By David Marino

California Property Taxes Under Prop 13

To understand how Proposition 15 would affect property taxes for commercial real estate, one must first understand how property taxes are assessed today. California commercial and residential property taxes are limited by Proposition 13, whereby property tax is fixed at 1% of the original purchase price, with annual increases thereafter capped at a maximum of 2% per year. Prior to the passing of Proposition 13 in 1978, local governments set property tax rates to fund local services, and the average property tax rate in California was 2.67 percent. Also prior to Prop 13’s limitations on property tax increases, California property tax rates were based on changes in market value, and annual increases were subject to the changing fiscal needs of local governments. The citizens “tax revolt” at the time was based on the notion that California property taxes were excessive, and their market increases were unrestricted and subject to abuse by legislators and county tax assessors.

Proposition 15 Ballot Changes Affecting Commercial Property Taxes

Proposition 15 would amend the California State Constitution to require commercial and industrial properties (except agricultural) to be taxed based on market value, and they would no longer have the benefit of protection under Prop 13. This is the basis of the term “Split Tax Roll,” which maintains Prop 13 protection for residential owners while having a different treatment for commercial property owners. Under Prop 15, the State of California will pick a new tax rate based on its operating needs through a committee, and the 1% tax rate under Prop 13 will no longer apply. All commercial property would be reassessed in 2022 through 2023 based on their then-market value, and adjusted on the tax rolls to that new tax basis. Prop 15 also eliminates the 2% maximum annual property tax increase protection under Proposition 13, and instead future property tax increases would be reassessed by each county assessor based on changes in future market value over time. The state fiscal analyst estimates that, upon full implementation in 2022 and 2023, the Prop 15 ballot initiative would generate between $8 billion and $12.5 billion in additional tax revenue per year. The promoters of Prop 15 characterize this as a “tax on big business” or on developers and commercial landlords. But where is all that money really coming from?

Future Tax Increases Become a Direct Pass Through to Commercial Tenants

Commercial leases are either structured as “triple net” or a form of “gross” lease. All forms of commercial leases allow landlords to “pass through” any additional tax increases that occur during the term of the lease. In triple net leases, where the tenant pays their prorated share of operating expenses for the building, the increase in property taxes from the passing of Prop 15 will flow directly to each tenant. For tenants in a gross lease, those tenants pay their prorated share of expenses above a “base year” (typically the initial calendar of the lease), so the property tax increase triggered by Prop 15 will flow directly to the tenants as an excess operating expense charge over their “base year.”

To illustrate the financial impact to tenants, consider an office property which has a current assessed value of $200 per square foot due to Prop 13 limitations—there are thousands of such buildings in California. The tax at 1% under Prop 13 means that this building owner pays $2.00 per square foot per year in property tax, which is part of each tenant’s rent under a gross lease, or which is passed through directly to tenants in triple net leases. With the passing of Prop 15, the market value of that leased office building is then determined by the County Assessor to be $500 per foot. Overnight, on January 1, 2022, the tax assessed value increases by $300 per foot. But further, let’s say that the State of California deems that the tax rate needed to fund state services is 2%. The new property tax at 2% of the new $500 per foot market assessed value becomes $10 per square foot per year…no longer $2. This increase of $8 per square foot in value gets passed through to every tenant in the building no matter what form of lease the tenant has. If you are a 2,000 square foot tenant, your share is $16,000. If you are a 10,000 square foot tenant, your share is $80,000. If you are a 50,000 square foot tenant, your share is $400,000…every year. Tenants of this size are not “big businesses” in California, but rather comprise the small to medium size businesses that make up our entire state economy employing 10-200 people each.

Are you starting to understand where that estimated $8-$12.5 billion dollars of new tax revenue is coming from? This is a tax increase that will mostly be funded on the backs of commercial tenants, and not landlords, and not big businesses. Every office, lab, industrial and retail tenant of every size, in every commercial building has this future increased tax expense coming their way…every year…if Prop 15 passes. The problem is that commercial tenants don’t see it coming, as it’s not well understood and not properly positioned by the opponents of Prop 15, mostly because the opponents of Prop 15 don’t understand how commercial lease mechanics work.

As the biggest advocates for commercial real estate tenants in the State of California, it is our duty and obligation to make you aware of Prop 15’s cost exposure to your business so that you can make your fellow business owners and employees aware of the dire effect Prop 15 will have on our already struggling California business sector.

What Tenants Can do to Avoid the Surprise and Quantify the Risk

Not all properties will be equally affected by the tax increase if Prop 15 is passed. Each tenant’s exposure will depend on the difference between the property’s future market taxed value and the lower Prop-13-protected tax basis. This will become critical for anyone negotiating a commercial lease between now and November 2020, or thereafter if Prop 15 is passed.

The future impact of this tax increase now needs to be considered and financially modeled for every property under consideration. A determination needs to be made if the current taxes are being calculated on an assessed value close to future market, or if there is a significant exposure to an increase in costs based on a market valuation in the future that is significantly higher than the current assessed value. At Hughes Marino, we are evaluating the current assessed value relative to future market to help direct our clients to achieve the most cost-effective outcome, and to understand the future cost impact for each building should Prop 15 be passed by California’s voters in November.