Prior to 1978, buildings and property in
California were assessed each year
based upon their fair market value.
Proposition 13 stopped that.
Approved in June 1978 by 65 percent of
the California voters, Proposition 13 enacted Section 2 of Article XIIIA of the California Constitution and provided for a property acquisition value assessment system.
Under the revised system, property values are assessed upon market value when
there is a change of ownership or by new
construction. Thereafter, the taxable value
of property can increase annually by no
more than the rate of inflation or 2 percent,
or whichever is less. The current tax rate
fluctuates statewide between 1 percent
and 1.2 percent.
“The biggest injustice of Proposition 13 to
office market tenants is the real estate tax
pass-through,” says Craig A. Irving, principal, Irving Hughes. “If your company
moves into a building with a low tax basis
and that building sells later at market,
you’re exposing the company to a potentially huge increase in occupancy costs.”
Smart Business asked Irving to illustrate
some of the facts about real estate tax
pass-throughs and the devastating effects
they could potentially have on office space
lessees.
How are lease costs determined?
Typically a tenant signs a lease for a
defined period of time — three-, five- and
10-year leases are most common. The first
calendar year of the tenant’s occupancy
determines the base year for the operating
expenses the landlord pays, and each subsequent year, the tenant pays additional
rent for any incremental increases in
expenses over the base year aggregate.
So as the cost of supplies, insurance, janitorial contracts, electricity and other
maintenance expenses rise, the landlord
passes those increases directly to the tenant. This is an inflationary hedge by the
landlord. Never mind that a landlord likely
collects 3 to 4 percent increases each year
in the base rent and possibly parking revenue.
What is causing a large area of exposure for
office tenants?
We represent tenants in office leasing and
protect them in as many financial areas as
possible. Rent and tenant improvements
are the primary areas of focus for most tenants and brokers, but financial pitfalls lurk
in many other areas of a lease transaction.
None is more dangerous than the real
estate tax pass-through.
How do real estate tax pass-throughs come
into play?
Tenants pay rent and provide landlords
the revenue to pay expenses, the mortgage
and, in most cases, a return on their investment. Tenants, and the rent they pay, create
the value in the buildings they occupy. The
real estate tax pass-through creates a huge
exposure for tenants because, under
Proposition 13, every time a building is sold, it is reassessed for real estate tax purposes. The new value, and the new incremental tax base, gets passed directly
through to the tenants. With buildings selling for higher and higher prices these days,
tenants are getting hammered with significant real estate tax pass-throughs.
Can pass-throughs cripple an organization?
Here’s an example: Let’s assume a tenant
signs a 10-year lease in 1999 for 20,000
square feet. The tenant receives a 1999
base year for operating expenses that
totals $10 per foot per year in costs to operate the building, including property taxes
of $1.80 per year based on an assessed
building value of $150 per square foot. The
fact that this tenant signed a lease for 10
years increases the value of the building
and, five years into the lease, the landlord
gets an offer to sell the building for $400
per foot. The seller makes a fortune and
never looks back.
The new assessed property tax value after the sale is $4.80, and the difference between the base year assessed value and the
new value is $3 per year, or 25 cents per
square foot per month. This difference is
now passed on to all the tenants in the
building. In our example, the tenant will
have to start paying an additional $60,000
per year for the remaining five years on the
lease. This significant impact on the tenant’s bottom line was probably never anticipated or expected.
What can be done about this?
Almost nothing. Proposition 13 tax protection is rarely negotiable unless a tenant
has a lot of leverage from occupying a significant portion of a building, has exceptional credit and is in a tenant-favorable
market. When weighing different options
in the market, it’s important that tenants
understand the cost basis of each building
they are considering. Cost basis varies
from building to building and submarket to
submarket. A contingency must be considered if, on the surface, two buildings offer
the same economic package, but one building has half the basis as another and
Proposition 13 protection is not available.
Tenants must understand the potential
downside cost in the event their building is
sold out from under them.
CRAIG A. IRVING is a principal at Irving Hughes in San Diego.
Reach him at (619) 238-4393 or [email protected].