How Prop 15 Will Break California Commercial Real Estate

California, the nation’s most populous state and the world’s fifth largest economy, was already having a rough time long before the COVID pandemic was even a thing.

Mired in skyrocketing living costs, rising homelessness, all the while sporting the highest sales, gasoline and income tax rates in the nation, California has seen a recent exodus of priced-out citizens. And now COVID-19 has not only seen to it that consumer activity is stunted amidst business closures and widespread unemployment but has resulted in real estate values plummeting in the retail and office submarkets.

So even when looking at the businesses that survived the COVID purge, future reassessments based on lower market values would result in tax revenue substantially less than the measure’s proponents are forecasting. In the wake of the COVID pandemic, an uncertain future is exactly the very thing Prop 13 specifically protects businesses from, ie. being vulnerable to market fluctuations in property values.

Furthermore, the most vulnerable sector in California is not populated by proverbial whales like Google and Disney at all but rather small businesses. Prop 15’s revised inclusion of the small business exemption is an attempt, undoubtedly, to assuage fears of a mass small business extinction event in California in the coming years.

Except, of course, there is a catch. The $3 million value exemption combines the fair market value of a property with that of all other commercial properties in the state in which any direct or indirect beneficial owner possesses a direct or indirect beneficial ownership interest. So in reality, a $1 million property owned by an entity that also owns three other $1 million properties, for example, will not receive the tax exemption and neither will the other three. Same goes for a part share in an LLC; you are subjected to the tax if all partners together own more than $3 million worth of commercial real estate combined. This exposes a fundamental flaw in the measure’s touted exemption.

The inevitability of pass through increases, however, are ultimately where this measure falls apart. First of all, many commercial leases are triple net agreements where the tenant agrees to pay building insurance, maintenance, and, most importantly, all real estate taxes in addition to any normal fees such as rent and utilities. So either triple net leases become extinct in the future California or small business owners renting commercial space are picking up the new tax bill. In that event, landlords of properties that are worth more than $3 million and who do not offer triple net leases can and will have no choice but to pass the higher financial burdens through on to their tenants through increased rents… leading them to move to what will be cheaper (and inevitably impacted) commercial properties or shut down permanently. Or leave California.

Just as COVID-19 wiped out small businesses who could not afford to operate without revenue, the new act would wipe out businesses whose revenue survived the coronavirus but was modest to begin with.

Let’s take a look at a real world example of the magnitude of the pass through effect.

A 46,301 square foot warehouse built in 1978 on a 2.34 acre plot that has not been sold or transferred since has a value of $1,456,306 that has increased incrementally under the guidelines of Prop 13. Its present property tax bill checks in at $14,563.06. If Prop 15 is passed, the new assessed value of the same property would be $2,181,814 at a 6.50% cap rate (capitalization being an indicator of the rate of return that is expected to be generated on real estate property). Its new adjusted property tax bill would check in at $21,813.14 which is a 49% increase. If this building leases its space to tenants through triple net contracts, that 49% is a direct expense of the tenants. If not, well then, rents will likely increase. Increased overhead costs lead to either business downsize, business closure or increased costs of goods and services.

And so now the business and the consumer are saddled with added costs. Project that across countless commercial properties across the state and the cumulative effect on small business is jarring.

This demonstrates the immeasurable indirect effect of increasing taxes on unprotected businesses unfit to withstand the growing costs to operate in an ever more regulated California. We can lament the inevitable loss of many existing (read: COVID-surviving) small businesses but, sadly, the true tragedy lies elsewhere: even less future Californians will be able to start small businesses of their own. Or in the very best case of scenarios, a decades long paradigm shift in how small business will be based; moving away from the commercial sector and into the home where the 75% pro rata cutoff to qualify for exemption from the split tax roll becomes ideal for prospective small business owners.

But… Google and Disney will be just fine.