Navigating Property Tax Liabilities: A Guide for Commercial Property Tenants in California6/20/2024
 As tenant representatives, we emphasize that ownership quality is a critical factor when comparing similar commercial properties. The long-term ownership and management of a property often result in better maintenance and stability.
Understanding Proposition 13 and Its Impact on Property Taxes Proposition 13, passed by California voters in 1978, limits annual property tax reassessment increases to 2%. However, a full reassessment to market value occurs if the property is sold, more than 50% is transferred, or significant new construction is completed. This reassessment can significantly impact tenants, as commercial landlords typically pass on property tax costs to tenants. Lease Types and Their Implications In California, commercial leases generally fall into two categories:
Example of Property Tax Impact on Tenants Consider a prominent San Francisco office building with 500,000 rentable square feet (RSF). A tenant leasing 10,000 RSF (2% of the building) would share 2% of the property tax burden. Assuming a 1% property tax rate and a base year of 2023, with an assessed value of $80,000,000 and property tax of $800,000, the scenario changes dramatically if the building is sold. If sold in 2024 for $250,000,000 ($500/RSF), the reassessed property tax would increase more than 200% to $2,500,000. The tenant's share of the increase would be $34,000 annually, significantly higher than a 2% Proposition 13 increase before the sale. The Hidden Risks of Property Tax Liability Tenants in long-held properties face substantial tax liabilities if these properties are sold or transferred. Even with decreasing office property values, many buildings owned for decades by family offices carry significant reassessment risks for tenants. The Role of Brokers in Mitigating Property Tax Risks A key differentiator between similar properties can be the tenant’s potential property tax liability. We meticulously calculate this liability for every property option presented to our clients. As a tenant-exclusive brokerage, we strive to negotiate protections such as caps on OPEX increases, including property taxes. While landlords often resist these caps due to the impact on property sale value, the post-pandemic market shift has made it more feasible for tenants to secure such protections. The Conflict of Interest in Traditional Brokerage Many commercial brokerages represent both tenants and landlords, creating a conflict of interest that can prevent them from addressing property tax liabilities effectively. If your broker isn't discussing this critical issue, it might be due to the inherent risks to their business model. Actionable Advice for Tenants Before signing a lease, tenants should thoroughly assess their property tax liability by determining the property's last reassessment date, its assessed value then, and its current assessed value. This helps forecast potential increases due to ownership changes. Understanding and negotiating property tax liabilities is crucial for avoiding unexpected financial burdens. By prioritizing ownership quality and understanding property tax implications, we help our clients make informed leasing decisions, ensuring they avoid unforeseen expenses and secure more favorable lease terms.  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. Buildings that have been owned and managed by the same entities for a long period of time tend to be better managed.
 A What does the sale of the Transamerica Pyramid mean for Tenants? A New York investment firm and its partners closed a deal to buy San Francisco’s iconic Transamerica Pyramid for $650 million, marking the first time the building has changed hands since it was delivered in 1972. 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 approved 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. Property tax reassessments can 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 the case of the Transamerica Pyramid, since it was built in 1972. As a result, tenants in buildings like the Transamerica Pyramid carry a potentially large tax liability when the property is sold or transferred during the term of their lease. What is the property tax liability for Tenants of a building like the Transamerica Pyramid? 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 1972 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 was increased by the Proposition 13 maximum of 2.0% in 2019, the building’s subsequent year’s taxes were $2,932,500. You paid your 2% share of the $57,500 increase, or $1,150. However, in October 2020 the building sold for the first time since 1972 for $650,000,000. Under Proposition 13, the property will be reassessed and taxed on the new value, and the property taxes will be increased to $7,475,000. The increase in property taxes from your base year 2018 to 2020 will be $4,600,000 and since your firm occupies 2% of the building, you’ll get handed a bill for $92,000 ($9.20/SF). And, you’ll pay that bill and more every year 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 in their lease negotiations. 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 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. 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. That 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 . The longer it’s been since the last reassessment, the greater your exposure to property tax increases.  California is in the midst of an unprecedented economic crisis, and yet another threat is on the horizon. The 2020 California Proposition 15 would change the way commercial property is taxed and have a devastating effect on small- and medium-sized business that make up half of California office tenants.
Proposition 13 was approved 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, 2020 California Proposition 15 (aka “split roll”) would remove the 2% reassessment limit and require commercial and industrial properties to be taxed based on their market value beginning in fiscal year 2022-2023. In California, commercial landlords in multi-tenant buildings typically pass on a pro-rata share of building operating expense (OPEX) including property taxes, to their office tenants. In the most common office lease, tenants are only responsible for OPEX increases over the “base year” amount which is most often the year of the commencement date or the year following the commencement date. 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. Buildings that have been owned and managed by the same entities for a long period of time tend to be better managed. Under Proposition 13, buildings like these may not have been reassessed at market value for years and in some cases decades. As a result, their tenants carry a large tax liability if the property is sold or transferred during the term of their lease. Or, if Proposition 15 passes. How much will tenants absorb when Proposition 15 tax increase is passed through to them? Let’s keep the math simple for this hypothetical example and use a 1.15% property tax rate and assume that you entered into a 7-year lease for 10,000 rentable square feet (RSF) in a San Francisco building with ~500,000 RSF. You would have a 2% pro-rata share with a 2019 commencement date and base year. In this example, the building hasn’t been sold since 1998 and has a Proposition 13 assessment value of $75,000,000 in your 2019 base year with property taxes of $862,500. When the assessment value of the property is increased by the Proposition 13 maximum of 2.0% in 2020, the subsequent year’s taxes will be $879,750. You will have to pay your 2% share of the $17,250 increase over base year, or $345. In 2021, taxes will be $897,345 and your 2% share of the $34,850 increase would be $697. All very manageable. However, in 2022 under Proposition 15 the 2% limit on property tax reassessments is removed and property will be reassessed and taxed on the market value of $400,000,000 (estimated $850/SF sale price) with property taxes increasing to $4,600,000. The increase in property taxes from your base year 2019 to 2022 would be $3,737,500 and since your company occupies 2% of the building, you’ll get handed a bill for $74,750. And, on top of your base rent you’ll pay that bill and more every year until your term runs out. How many CEOs would knowingly take on a contractual obligation without the ability to control, or plan for cost increases? Whether Proposition 15 passes or not, California office tenants still carry a large tax liability if the property is sold or transferred during the term of their lease. Just as we advise our clients that ownership matters, so too does a building’s property tax liability. In addition to ownership, the differentiator between two similar buildings and spaces with like amenities and rent may come down to size of a tenant’s property tax liability. For this reason, we pursue some level of protection for our office tenants by seeking a limit on Operating Expense increases throughout the term of the lease. For the last decade only the largest tenants in softer markets have been able to negotiate caps on OPEX increases. But a black swan event like the coronavirus pandemic shifted leverage in markets that once favored landlords to favoring tenants overnight. Seeking and obtaining OPEX protection is easier said than done but it should always be subject of negotiation. At a minimum, it’s important to do the math on your 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 Proposition 15. The longer it’s been since the last reassessment, the greater your exposure to property tax increases.  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. |
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