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.
In full-service gross office leases, landlords typically pass on a pro-rata share of operating expenses (OPEX) related to the tenant's occupancy of the space. In the most common office lease, tenants are only responsible for common area maintenance, utilities, property insurance, and 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.
Each year during Q1 you and your accounting department receive estimates of current year operating expenses as well as reconciliation of previous year actual operating expenses.
What to Expect
Since landlord’s pass through operating expenses to tenants they have little incentive to control these costs. For this reason, operating expenses almost always increase from year to year. You can view any OPEX category that increases less than 3% or 4% over the previous year as reasonable while anything over that should be explained by the landlord.
Check the Math
If the Landlord doesn’t itemize your charges be sure to ask for an itemized break down by category. Whenever an annual reconciliation hits your inbox without sufficient back up to verify expenses and calculations, it’s time to check the landlord’s math and determine if a lease audit is called for. Your broker can help you check the math and assess if you are being overcharged by your landlord and assist in recovering any overpayments.
If your broker doesn’t have the time or interest to assist you it may be that their brokerage doesn’t exclusively represent tenants. The dirty little secret in office leasing is that most commercial real estate brokers represent both landlords AND tenants. This creates a built-in conflict of interest that few tenants understand and even fewer brokers discuss.
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 offering to assist in your annual OPEX reconciliation, it’s probably because they or someone in their firm also represents the landlord that overcharged you for your operating expenses.
Finding the right office space can be an exciting challenge for a business. Once you've made the decision to seek your first or your next office, your instinct may be to ask Siri, Alexa, or Google search to "find office space".
Your results will be dominated by listings in free databases of office space (Loopnet, 42Floors, Officspace.com...), paid advertising listings from coworking firms and flexible office providers (WeWork, Regus, Knotel, Servcorp...), and likely some listings from commercial office brokers that represent landlords.
One of the biggest mistakes to avoid when looking for office space is not finding multiple, competitive alternatives. On the surface it may seem like your search has produced plenty of potential alternatives but in fact, the free databases, coworking and brokerage listings are populated and paid for by landlords and brokers representing landlords. Therefore, you are presented with the listings and information that benefit landlords and their brokers, not you the tenant.
Not every available office space is included in the free databases because of the cost to brokers and landlords. And, listings that are included often only quote a range of asking rents or in tighter markets, asking rents may even be WITHHELD.
Paid advertising listings from coworking firms and flexible office providers direct you to their websites to begin your deep dive into their plans, pricing, locations and FAQs.
There is nothing wrong with asking Siri, Alexa, or Google to find office space for an overview of the market through the eyes of a landlord and their brokers. But, the results are not comprehensive, lack key information and don't represent the true market condition for office space.
Consider hiring a broker that works exclusively as your tenant representative who will save you time normally spent researching space and provide the peace of mind that every opportunity in the market will be presented to you. Firms that specialize in tenant representation are only focused on finding value and multiple alternatives, many of which aren't found by asking Siri, Alexa, or Google search.
In commercial office lease transactions fees for the tenant representative are paid by landlords, not tenants. Even though tenant representatives are paid by the landlord, they work exclusively for you and unlike Siri, Alexa, or Google, have a fiduciary duty to represent your needs in everything they do.
Blockchain is best known as the technology powering cryptocurrencies like Bitcoin and Ethereum. The "block" is digital information stored in the "chain" which is a public database. The blocks on the blockchain are made up of digital pieces of information:
In contrast, the commercial real estate (CRE) industry has historically isolated information that is essential for searching, selecting and negotiating office leases behind private brokerage in-house databases and an imperfect subscription-based industry database. Much like the travel industry prior to the Internet, the commercial real estate industry is extremely inefficient and lacks transparency.
Standard operating procedure for commercial real estate brokers is to keep transaction information secret and centrally controlled for the purpose of creating competitive advantage. There is an intentional lack of transparency on the part of brokers representing landlords that increases the potential for inaccurate market information. But what if the data related to every office lease transaction and every property was held in an open and shared public blockchain database for all involved parties in a transaction?
Technology-driven information transparency is one of the major disruptive forces on the horizon for commercial real estate and office leasing. Globally, venture-backed real estate tech companies raised $14 billion USD in 2019 Q1-Q2, a 309% increase from 2018 Q1-Q2. (Source: CREtech, Mid-Year Report, 2019)
It is not a matter of if, but when. And when that day comes, you can count on an erosion of the lucrative fee structure in office leasing. The market will eventually demand transparency and the removal of information silos built and maintained by commercial real estate brokers and real estate database companies. Today, the huge commissions that brokers earn are largely justified by the existence of these silos.
Eventually, all markets demand transparency and so too will tenants of commercial real estate. As market information becomes more freely accessible the leverage in an office leasing transaction will shift from listing brokers and landlords to tenants and tenant representatives. This new market landscape will empower tenants to demand more value from their broker than just sharing proprietary market data.
That said, an office leasing transaction is much more complex than booking travel online. No two deal terms are the same just as no two spaces with the same square footage are the same just as no two landlords or buildings are the same.
So, there will be a role for a middleman in office leasing, but it won’t be about sharing lease comps or asking rents. It will be about adding quality, value and services to the transaction. Brokers clinging to legacy business models and fee structures are likely to feel like travel agents in the '90s standing on the wrong set of tracks when the Internet train passed by.
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.