A look at the potential cost impact of the proposition to tenants, owner/users and investors, along with how commercial property values are likely to be effected.
In Part 1, we took a high altitude look at the major provisions contained in Proposition 15, the California ballot measure to split the property tax rolls and make commercial properties subject to reassessment to full market values every three years.
If passed, it would upend 42 years of stability and predictability in terms of property tax assessments and extract up to an estimated $11.5 billion from the pockets of almost all commercial property owners every year beginning with the 2022-2023 fiscal tax year.
In this post we look at the potential cost impact of the proposition to tenants, owner/users and investors, along with how commercial property values are likely to be effected.
Almost all commercial property leases in all product types contain some kind of provision that requires the tenant to pay all or a portion of property taxes for the space they occupy in addition to base monthly rent. In a net lease, the tenant pays it all from day one. In a typical gross lease, taxes for the “base year” are included in the rental rate with increases for subsequent years passed along to the tenant. But, even in a gross lease the burden is on the tenant because the base rental rate is higher to cover the landlord’s base year levy.
So, a tenant who occupies a building with a low property tax basis could likely see his or her tax bill double, triple or even quadruple depending on when the landlord acquired the property. In just the last 9 years, property values have more than doubled and the majority of property owners have owned their buildings for at least that long. The way we see it, the property tax burden on almost all tenants is likely to go up, thereby increasing occupancy cost and driving down profits. Businesses may or may not be able to absorb that cost, and may opt to raise the price for their goods and services to cover it. That is, by definition, inflationary and the ripple effect of passing along additional costs will increase the cost of everything over time.
Then there is the distinct possibility that frustrated business owners may add the hike in property taxes to other reasons to leave a state they see as hostile to business. Not what the doctor ordered in terms of promoting business growth at any time, let alone a time like this.
Owner/users wear the hat of both landlord and tenant, making it impossible to avoid any portion of the tax increase. In an arms-length transaction, the parties could negotiate who has responsibility for taxes dependent on market conditions. The owner/user cannot.
The typical owner/user holds a property for much longer than the typical term of a lease. The whole idea is to fix occupancy cost over the long term by obtaining fixed rate financing, and staying put as long as possible. Generally, those who choose the owner/user route can use the acquired property for 10 years or longer. So, imagine the property tax increase for a building owner who bought his industrial building for $60 per square foot back in the mid-1990’s. That property is worth perhaps $260 per square foot today and come 2022, the property would be assessed at current market value and the taxes would skyrocket overnight!
The promoters of Proposition 15 claim they are protecting small businesses who occupy their own facilities, but the threshold for exemption is so low, it applies to only the fraction of business owners who own buildings under 10,000 square feet, provided they don’t own additional commercial property in California. They and their other corporate officers must also be California residents, or the exemption is null and void. It is a disingenuous ruse to garner votes that we hope will exposed by the campaign against the measure.
All commercial property (no matter the value) that is not owner-occupied would be subject to the new taxation scheme. So, even the smallest mom-and-pop investor will face the consequences, and the properties they tend to own are occupied by small tenants who will have to share the tax burden with them one way or another. Institutional investors, the primary target of Proposition 15, should be able to pass most or all of the tax increases to their tenants pursuant to the terms of their leases. So, most of their net operating income should be protected.
However, the additional risk associated with potentially higher operating expenses in the future would put upward pressure on cap rates for all commercial properties, which will lower their value across the board. A 1% increase in cap rates (from today’s average of 5%) would wipe out 20% of the current value of commercial properties. How much that adds up to we can’t be sure of, but it could be in the hundreds of billions of dollars.
With that potential in play, lenders would pull back and tighten their underwriting, resulting in higher interest rates and lower loan amounts. That means buyers would have to use more of their dry powder to acquire each property, reducing their appetite for future acquisitions.
Imagine being the owner of a small retail strip center that is suffering from high vacancy or rent defaults. Such properties are already under pricing pressure and adding higher property taxes to pass along to existing and prospective tenants would only make things more painful. Those acquiring such properties would capitalize only existing rents and at a higher rate; a double-whammy to the property’s value. There is just nothing good about that unless you are a very well-capitalized buyer willing to take on high risk in hopes of a market turnaround.
Will it Pass?
Preliminary polls show a slight advantage to the proponents of Proposition 15. They are counting on tugging at voter heartstrings by saying it’s all for the kids when, in actuality, just 35.6% of the net take each year would go to K-12 education. They already have a huge campaign advantage, having amassed tens of millions of dollars to promote the measure. Opponents promise a vigorous campaign to defeat this major threat to our economy, but they have an uphill battle to fight.
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