Tenants Could Take $11B Hit Under “Split Roll” Prop 13 Proposal

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.

In California, Proposition 13 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 (aka The California Schools and Local Communities Funding Act of 2018), office, industrial and retail buildings would be reassessed every three years based on their market value starting in 2020. As a result, property tax reassessments could have a devastating effect on California office tenants.

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 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.  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.

Math

Let’s assume that you are entering into a 5-year lease for 10,000 square feet in a 200,000 square foot building (5% pro rata share) with a 2018 commencement date.  Let’s say that the building hasn’t been sold since 1987 and has a current assessed value of $30,000,000 or $150 per square foot.  And, that in 2018 (your lease “base year”) property taxes for the building are approximately $345,000 (at a rate of 1.15%).

When taxes are increased by the Proposition 13 maximum of 2.0% in 2019 to $351,900, you will have to pay your 5% share of the $6,900 increase, or $345.

However, under the split roll ballot measure let’s assume the building is reassessed in 2020 for $100,000,000 ($500/SF) and taxed on the new value. As a result, the property taxes are increased to $1,150,000.  The increase in property taxes from 2018 to 2020 would be $805,000 and since your firm occupies 5% of the building, you’d get handed a bill for $40,250.  And, you’ll pay that bill every year until the building is reassessed again in three years or your term runs out.

How many CEOs of CFOs would knowingly take on a contractual obligation without the ability to control, or plan for cost increases?  This is why we have always advised our California office tenants to pursue a cap on Operating Expense (OPEX) increases.

Protection

Unfortunately, the example above is more likely to be the rule rather than the exception for several reasons. The largest tenants in softer markets are sometime able to negotiate a cap on OPEX increases. In tighter markets like San Francisco and for smaller tenants where the landlord has the leverage, it is very difficult to negotiate for an OPEX cap.

With the proposed split roll ballot measure, not having OPEX protection could be devastating for tenants to the tune of $11B. But, building owners are extremely resistant to agreeing to OPEX caps. Commercial property is harder to sell if its tenants have Proposition 13 protection or OPEX caps.  So, it’s understandable that landlords and their brokers are somewhat inflexible and seek to pass the full 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 brokers represent both landlords AND tenants. This creates a built-in conflict of interest that few tenants understand and even fewer brokers discuss. (Full disclosure: The Mehigan Company is a corporate real estate advisory firm that specializes in tenant representation assignments.) 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 or an OPEX cap, 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 OPEX protection for their clients.

Obtaining full protection is easier said than done but it should always be subject of negotiation.  If full protection against reassessment is not possible, a more typical compromise is seeking some level of protection for example a partial cap on Operating Expense increases throughout the term of the lease.

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 in 2020. The longer it’s been since the last reassessment, the greater your exposure to property tax increases.

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