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.

5 Things Every Office Tenant Should Consider in the New Year

©2012 Darvin Atkeson / LiquidMoon.com
©2012 Darvin Atkeson / LiquidMoon.com

Over the years I’ve observed that for many tenants, once the lease has been executed it’s filed away and forgotten until it’s time to renew or relocate.  This is partially because they’re focused on their core business but also because they assume that once the lease is signed, the terms cannot be modified again until after the expiration date; this is simply not true.  Depending on factors such as a change in the building’s occupancy level, the general overall health of the local market, and even a change in the building’s ownership, improving the terms and rental rate could be achievable by the tenant as leverage may have shifted.  At the very least, a quick refresher will remind a tenant of key dates, their rights and options, or even a potential liability they’re currently exposed to.

As we head into the New Year it’s a good time to dust off your lease and ask your commercial real estate advisor to conduct a review and provide you with an updated lease abstract. Here are five things they should consider:

1.  Could your rental rate be immediately lowered?
If the rental rate you’re currently paying is substantially higher than where current market rates are, then a “Blend and Extend” strategy may be possible.  Simply put, you amend your lease to extend the length of your term, and blend the new lower rate into the present high rate, thereby immediately lowering your rent.  If your lease expiration date is too far in the future or you do not wish to extend the lease beyond that date, there could be other options as well.  Perhaps the landlord has a large security deposit on file, and you’ve made timely rental payments whose sum now eclipses the cost of the landlord’s up front occupancy costs (tenant improvements, broker commissions, etc.).  Albeit risk-adverse, savvy landlords understand that their tenants’ success is tied to their own.  Therefore, they may allow you to apply a portion of your existing security deposit towards rent, and in some cases just simply give some back.

2.  Are you aware of important notification and lease dates?
If you have the right to extend your term, the landlord typically will build notification dates into the lease.  For example, you may need to notify the landlord of your intent to renew no sooner than nine but no later than six months prior to your lease expiration.  This also goes for Early Termination, should you have that right.  Make sure to be well aware of when your lease expires, as well.  It can sneak up on you and if you don’t plan and time your renewal or relocation wisely, your leverage could potentially be substantially reduced.  Mark your calendar and stay ahead of these dates.

3.  Have you received and reviewed your Operating Expense Rent Statement?
If the landlord is passing through operating expense increases to you as additional rent, they should be providing you with an annual expense statement.  Don’t hesitate to ask your real estate advisor to review your statement for you.  If something is irregular they’ll catch it and perhaps recommend you exercise your right to audit, which tenants are usually allowed to do no more than once a year.  It’s also worth the effort to make sure expenses are not being passed through to you that were not agreed to in the lease.

4.  Does the size of your office still accommodate your needs?
Do not think that you have to “ride out your lease” if you’ve outgrown your space or perhaps have had to reduce the size of your staff.  Your real estate advisor can help you work with the landlord to relocate within the building into a more appropriately sized suite, and if one is not available, then subleasing may be an appropriate solution.

5.  What sublease rights do you have?
For many reasons, tenants often need to get out of their space in advance of their lease expiration date, and subleasing can be a wise exit strategy.  However, not all sublease clauses are created equal.  First, do you even have the right to sublease, and if so, what restrictions will be placed on you?  Are you allowed to sublease to existing tenants in the building, or tenants who have recently toured the building on a direct basis?  Can you market the space at any rate you set, or does it have to be equal to or higher than direct space in the building?  How are sublease profits shared and how much time does the landlord have to respond to a consent request?  Know your rights, and how the subleasing terms will likely affect the ability to achieve your desired results.

When several years have passed since you’ve signed your lease, it’s easy to forget what you signed up for in the first place.  Your real estate advisor can effectively and efficiently digest your lease, extrapolate key points, and then present them to you in a lease abstract within the context of today’s current market conditions.  This quick refresher is time well spent, and having a better handle on your lease’s key points and terms could prove invaluable for whatever may come your way in the New Year.