Effort to overturn Proposition 13 could result in billions of dollars in new taxes that will be paid for by tenants of commercial real estate.

An effort is underway and gaining momentum in California to overhaul the current property tax system which will result in billions of dollars in taxes on the backs of businesses. Already one of the costliest states in the nation to conduct business, this tax will flow to the cost of renting commercial real estate in the Golden State.

For occupants of commercial real estate, it is critical that they understand what impact such a change will have to their current situation and alternatives that they may want to consider if contemplating a relocation or new facility.

Background on Current Tax System

Property taxes in California are currently based on an assessed value that was established when the owner purchased the real estate. This system was established with Proposition 13 in 1978, which also fixed annual increases in the assessed value to 2% per year.

The fixed increase allows California residents and businesses to avoid significant fluctuations in their property tax cost year over year. It is the proposed elimination of this fixed increase that is creating uncertainty and the potential for significant exposure. Depending on how long the existing owner has held the property, the assessed value used to determine property taxes today may or may not be comparable to a market value—and in many cases the delta is significant.

To illustrate, a property purchased for $500,000 will have an assessed value of $600,000 after 10 years with the 2% escalator used under the current system. If California experiences its typical above standard growth over the same period, say 5%, that amount would be 30% higher, or $775,000 after the same 10-year period. In this illustration, it is the $175,000 delta between the two values that will create the exposure if the “split roll” measure is passed and properties are reassessed to market annually.

The Ballot Measure

In August, enough signatures were gathered to put a measure on the ballot in 2020 that will allow the state to treat commercial real estate in a different manner than residential properties, hence the “split roll” reference. Specifically, commercial real estate will no longer utilize the 2% fixed increases under Proposition 13 illustrated above and instead be reassessed annually. If passed, an annual reassessment will take place that will result in significant increases in the assessed value of many properties and thus property taxes.

Proponents of the measure believe this will bring the state an additional $6-10 billion in new taxes on California businesses. While this figure has a lot of flaws, the bottom line is that business owners will face increased taxes, and these taxes will be passed onto tenants, and ultimately, the consumer.

What it Means for California Tenants

For tenants, commercial leases are either structured as “triple net” or “gross.” Neither of these structures are immune to the impact of a tax change. In triple net leases, where the tenant pays their prorated share of property expenses, an increase in taxes will flow directly to the tenant as an increased CAM (common area maintenance) charge. For tenants in a gross lease, they pay for their prorated share of expenses above a “base year” (typically the initial calendar of the lease), so an increase in any year but the first year of a lease will directly flow to the tenant as an excess operating expense charge.

The exposure and risk will be for businesses that are located at, or contemplating a move to, a property with a current assessed value that would be considered below market. A reassessment during the term of your lease could result in a huge passthrough of expenses by the landlord.

As an example, as part of Hughes Marino’s lease audit services, we recently reviewed a CAM statement for one client that was paying $75,000 per year in taxes. While this is significant, when we evaluated the current assessed value to the market value of the property, we determined that the assessed value was well below the market value and our client would be facing an increase in taxes of up to $200,000 if the ballot measure passes.

What Tenants Can Do to Avoid the Surprise

It is important to understand that not all properties will be impacted equally by a change in the tax law. Since the exposure will depend on when the basis of the assessed tax value was determined, two identical properties quoting the same rental rate may be on opposite ends of the spectrum on exposure. As an example, if one property (“Building A”) was purchased during the last downturn in 2010 for $200 per square foot, and the other (“Building B”) was purchased last year for $600 per square foot, a reassessment that puts both properties at $600 will only impact the tenants in Building A, and that impact will be significant. The $400 per square foot increase in the assessed value will mean an extra $4.00 per square foot in taxes that will be passed on to tenants in the form of increased triple net charges or excess charges above a base year in full service or gross leases. For the typical 10,000 square foot tenant, that will be an increase of $40,000 per year.

Because of the uncertainty ahead, today’s lease evaluations and decisions should be made taking into consideration the “what ifs.” A determination needs to be made if the current taxes are being calculated on an assessed value close to market, or if there is a significant delta and exposure to a split roll system.

A good commercial real estate broker should be helping their client with this evaluation. At Hughes Marino, we are evaluating the current assessed value to market, quantifying this tax exposure for our clients, and negotiating protections where possible.