Prop 8 Protection

Prop 8 allows owners to appeal for a temporary reduction in taxes when property values have declined.  When granted, the relief is for a period of one year, after which point the owner must reapply.  This is a important topic, as given the current state of the San Francisco office market, we anticipate a lot of owners will go to the city seeking relief. 
 
Why do occupiers need to be aware of Prop 8 relief?  It’s important because many buildings in San Francisco use a base year lease structure, wherein the tenant is responsible for increases in operating expenses and real estate taxes above a base amount (typically the calendar year in which the lease is executed).  With this type of lease the tenant is thus exposed to a potentially large increase in taxes if it does not have a Prop 8 protection clause.  Let us explain with an example.  Let’s say Company X leases 15,000 sf on a base year lease.  The lease is signed in February of 2023 and the 2023 calendar year is the tax base year.  At the time of lease execution, the tax value is $6/sf.  However, the landlord successfully appeals the taxes and gets the 2023 value down to $4/sf.  But this relief only lasts for one year, after which point the tax value reverts to the prior level.  The issue is Company X ends up with an artificially low value for its tax base year ($4/sf, the value of the taxes during the base year per the lease).  This means that as the asset’s tax value reverts to its pre-relief value ($6/sf), the tenant is hit with a $2/sf tax increase (the same as a $2/sf rent increase).  And it continues to pay increases thereafter on the low base year value (meaning its future increase are also larger than they should be).  Under Prop 13 in California, but for asset financing activity (sale or loan) relating to an interest of 50% or greater, taxes increase only 2% annually.  Absent the landlord’s temporary relief in 2023, Company X’s tax exposure in the subsequent year would have been $6/sf + 2%, or $0.12/sf, or $1,800.  Instead, it’s $30,000.
 
The solution to this problem is simple; and most (if not all) landlords will give it in lease negotiations.  It is generally referred to as Prop 8 protection and it states, irrespective of any tax appeals and relief that lowers the building taxes below the base year value, the tenant’s base year shall remain unchanged.  If Company X had this protection, it’s base year tax value would have remained $6/sf and, despite the landlord’s successful appeal, subsequent tax increases would have been calculated off the pre-relief tax value ($6/sf).  By the way, when a lease is NNN, you don’t have this issue because the taxes are passed through directly at whatever value they happen to be at that time, not over a base year.  With so many landlords poised to appeal, this is a must have provision in current lease negotiations.