Are Data Centers Special Purpose Properties?

Data centers are now an important part of Illinois’ commercial property environment. The tax incentive legislation passed in 2019 is expected to accelerate the growth of data centers in Illinois and the greater Chicago metropolitan area.

The primary challenge facing property assessors nationwide is separating the business value and the value of the contents (personality, furniture, futures and equipment) from the real estate (the land and the “shell” or building).

It is unclear what methodology the Cook County Assessor and Board of Review, as well as other assessing bodies around the country, are using to determine the fair market values of data centers. This uncertainty raises the question of whether data centers are special purpose properties requiring a cost approach for determining fair market value.

A special purpose property is defined by “The Appraisal of Real Estate, 12th ed. published by the Appraisal Institute” as follows:

“A limited market property with a unique physical design, special construction materials, or a layout that restricts its utility to the use for which it was built (also known as Special-Design Property).”

The Appraisal of Real Estate further defines a Limited Market Property as follows:

“A property that has relatively few potential buyers at a particular time, sometimes because of unique design features or changing market conditions. Many limited-market properties include structures with unique designs, special construction materials, or layouts that restrict their utility to the use for which they were originally built. These properties usually have limited conversion potential and, consequently, are often called special-purpose.”

The cost approach is one of three valuation methods for real estate; the others are the income approach and the comparable sales approach.

The cost approach determines real estate fair market value by calculating how much the building would cost today if destroyed and were replaced. The cost approach also factors in the land value and makes deductions for depreciation, or any loss in value.

Much of the value in the data center is in the personality and intangible assets, such as business value. It appears that data center assessments, not only in Illinois, but nationwide, consistently include the personalty and business value in the fair market value for the property. The fair market value should reflect only the value of the building and the land.

There is very little legal authority on whether data centers are special purpose properties. The little existing authority is outdated, and provides minimal guidance for answering this question today.

Relevant Cases

United Airlines, Inc. v. Pappas, Appellate Court of Illinois, First District, Sixth Division.April 16, 2004348 Ill.App.3d 563809 N.E.2d 735284 Ill.Dec. 169.

Special purpose property is property “of such nature and applied to such special use that it cannot have a market value.” Chrysler Corp., 69 Ill.App.3d at 212, 25 Ill.Dec. 695, 387 N.E.2d at 355, quoting City of Chicago v. Farwell, 286 Ill. 415, 420, 121 N.E. 795, 797 (1918) . The key criterion in determining whether property is special purpose property is “whether the property is in fact so unique as to not be salable, not what factors might or might not make it so unique.” Chrysler Corp.,_69 Ill.App.3d at 213, 25 Ill.Dec. 695, 387 N.E.2d at 356 .

“Generally, the reproduction-cost approach should be emphasized only in the context of special-purpose property, which is defined as property of such a nature and applied to such a special use that it cannot have a market value.” Chrysler, 69 Ill.App.3d at 212, 25 Ill.Dec. 695, 387 N.E.2d 351.

In light of these Illinois cases, not all data centers would qualify as “special purpose properties.” Most recent data centers are built to suit, and would have no or minimal use for any other purpose. The characteristics that optimize their value as data centers (raised floors, electrical transmission capacity, cooling and temperature maintenance, security) are not practical or necessary for other uses. Older data centers include buildings that were retrofitted to be data centers. Clearly, such buildings are not special purpose properties, as they have proven their adaptability by having been converted to data centers.

Data Center Leases

While data center leases include physical space, they often include services and resources also, such as access to batteries, generators, cooling systems, and continuous security systems. These components, while needed to satisfy the expectations of data center tenants, are not part of the real estate as it is defined for tax assessment purposes.

The Appraisal Institute emphasizes the dangers of using sale-leaseback rents in estimating market rent. When analyzing whether or not a lease is representative of market levels:

“It is [also] important to ascertain that the lease represents a freely negotiated, arm’s-length transaction. A lease that does not meet these criteria, such as a lease to an owner-tenant or a sale-leaseback, often does not provide a reliable indication of market rent. Since sale-leasebacks are actually financing vehicles, they should not be used in estimating market rent.”

Conclusion

Although data centers do not uniformly qualify as special purpose properties, property assessors should still consider cost approach evidence in assessment appeals. The Cook County Board of Review has described data centers as “unique” and has requested cost approach evidence in data center assessment appeals.