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.