Proposition 13 and California "Split Roll" Ballot Measure
Most California office tenants know that commercial landlords typically pass on a pro rata share of real estate taxes, including property taxes, to their tenants. In the most common office lease, tenants are only responsible for property tax increases over the “base year” amount which is most often the year of the commencement date or the year following the commencement date.
Proposition 13 was passed by 65% of California voters in 1978 and currently limits property tax reassessments (increases) to 2% annually but allows for full tax reassessments if the building is sold, more than 50% is transferred, or substantial new construction is completed. Significantly, under a proposed California "split roll" ballot measure, office, industrial and retail buildings would be reassessed every three years and taxed at their full value years commencing in 2020. Whether the split roll ballot measure passes or not, property tax reassessments have a devastating effect on California office tenants.
Property Tax Liability
As tenant representatives, we advise our clients that ownership matters. The differentiator between two similar buildings and spaces with like amenities and rent can often come down to the quality of ownership. In general, buildings like the Transamerica Pyramid that have been owned and managed by the same entities for a long period of time tend to be better managed.
However, these same buildings may not have been reassessed under Proposition 13 for years and in some cases decades. The Transamerica Pyramid has been under the same ownership since 1999. As a result, tenants in buildings like the Transamerica Pyramid carry a potentially large tax liability if the property is sold or transferred during the term of their lease. Or, if the split roll ballot measure passes.
What would the sale of a building like the Transamerica Pyramid mean for Tenants?
Let’s keep the math simple for this example with a 1.15% property tax rate and assume that you entered into a 5-year lease for 10,000 square feet in a building like the Transamerica Pyramid with ~500,000 square foot. You have a 2% pro rata share with a 2018 commencement date.
The building hasn’t been sold since 1999 and had an assessed value of $250,000,000 in 2018 (your lease “base year”) and property taxes for the building were $2,875,000.
When the assessed value of the property is increased by the Proposition 13 maximum of 2.0% in 2019, the building’s subsequent year’s taxes will be $2,932,500. You will have to pay your 2% share of the $57,500 increase, or $1,150.
However, let’s say that in 2020 the building is sold for $460,000,000. (According to CoStar, the average sales price per square foot in the Financial District is about $920.) Under Proposition 13, the property will be reassessed and taxed on the new value, and the property taxes will be increased to $5,290,000. The increase in property taxes from your base year 2018 to 2020 would be $2,415,000 and since your firm occupies 2% of the building, you’ll get handed a bill for $48,300. And, you’ll pay that bill and more every year until your term runs out.
Split Roll Example
Under the proposed California "split roll" ballot measure, even though the building in the previous example was not sold, it will be reassessed in 2020 and taxed on the new value. Property taxes will increase to $5,290,000 and you’ll get handed a bill for $48,300. Your building would be reassessed every three years and taxed at its full value until your term runs out.
Why is Proposition 13 protection a third rail issue for brokers?
How many CEOs would knowingly take on a contractual obligation without the ability to control, or plan for cost increases? This is why California office tenants should pursue Proposition 13 protection.
Unfortunately, the example above is the rule rather than the exception for several reasons. The largest tenants in softer markets are more likely to gain Proposition 13 protection. In tighter markets and for smaller tenants where the landlord has the the leverage, it is very difficult to negotiate for Proposition 13 protection.
Not having Proposition 13 protection can be devastating for tenants but building owners are extremely resistant to agreeing to this protection. Simply put, commercial property is harder to sell if its tenants have Proposition 13 protection. So, it’s understandable that landlords are somewhat inflexible and seek to pass the tax reassessment burden onto tenants. Proponents of the split roll measure estimate it will raise ~$12 billion in new annual revenues which will be passed directly through to tenants.
Somewhat harder to explain and understand is why Proposition 13 protection is a third rail issue for brokers. The dirty little secret in office leasing is that more than 90% of the commercial real estate brokerages represent both tenants AND landlords. This creates a built-in conflict of interest that few tenants understand and even fewer brokers discuss. No one would hire a lawyer who works for the other side. Yet, the equivalent happens every day when tenants work with commercial real estate brokers and firms that also represent landlords. So, if your broker or anyone else in their office represents landlords, you have a built-in conflict of interest.
If your broker isn’t asking for Proposition 13 protection, it’s probably because like a third rail, touching it is extremely dangerous for their business. This is why many California brokers don’t pursue Proposition 13 protection for their clients.
Seeking and obtaining Proposition 13 protection is easier said than done but it should always be subject of negotiation. If full Proposition 13 protection against reassessment is not possible, a more typical compromise is seeking some level of protection, for example a cap on Operating Expense (OPEX) increases throughout the term of the lease.
At a minimum, it’s important to do the math on your potential Proposition 13 reassessment liability before entering a lease in any building in California. Tenants need to know when the property was last reassessed for Proposition 13 purposes, what its assessed value was and what its assessed value is today in order to forecast the potential liability due to a transfer of ownership or passage of the split roll measure. The longer it’s been since the last reassessment, the greater your exposure to property tax increases.
Most California office tenants know that commercial landlords typically pass on a pro-rata share of operating expenses, including property taxes, to their tenants. In the most common office lease, tenants are only responsible for property tax increases over the “base year” amount which is most often the year of the commencement date or the year following the commencement date.
In California, Proposition 13 currently limits property tax reassessments (increases) to 2% annually, but allows for full tax reassessments if the building is sold, more than 50% is transferred, or substantial new construction is completed. Under the proposed California "split roll" ballot measure, office, industrial and retail buildings would be to be regularly reassessed and taxed at their full value. As a result, property tax reassessments could have a devastating effect on California office tenants.
Buildings that have been owned and managed by the same entities for a long period of time may not have been reassessed under Proposition 13 for years and in some cases decades. As a result, these buildings carry a potentially large operating expense/tax liability that buildings with high resale turnover do not. Tenants in buildings with the most stable long-term ownership will have the largest tax reassessment liability under the split roll ballot measure.
At a minimum, it’s important to do the math on your potential split roll and/or Proposition 13 reassessment liability before entering any new lease or renewal in any building in California. Tenants need to know when the property was last reassessed for Proposition 13 purposes, what its assessed value was and what its assessed value is today in order to forecast the potential liability due to a transfer of ownership under Proposition 13 or a mandatory reassessment under the split roll initiative. The longer it’s been since the last reassessment, the greater your exposure to property tax increases.
Average Square Footage Approach
The trend in average square footage of office space per person is clearly down. Companies have been modifying their space parameters to attract and retain the sharing generation workforce. Layouts of offices are dramatically different now than even 10 years ago. The open design has replaced a cube farm which years ago replaced enclosed large office designs.
In 2017, U.S. office space per employee dropped to 182 square feet per worker according to commercial real estate information provider CoStar. That's down from 197.3 square feet in 2010. The rule of thumb for creative open space that startup and small technology companies seek has been decreasing from 200 to 250 square feet to as low as 100 to 150 square feet of “usable" office space per person.
Space Allocation Approach
The following office space allocations can be used to help estimate the amount of usable office space required for your business based upon uses. Any common area load factors (typically between 10% and 20%) will need to be added on to determine the "rentable" area.
Keep in mind that no two spaces are alike. Look for spaces that are more efficient, like rectangular spaces versus angled corners of a building. No two spaces with the same square footage are the same. Floor plan and layout matter.
If you are planning to grow, minimize the disruption to your business by seeking termination rights and expansion rights on contiguous space. Growing into adjacent space is far less disruptive than relocating your business to another building.
Efficient space planning will not only quantify the right amount of office space but identify the office space with the best combination of value and size fit.