Local budget shortfalls are driving city governments to take desperate steps with significant implications on commercial real estate values.
Despair can sometimes take unexpected forms. On one hand, conservative cities in Texas are raising taxes, while San Francisco is rumored to be slashing its welfare budget. The end of the world as we know it? Fortunately for our sanity, San Francisco has the good manner to remind us that everything is not totally upside down: the City Government is also looking at opportunities to raise taxes.
I read today in the San Francisco Business Times that San Francisco is considering a new tax on commercial rents. Some of the numbers discussed range between 1.4 and 2%. Who will pay and how will this impact the business landscape?
The commercial rent tax, they said, would be charged to commercial property owners who would recoup the cost by passing it to tenants. Is that how we should expect it to work? Not quite.
In NNN leases (preferred by large corporate tenants), the rent tax will indeed be passed through to the tenants until the end of their lease. With Full Service Leases (more common with medium size and smaller tenants), the rent tax will be part of the “CAM” charges and in some cases will be also passed on to the tenant via the pro-rated allocation of increase in operating expenses over base year. This will of course apply to lease agreements with such a provision (not all of them do) and only until the end of the current lease. In virtually all cases, the counters are reset at the next lease renewal. Notwithstanding these exceptions that are limited in time, the property owners will end up absorbing most of the cost.
The reason is very simple: competition. Supply and demand is driving market rent. Demand is a function of alternatives. If competing cities become less expensive, more tenants will move. The price differential between office rents in San Francisco and nearby cities, like Oakland or San Mateo, reflects an indifference point between quantitative and qualitative attributes, such as commute time for employees, prestige, and occupancy costs. Changing one variable (in this case raising occupancy cost by 2%) will change that indifference point to the detriment of San Francisco, thereby reducing the demand accordingly. A weaker demand will depress prices relative to competing cities until reaching the new indifference point. In the end, everything else equal, rent will not change but landlords Net Operating Income (NOI) will drop by the amount of the tax. Because NOI is significantly less than gross Rent, the rent tax will represent a much higher percentage of NOI than the 2% used in this example.
The end result is that property owners will have to effectively fit the bill at a much higher rate than initially intended and their asset value will immediately drop by as much. Economics 101.
I am sympathetic to the needs of local governments to find new sources of revenue and I do not want to make a statement here on whether or not it is justified to tax property owners. It might be. Pacific Business Centers is a tenant in San Francisco amongst many other locations and we do not own commercial real estate ourselves. City officials need to understand that if their intent is to get all businesses with a foothold in their cities to contribute to the needs of the community, a rent tax is not the way to go. As unpopular and counter-productive the payroll tax is in San Francisco, it does a better job of achieving the city stated objective of taxing the broader business community than a rent tax would.
Chief Executive Officer
Pacific Business Centers
Pacific Business Centers, which Laurent co-founded in 2003, is a leading operator of Business Centers in the West Coast and a provider of on-demand office space with 300 locations in North America. Prior to that, Laurent held various executive and management positions with responsibility in Corporate Real Estate, Corporate Development, Finance, and Operations, at Sun Microsystems, Litchfield Advisors, and Hewlett-Packard.
Tracy Wilson, Managing Partner with SC Commercial, contributed to this article. SC Commercial is a commercial real estate brokerage firm with offices in Sacramento, San Diego, Oakland, and San Francisco.