This Tax Loop Hole Helps Commercial Landlords Keep Vacant Stores and Vacant Lots

In California, property taxes are kept low which is good for homeowners. However, commercial and industrial landlords enjoy these same tax benefits. This makes it easy for them to keep vacant spaces and, in some cases, vacant lots. In this post, we look at this problem and the factors that make it possible. And we present a measure on the ballot in the upcoming election which would close this loop hole for good.

At the Quad at Whittier, this large storefront next to Michael's has been vacant for years. Source: Chris La Farge, 9/13/2020

Vacant Spaces and Vacant Lots

Effectively built in 1990, the Quad at Whittier has some high quality stores and restaurants including Burlington Coat Factory, Staples, Michael's, Vallarta, Petco, Chili's and the Olive Garden, amongst others. The center's tenants provide great shopping and dining opportunities for Whittierites. And a portion of its sales tax receipts go to the City's general fund to help pay for services such as the police, fire department, libraries, and parks.

In addition, the shops and eateries provide local jobs. Therefore, the Quad is a real asset to our community. But if you look closer, you will notice a number of vacant spaces there.

There's the large empty storefront next to Michael's, the large space between Big 5 Sporting Goods and Famous Footwear, the two empty spaces between Rubi's and H&R Block and two vacant stores between Sally Beauty Supply and Natalie Nails & Spa.

These spaces have been vacant for over a year, as you can see from the Google timestamps. And some have probably been vacant over two years. Based on a rough calculation, these vacancies total about 43,000 square feet of building area which is approximately ten percent of the Quad's total building space.

The Quad's owner, TRC Retail, can easily afford a ten percent vacancy. But 43,000 square feet of unused space equals lost jobs, shops, restaurants, and lost sales tax revenue dollars for the City of Whittier.

And as if vacant stores were not bad enough, we also have large vacant lots. Most notably are two parcels totaling more than one and one half (1.5) acres at the northwest corner of Whittier and Washington Boulevards at Five Points. Again, these empty lots constitute an inefficiency that should not be overlooked: lost employment and lost shopping and dining opportunities on top of lost sales and property tax revenues.

Source: Google

These are just a few examples of vacant commercial and industrial space and land in Whittier. There are others. And this is not just a Whittier issue. There are countless underutilized or unused properties in the Whittier Area, Southern California, and throughout the State of California.

The owners of these properties pay property taxes on them. But how can they afford the property taxes when their property is not fully leased or not even developed?

Some Owners Pay Very Little in Property Taxes

Under California law, all property owners pay on average about 1.25% of assessed value in property taxes and special assessments. Therefore, someone who owns a home or commercial building assessed at $1,000,000 by the local county will pay about $12,500 per year in property taxes.

Furthermore, proposition 13 only allows real property to be re-assessed at fair market value when it changes hands from one owner to another in a sale. If property is not sold, the assessed value is limited to a modest 2% increase each year.

Most people own their residences directly in their own names or in a trust. On the other hand, most people hold office, retail, and warehouse buildings in a limited liability company (LLC), limited liability partnership (LLP), limited partnership (LP) or corporation. These are legal business entities.

Over time, real property remains owned by the same business entities so legal ownership doesn't change. However, ownership interests in the entities changes hands over time. Ownership interests in the entities changes from person to person or person to business or business to business. As long as no more than a 50% percent ownership interest in an LLC, LP, etcetera is transferred in one sale, the property cannot be reassessed under prop 13. This is the tax loop hole commercial and industrial property owners love.

In the case of the Quad, its approximately 30 acres of land and 450,000 SF of building area is divided into seven parcels with a combined 2020 assessed roll value of $64,017,997 according to the LA County Assessor. So the estimated annual property taxes and assessments they'll pay in 2020 is $800,225. (The roll base year is 1997.)

While $800,000 seems like a lot to many of us, it's not much for TRC Retail when we account for the likely rent income the Quad generates.

With five years of experience in commercial, industrial and residential real estate appraisal, I can apply valuation methodology to roughly estimate cash flow and property values.

The Whittier Marketplace is located down the street at 11701 Whittier Boulevard, Whittier, CA, 90601 and is asking between $1 and $2 per square foot in triple net rent. So if we use those listings as comparable rents, we can assume a ballpark average rent of $1.50 per square foot for the Quad. Using this average, I created this rough estimate of a Net Operating Income Statement:

TRC Retail's Effective Gross Income (EGI) is likely somewhere in the neighborhood of $7.3 million for the year. And their share of the property taxes and assessments is only $80,022.50 (for the vacant space) because with triple net rents, tenants pay the property taxes (and insurance and maintenance expenses) on a pro-rated basis. This is based on their share of the of the total building space they occupy. Under triple net lease agreements, property taxes are effectively paid by the tenants.

Based on the comparable rents, I estimate Net Operating Income (NOI) to be almost $6 million annually. The Income Method of Valuation takes the NOI and divides it by a capitalization (cap) rate, which is similar to the yield on a bond or stock.

I researched cap rates for retail properties in Southern California. Currently, they range between 5% and 8%. So I took the middle of the range at 6.5% and divided the NOI by that 6.5% and calculated the value of the Quad to be about $92 million. Using this valuation method, we see that it's assessed value of $64 million is significantly lower.

Therefore, large commercial and industrial owners of older buildings tend to pay very little in property taxes. The combination of prop 13 tax limits, the LLC loop hole, and triple net lease agreements tilts the game in favor of the big landlords.

With such low property taxes and total expenses overall, these companies and wealthy investors can easily afford to keep 10 percent or more of their space vacant. And some can even afford to keep entire parcels vacant, like the owners of the vacant lots at Five Points.

The vacant parcel on the northwest corner of Whittier and Washington is about three quarters of an acre and has an assessed value for 2021 of $1,328,101. The lot next door is about one acre and has an assessed value for 2020 of about $2.5 million.

The property taxes on these assessments are low at an estimated $16,600 and $31,250 per year. So again, the owners can afford to keep them vacant.

Closing the Commercial and Industrial Property Tax Loop Hole

The good news is that we have a chance to close this loop hole. We can eliminate it if we pass Proposition 15 on November 3rd.

In the State of California, Proposition 15 will require commercial and industrial property to be reassessed based on its actual fair market value. It creates a split roll where residential property continues to be assessed per the law under prop 13 but where commercial and industrial property will be assessed at fair market values under the law of prop 15.

And with higher assessments comes higher tax bills. By making those vacancies more costly, commercial and industrial owners will be nudged to lease all their vacant space.

Similarly, owners of vacant lots will be incentivized to either develop or sell. If they sell, their land will more than likely to pass into the hands of owners with plans and financing for new developments. Therefore, from an economic development perspective, Proposition 15 is good policy. With that, I encourage all California voters to vote Yes on 15 on November 3rd.