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. According to Costar the Transamerica Pyramid hasn't been sold since it was built in 1972. 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 does 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 in decades and had a Proposition 13 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, according to Costar the building is being sold for the first time since 1972 for north of $700,000,000. Under Proposition 13, the property will be reassessed and taxed on the new value, and the property taxes will be increased to $8,050,000. The increase in property taxes from your base year 2018 to 2020 would be $5,175,000 and since your firm occupies 2% of the building, you’ll get handed a bill for $103,500. 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 $8,050,000 and you’ll get handed a bill for $103,500. 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.
Tenants are reading and hearing conflicting data on today’s San Francisco office market that makes it difficult to determine if the office market bubble is about to burst or if the market is strong and growing stronger.
The Bay Area economy remains strong, direct vacancy is tight, and tenants are paying record high rents:
On the other hand, there are indicators that an office market bubble could be on the horizon.
Reading the Tea Leaves
From a tenant’s perspective it’s important to understand what is causing these conflicting market conditions in order to leverage your advantages as a tenant in the current office market.
Nearly every rapidly scaling tech company has a business plan that relies on headcount growth, which is why tech tenants like Dropbox, Micron Technology and Splunk are “banking” space in advance of hiring and are offering to sublet portions that are going unused for now.
These unicorns are wisely looking to monetize their leased but unused space until they grow and are therefore creating large amounts of sublease space on the market. This monetization of banked space is not likely a leading indicator of an office market bubble. In fact, it presents below market opportunities and leverage for tenants willing to move into a sublease.
So, given the below market rents for sublease space, why isn’t your broker enthusiastic about sublease space options?
More than 90% of the commercial real estate brokers in San Francisco represent both landlords and tenants. 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.
It is in the best interest of brokers that represent landlords to keep perceived asking rates as high as possible and vacancy rates as low as possible. But, large amounts of below market sublease space softens the market. Otherwise, landlords and listing brokers would openly publish asking and actual rents on every direct and sublease space they list.
A bigger reason your broker isn’t enthusiastic about sublease space options is brokers are sometimes paid a lower fee on subleases. And, a sublease transaction is often more complicated and difficult to negotiate than a direct space lease. So, more work and less commission make sublease options a lower priority for most commercial real estate brokers.
Leverage Your Advantages
In order to gain leverage on your office transaction you need to first eliminate conflict of interest. If your broker or anyone in their office has listings in the market, they have a conflict of interest. Make sure you are working with a tenant representative firm and not listing brokers.
Next, explore all your options with your tenant representative. There are very real differences and trade-offs associated with each of your options - shared, co-working, sublease, direct, etc…
If you decide to explore subleases be certain they fit your timeline and flexibility. Companies that are uncertain about long-term growth plans may desire shorter lease terms. In this case, sublease may be an option that would otherwise not be available in the direct lease market. You’ll definitely be able to find sublease space at below market rates but your trade-offs will include limited flexibility on tenant improvements, renewal options and financial liability.