predict the likely purchase price of a property in 2007 when only its 2017 sale price is available, the 2017 sale price is simply deflated by 30 percent.
The $545,511 price represents our best counterfactual estimate of what this property would have been purchased for in 2007 if it didn’t have an abatement. However, the actual purchase price of the property in 2007 (with an abatement) was $679,975. The difference between these two numbers, $134,464, represents the actual price that the buyer “paid” for the abatement.
Since the actual value of the abatement was $87,124, these numbers imply that the buyer overpaid for the abatement by $47,340, which added a 20 percent premium (rather than a 13 percent premium) to the base price of the property. Such a higher premium could be rationalized if the buyer expected to see their assessed value (and hence, tax bill) increase by a faster and higher amount than it actually did. The 13 percent premium that represents the actual value of the abatement reflects the actual appreciation rate of its assessed value, which was an average of 1.4 percent per year. Based upon the 20 percent premium that the buyer paid, they would have expected the property’s assessed value to increase by significantly more than 1.4 percent per year.
The above exercise was carried out for all 1,175 abated properties that have since seen their abatements expire and have also since sold under arms-length conditions. The following inferences can be made from the data:
- The price that buyers paid for the abatement typically exceeded the actual value of the abatement.
- The variation in what buyers paid for the abatement is significantly greater than the variation in the actual value of the abatement.
- Abatement prices can have negative values, while abatement values are always positive:
o An empirical examination of these properties with negative abatement prices revealed that most of them were purchased in the 2000 to 2003 period, before the significant inflation of the housing boom/bubble. But, they were also disproportionately sold in the 2009 to 2012 period, after the bubble had burst and prices were in a significant deflationary cycle. Hence, when the post-bubble low sales prices were discounted even further to obtain pre-bubble purchase prices, a negative difference between the implied purchase price and actual purchase price resulted.
o Thus, rather than characterizing the owner of these properties as “shrewd buyers” (negotiating a purchase price that was less than the abatement’s value), it would be more appropriate to characterize them as “panicky sellers” (they sold their unit at a significant discount at a time when the market was also in a downturn).
To examine the percent premium that the abatement contributes to property prices the next chart compares the distribution of Pct_Abate_Value to Pct_Abate_Price across all post-abated properties. These numbers were computed by simply dividing Abate_Value and Abate_Price into the original purchase price of each property:
The information in the chart shows that the price premium that buyers paid for the abatement was typically greater than its actual value.
To empirically quantify the relationship between the prices that buyers paid for the abatement versus the abatement’s actual value, a regression of the former against the latter was computed. The next chart shows a scatterplot of abated prices against abated values, with the fitted regression line showing the explicit mathematical equation between these two variables fitted to the data:
The regression yields the following findings:
- Despite abatement prices generally exceeding abatement values, the correlation between the two is still very strong.
- For every $1 in a property’s abatement value, buyers paid an average of $1.75 in a higher price for that property.
Lastly, using both the historical and current assessed values of these properties, we can calculate what revenue they have and are generating in real estate-related taxes:
- While their abatements were in effect, these approximately 10,000 properties have collectively generated $103.7 million in tax revenues to the city, most of which is from their (unabated) land values.
- In 2017, when all of their abatements had expired, these properties generated $44.8 million in tax revenues.
- With their 2018 assessed values, they are projected to generate approximately $50.2 million in tax revenues.
- Due to the overpayment for the abatement, the city is estimated to have reaped a $15 million windfall in additional transfer taxes during the 2000 to 2009 period when these properties were first purchased. If this same condition also applied to currently abated properties, this number would be approximately double that.
The numbers clearly show that abatement has both a very real and very significant value in the marketplace, typically adding 11 to 20 percent to a property’s value. And, the improvement/construction of these properties has contributed significantly to the city, with over $100 million in direct tax revenue to date and approximately half of that in each year since their abatements have expired.
However, what are the larger implications of these results for the abatement program and its fiscal costs/benefits to Philadelphia? In particular, what is to be made of the result that buyers have typically “overpaid” for the abatement?
From the short-term and narrow perspective of city government, having the abatement priced at a number greater than its intrinsic value may not necessarily seem like a bad thing. It results in both real estate transfer tax revenues and real estate tax revenues being higher than they would be otherwise, since both are indexed to market values. However, this myopic view ignores several key facts:
- First, every additional dollar that is unnecessarily spent on the abatement by Philadelphia households is a dollar that has been wasted and can’t be spent elsewhere. So, additional revenues from real estate taxes are offset at least partially by lower revenues from other taxes, such as the sales tax.
- Second, paying an excessive premium for the abatement can have distortionary effects on both the overall real estate market and assessed values. In areas with high concentrations of abated properties, such as Center City and the revitalized neighborhoods surrounding it, the general level of real estate values will be higher than what they should be since the premium placed upon abated properties will skew average prices upwards. Longer-term, it can result in a more inequitable and inefficient distribution of property taxes, since both abated and non-abated households in these neighborhoods will have higher assessed values than they should.
- Thirdly—and importantly—it should be pointed out that all of the analysis in this paper used property sales from 2000 to 2009, when property prices were rising very rapidly, and that this may explain why most abatement prices surpassed their values. If the buyers of these properties expected their assessments—and hence, tax bills—to continue to rise quite rapidly in the years following their purchase, then this could lead them to value the benefit of the abatement as being higher than its intrinsic worth. If so, then the fact that abatement prices exceeded abatement values may be just a transitory and outlying artifact of that particular time period, with minimal implications for the current debate over the abatement program’s future
Lastly, it could be quite tempting—but also quite possibly incorrect—to interpret these results as evidence that the abatement program could be scaled back with minimal adverse effects on housing production and sales in Philadelphia. After all, if the abatement is generally overpriced, then curtailing its benefits would seem to intuitively work to bring its market price back into line with its intrinsic value. But, any reduction in the program’s scope or duration will also result in a decline in the abatement’s intrinsic value in addition to a decline in its market price. So, the gap between price and value would still persist. Moreover, this reduction would drop the overall return on housing development in Philadelphia, which could result in a dramatic decline in new housing production and investment in Philadelphia, even if the abatement still had a positive market value. Hence, these results should be understood and applied with caution.
Kevin Gillen, PhD, is the senior economic advisor at Houwzer, a Philly-based real estate agency. He is also a senior research fellow at the Lindy Institute for Urban Innovation at Drexel University.Photo: Paul Sableman via Flickr (CC BY 2.0)