Why California Office Tenants Should, But Don’t Pursue Proposition 13 Protection

Background

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.

TAXIn 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.  As a result, property tax reassessments can 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 have no visibility into the timing or the amount of their liability yet they are contractually obligated to pay Proposition 13 tax reassessment increases if the property is sold or transferred during the term of their lease.

Math

Let’s assume that you entering into a 5-year lease for 10,000 square feet in a 200,000 square foot building (5% pro rata share) with a 2016 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 2016 (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 2017 to $351,900, you will have to pay your 5% share of the $6,900 increase, or $345.

However, let’s say that in 2017 the owner of your building decides to sell the building for $100,000,000 ($500/SF).  Under Proposition 13, the property is reassessed and taxed on the new value, and the property taxes are increased to $1,150,000.  The increase in property taxes from 2016 to 2017 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 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?  This is why California office tenants should pursue Proposition 13 protection. 

Protection

Unfortunately, the example above is the rule rather than the exception for several reasons.  Larger 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 Proposition 13 protection.   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 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, 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.

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 any 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.

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