How the Sale of Your Building Could Cost You Money

Jarvis
Howard Jarvis – Author of Prop 13

California’s Proposition 13 provides a statutory limit on annual increases to the assessed value of a property. Basically, the state general levy tax rate is limited to 1.0% of the property’s value and cannot increase more than 2.0% per year, unless the building is sold, more than 50% is transferred, or substantial new construction is completed.  (Note that the tax rate can and usually does exceed 1% because there is no limitation on municipal tax rates or special assessments).

So what does this mean to California’s office tenants?  If the building you occupy sells to a new owner during your tenancy, the building could be reassessed at a much higher value than when you initially moved in, and you could get stuck with a substantial increased tax bill passthrough.

Let’s assume that your company leases 10,000 square feet in a 100,000 square foot building (10% pro rata share)  and signs a 5-year lease in 2013.  Let’s also assume that the building hasn’t been sold in a while, and therefore has a low property tax assessment.  For our example, we’ll pretend that the building is currently valued at $200 per square foot, or, $20,000,000, and that in 2013 property taxes for the building were approximately $300,000 (at a rate of 1.5%).

Increases in operating expenses such as property taxes are passed through to tenants and collected according to the tenants’ pro rata share.  Therefore, when taxes are increased by 2.0% to $306,000 in 2014, you will have to pay your 10% share of the $6,000 increase, or $600.

However, let’s say that in 2014 the owner of your building decides to sell it to an investor for $50,000,000 ($500/SF), the property is reassessed and taxed on the new value, and the property taxes are increased to $750,000.  In this example, the increase in property taxes from 2013 to 2014 would be $444,000 and since your firm occupies 10% of the building, you’d get handed a bill for $44,000.  And the fun part? You’ll get to pay that bill every year until your term runs out.

So is there any way to avoid this?  Yes, but it’s highly unlikely.  If you’re a large tenant in a soft market, you may be successful in negotiating “Prop 13 Protection” into your lease, whereby any “Due On Sale” taxes cannot be passed through to you.  Building owners are extremely resistant to agreeing to this, however, as it adversely affects the selling price.  Another strategy, if you know a sale is imminent, is to try and get your Base Year set to the year of the anticipated sale which could be achieved in a new lease or upon a renewal.

For everyone else, it is crucial that you do your homework before signing a new lease or renewing your existing one.  Being well informed is the name of the game.  Assuming you do business in a market that continues to appreciate, the more time that has passed since a property’s last reassessment, the larger the increase will be upon a sale.  Think of it like a rubber band; the more you stretch it, the more it’s going to hurt when it snaps.

Knowing not only when the subject property was last reassessed but also the likelihood the ownership could change hands during your tenancy should be a top priority and can help you avoid egregious and unexpected pass through expenses that most all office tenants are exposed to.

A Costly Time Bomb Could Be Hiding in Your Office Lease

The Restoration Clause is a seemingly harmless, fluffy little kitty that sleeps tucked away within an office lease… until you reach out to pet it and it jumps on your neck and claws your eyes out.

It is a legal obligation for a tenant to restore, at the landlord’s request, the premises back to the condition it was in before you moved in, and could be a very costly going away present to your landlord should they exercise their right.

Normally, a tenant can negotiate the teeth (or claws) out of this provision or have it deleted in its entirety, or many times the landlord won’t require the tenant to restore the space because the subsequent tenant will benefit from the leftover improvements.

So why are landlords now pushing harder for restoration in lease negotiations, and more frequently exercising this clause as leases expire?  Because there has been a 180° shift in how offices are being built out, and tenants are increasingly demanding “open plan” layouts rather than private office intensive build-outs.  Therefore, if the exiting tenant has landlord-centric restoration language in their lease and the new tenant wants an open office, you can be sure the landlord is going to stick that tenant with the cost of demolition.  That also means that if the incoming tenant desires an open plan and wants the landlord to tear down 30 perimeter private offices, the landlord is going to try its best to reserve their right to obligate that tenant to restore them at the end of their term if the new tenant doesn’t wants them back.

So what can a tenant do to protect themselves from this potential costly exposure?  First, fight hard in the initial lease negotiations to completely strike the restoration clause.  If the landlord won’t budge, then fall back on agreeing to restoration, but with the condition that the landlord must decide whether or not they’ll invoke their right BEFORE you conduct the work.  That way there, you’ll at least know before you spend the money whether or not you’ll be required to spend extra money (and effort) at the end of the term to restore your premises back to their original condition.  If the landlord won’t agree to those terms, then you’ll at least take out the guesswork and be in a better position to decide if this is still the right space for you and if the potential added expense is worth it.

If this little gem is already in your lease and you missed it because you weren’t represented by a real estate advisor, now’s a great time to call one up and have them conduct a lease review for you.  They’ll be able to provide you with their professional opinion of its implications, and may be able to provide a solution that could dampen or eliminate the exposure.