A bit of History

Proposition 13 is an amendment passed in 1978 which sets a cap on real estate tax increases for commercial properties at 2% per year. The building value is reassessed when a building is sold or the majority of the building undergoes new construction. In California office leases, most landlords typically “pass through” a tenant’s proportionate share of real estate taxes and operating expenses. These costs are typically small compared to the aggregate lease value, and are glossed over by most office-seeking tenants and their brokers.

By way of example, let’s say a hypothetical San Francisco tech company, Disruption.io, is looking for space for about 65 employees in a “creative” brick and timber building in SoMa.

A bit of Math

Disruption.io enters into a 5-year lease for 10,000 square feet in a 50,000 square foot building beginning in 2018. The building has been owned by a local family since 1990 and they have no intention of selling. Since the building hasn’t been sold in so long, it has a current assessed value of $10 million, or $200 per square foot. In 2018 (Disruption.io’s “Base Year”), property taxes for the building are approximately $118,000 (at the current rate of 1.18%). When taxes are increased by the Proposition 13 maximum of 2.0% in 2019 to $120,360, the tenant will pay its 20% share of the $2,360 increase, or $472. No big deal. Now in 2020, the family ownership group undergoes some hardships and decides to sell the building after all. The building is sold for $700/RSF, or $35 million, which triggers a reassessment under Prop 13. The building is now taxed on the new value of $35 million, and there is a massive tax increase of $413,000 year-over-year. Since Disruption.io occupies 20% of the building, and the building sold after their Base Year, Disruption.io will now have to pay 20% of this new tax bill every year, until the end of the lease term. This amounts to about $82,600 per year, plus the additional year-over-year increases!

What just happened?

Landlord sold the building, made a fortune, and their tenants are stuck paying the property taxes. Why isn’t every tenant representative making an attempt to protect their clients from such a large increase? The most common story you’ll hear is that San Francisco landlords simply don’t grant this protection. It makes their buildings more difficult to sell, and not something tenants win, so you’re better off focusing your efforts on an attainable concession. While it’s true that in this incredibly strong market, where most landlords are institutional investors who build their businesses on selling assets at market peaks, this is a battle that’s tough to win unless you are a huge tenant with stellar credit. However, that doesn’t mean Prop 13 protection isn’t worth fighting for, especially in certain “high-risk” cases, such as in a single-tenant building that is assessed at a significantly lower value than current market valuations. Even if you aren’t able to secure Prop 13 protection in your lease, every tenant (and tenant rep!) should be acutely aware of the tax risk for each building under consideration so they are not surprised by a potentially massive unexpected tax increase down the road!