Underwriting Tax Increases (Before You Lease)

Over the past decade, many office buildings in San Francisco have been sold, some multiple times.  For tenants, these sales translate to material increases in the cost of the lease.  Why?  Primarily because of taxes. 

California  has Prop 13, which limits annual increases in real estate taxes to 2%, excepting at the time of a sale or financing of the asset, at which point the tax base is adjusted to market, often causing a big spike in taxes.  It’s in these latter scenarios, a sale or financing, when tenants are exposed to potentially large cost increases.  This is true because the tax attributable to a sale or financing is passed on to the tenant. 
 
For every $100/sf in increased asset value, the rent increases by $1.50/sf.  So if a company leases space in a building that has a tax base value of $400/sf and the building subsequently sells for $800/sf, there is a $6.00/sf/year increase in the lease cost.  For a 10,000 sf lease, the added annual cost is $60,000.    
 
Yet for all but the largest tenants (e.g., leasing a large portion of a building), tax increases are unavoidable since landlords will not readily negotiate what is known as “Prop 13 Protection”.  The most advantageous form of such protection would simply be to prohibit tax increases due to a sale or financing.  However, the tax doesn’t go away.  If a landlord agrees to such a provision (and it almost never would) the effect would be to lower the value of the building.  When Prop 13 Protection is given, it is typically in a phased context, offering limited protection.
 
So what are most tenants to do, understanding that protection is not available?  The answer is to underwrite the potential for such an increase while evaluating leasing options.  To do so, when dealing with buildings which have a low tax basis, we run 2 iterations of the financials, one that shows the rental economics as negotiated, and one that shows the potential impact of a sale or financing.  This creates visibility for a key issue and helps the tenant make a fully informed decision.  This is particularly relevant because a building that has been owned for long period of time have will have a lower tax basis and typically offer more compelling rental economics (e.g., less expensive to lease).  Hence it’s possible for a tenant to think it has chosen to lease the lowest cost scenario only to have a sale occur mid-lease which spikes the cost, making it the most expensive.  As with most things relating to good tenant leasing outcomes, acquiring key knowledge early and understanding risk, makes all the difference.