Net Leases May Be Next For OFFICE LANDLORDS

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The Deep Impact

Last week we discussed a topic that is now finding its way onto the public radar screen: The California Schools and Local Communities Funding Act. The proposition, which aims to dismantle the property tax protection of Proposition 13 for almost all commercial properties, is set for a vote in November 2020’s General Election. If it passes, the impact on property owners, tenants and the general public could be profound. Today we take a closer look at the potential consequences of extracting up to $10 billion a year out of private hands and into the grasp of government agencies and school districts.

Let us first say that we are optimists by nature, as are most real estate investors who acquire and manage commercial real estate assets that carry significant risk. So, forgive us if what follows sounds a bit dire or downbeat, but we are going to call it like we see it, and what we see is not good.

Downward Pressure on Property Values

Uncertainty is the enemy of bull markets. Just look at the impact uncertainty is having on the equity and bond markets these days. The firmer the foundation that commercial property investors feel they are standing on, the more aggressive they become. Since property taxes are the largest of the operating expenses property owners incur each year, Proposition 13’s 2% annual base levy increase has made it much easier for property owners and professional managers like us control overall operating expenses. This proposition allows for the full reassessment to current cash value every three years, effectively throwing property tax expense into the unpredictable category.

That will add to the risk premium for real estate acquirers and put upward pressure on cap rates going forward. It doesn’t take much of an increase to take a bite out of building values. A move from 5% to 6% in terms of cap rate equates to a 20% loss in property value. If net operating income falls due to higher operating expenses that cannot be passed through to tenants, the loss in property values would be compounded. Capping lower income at a higher rate is a devastating one-two punch combination.

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How to Protect Yourself as a Property Owner

Net Operating Income (NOI) is the Holy Grail of real estate metrics. It establishes value and determines borrowing power, among other things. Protecting and enhancing NOI is what the game of property ownership is all about. Depending on the type of lease and product category, property owners are able to pass along some or all of the cost for property taxes during a lease. This ability is going to become even more important if this proposition passes.

If you own an office building with full service gross leases (FSG) in place, you probably set a base year for operating expenses. That means you pay the full cost of property taxes during the base year and pass through increases in subsequent years. If your property gets reassessed for twice its current base levy (very possible for long term owners), you’ll be able to pass along increases for tenants beyond their base year, but you’ll be absorbing the increase for new tenants, and quite possibly tenants who renew their leases who demand a base year reset.

While there are an increasing number of net (NNN) leases being negotiated for office space, the vast majority of leases still fall into the FSG or Modified Gross categories. As an office building owner, you may want to start moving to NNN leases for new leases going forward as a way of protecting yourself from the new law should it pass. You are bound to get resistance from many prospective tenants, but it may be a policy worth the disruption to your lease negotiations. By acclimating tenants to a NNN format, you will be adding a layer of protection from absorbing higher operating expenses in the future. 

If you are a retail property owner, chances are you already pass through all operating expenses to your tenants via NNN leases, which has been accepted practice in the retail category for decades. However, passage of the split roll proposition is likely put downward pressure on base rental rates, as tenants, many of whom are already struggling with changes in the retail sector, angle to protect themselves from a spike in operating expenses.

There are so many potential consequences to this dangerous new push to raise property taxes. While we hope that the lobbying efforts to defeat the proposition are successful, now is the time for you as an owner and our company as an owner advocate, to ready ourselves for what could be the biggest threat to our industry in decades. More to follow as we learn more.

Call us at (949)668-1110 or contact us to schedule consultation to learn how you can best prepare your property for changing market conditions.