Written by Iconic Investments
Amid historical economic and social upheaval, California landlords are being forced to deal with numerous and politically charged proposals that have a strong likelihood of passage and which would change the landscape of the state’s real estate market for years to come. This is not hyperbole – if one is to look at the potential impacts of Proposition 15, Proposition 21, or Assembly Bill 828 individually they might have reason for concern. When landlords understand the impact the three proposals combined could have on the commercial real estate industry in California, they cannot be left anything but shaken. My intent here is to break down each of these proposals succinctly and try to unpack the potential short- and long-term effects to our industry.
Proposition 21 – Extreme Rent Control
Sponsored and funded by AIDS Healthcare Foundation, the Rental Affordability Act proposes to repeal the Costa-Hawkins Rental Housing Act and instead create highly restrictive local and statewide rent control laws unseen since the 1970s.
Proposition 21 would create rent price caps and vacancy control, effectively doing away with “market rents” by limiting landlords' ability to increase rents to market when a unit becomes vacant. Owners are limited to increasing rents by no more than 15% over the previous tenants’ rate which can be given in the 1st year of tenancy or over the 1st three years (5% per year). In addition, landlords are able to give the annual allowable rent increase based on the local ordinance. For example, if a tenant who was occupying a unit for $1,000 per month moves out, the landlord could only increase the rent to $1,150 per month for a new tenant.
The proposition would create a statewide registry and bureaucracy to monitor rents on all properties statewide with a rolling 15-year exemption. As buildings become 15-years old they become subject to the law. This new proposition is also bold in its reach, as it impacts owners of single-family properties that own either in a trust or have 3+ properties, regardless of how they hold title.
This proposal impacts owners in a variety of ways. First, long-term owners that rely on their properties for cash flow are impacted by restricted growth, not be able to enjoy significant increases in rental income as units turn over. Opportunistic owners will be turned off by the inability to increase rents and property values. Both types of owners will likely seek to lower operational costs through reduced maintenance and upgrades to try to make up for decreases in cash flow, leading to more deferred maintenance and lower quality of housing stock for renters. Finally, owners of newer properties will see the values of their properties decline as they approach the 15-year mark when they become subject to these new rules. In all cases, we anticipate landlords to take drastic measures in property operations as all incentives for having a pride-of-ownership property are removed.
In 2018, California voters defeated Proposition 10, a nearly identical proposal, by nearly 20 points. Unhappy with the election results, state legislators, in 2019, passed AB 1482 which also had a rolling 15-year exemption, but allowed for vacancy-decontrol and market rents upon vacancy, with rent increases capped to CPI+5%. Proposition 21 just layers on top of AB 1482 with more restrictions across a broader swath of properties. With a critical election upcoming, higher turnout is anticipated, increasing the likelihood of passage this time around.
Assembly Bill 828 – Eviction & Foreclosure Moratorium
Originally known as the bill designed to reduce all residential rents by 25%, AB 828 has been restyled as the eviction and foreclosure moratorium bill. Originally introduced at the start of the Covid-19 quarantine in early March 2020, AB 828 is now in its fourth draft as it moves swiftly through the state legislature. While there are provisions to impose a moratorium on lender foreclosures, they are far more relaxed than the rights afforded to tenants for non-payment of rent, as I’ll outline, squarely putting the pressure and responsibility on the shoulders of landlords. AB 828 allows any tenant, retroactively from March 4, 2020, through 90-days following the end of the local declaration of emergency to not pay rent if they have, in any way, been impacted by the circumstances surrounding Covid-19. Reasons include any reduction in employment hours, reduction in wages, employment termination, out-of-pocket medical expenses, or closure of childcare facilities or schools.
Tenants will have up to 15-months following the lifting of emergency orders to re-pay rents, although that is likely the length of time it will take to secure and enforce an eviction order. As far as the eviction moratorium is concerned, it is helpful to apartment landlords insofar as it prevents any recordings of notices of default, recordings or postings of notices of sale, or foreclosures during the state of emergency + 90 days. Helpful, except that tenants are provided with 15-months following the lifting of emergency order to repay owners, so it is up to owners during those 15-months to keep their investment afloat. Also, the bill has a provision allowing for severability, so if one part of the bill is deemed invalid, the remaining sections of the bill can stand. For example, if the banking lobby is successful in overturning the restrictions on foreclosures, tenants may still be allowed to live rent-free while owners lose their assets.
The bill is set to automatically expire on January 1, 2022, so if the state of emergency is extended to such date, landlords may go as far out as March 2023 until they are able to either fully collect back rents or vacate the delinquent unit. In recent press conferences, Los Angeles Mayor Garcetti alluded to the state of emergency extending well into Fall 2021, so it is likely that local government is working hand in hand with state legislators on their timelines.
Proposition 15 – Split Roll Property Taxes
While Proposition 15 is designed to create a split roll property tax system between commercial and residential properties, we believe this is just the first stage to split the tax roll between single-family owner-occupied properties and all other properties held for investment purposes.
The way the split roll works is by taking commercial properties out from under the protections of Proposition 13, which assesses property taxes based on the purchase price of an asset + an annual increase limited to 1%. Under the new system, properties are assessed annually based on perceived market value. For example, currently under Proposition 13, if a shopping center is purchased today for $1,000,000, the property tax is 1.19% of the purchase price, or $11,900, and can increase by only 1% annually, regardless of the increases in income the property generates. In 5-years, following this system, the property taxes would be $12,383, regardless of increases in income. Under the proposed split roll method, if Year-1 property taxes are $11,900, but the property income is increased by 30% over 5-years, the resulting property tax would be $15,470 – a 24% increase over current methodology.
Now, let’s say an investor has owned a property for 25-years and the property taxes are only $5,000 even though the building is now worth $5,000,000. If Proposition 15 passes, it can increase the property tax rate to $59,500 – more than 10X increase overnight. Even with NNN leases, commercial tenants will likely balk at the massive increase in common area charges, and the result will likely be vacancies and/or reduced rental rates to offset the increased costs.
The method of assessing property taxes based on estimated market value of a property is not unique, and is commonplace in most of the U.S., including in Texas and Arizona. It has also spawned a cottage industry of law firms specializing in fighting property tax assessments on contingency. Our clients with out of state properties tell us that, every year they receive their property tax bill and every year they end up hiring a firm to go out and fight it, spending thousands of dollars to reduce their taxes.
Our view is that Proposition 15 is a precursor to splitting the tax roll completely to include all investment properties, including multifamily. The major risk with the apartment sector, though, is the inability to increase rents or pass through the costs to tenants, further burdening or crippling landlord investors.
As always, please feel free to reach out with your questions or concerns. I always welcome your feedback and look forward to speaking with you soon.
