Under the City’s new Actual Value Initiative real estate tax program (AVI), there are going to be many winners and losers. Properties are going to be re-assessed based on their actual market value, as opposed to historical values which have not been updated, in many instances, for years. As a result, some people who have owned their properties for a long time will find that their tax bills are going up significantly. Others, who have had their properties reassessed based on improvements or transfers in recent years, will find their property values and, therefore, taxes declining. Recent reports indicate that commercial office buildings, as a group, will be the net winners of this new assessment program, realizing tax savings of approximately $65 million.
What does this mean for the tenants in these office buildings? The answer depends on the tenant’s lease structure, which generally falls into one of two categories: gross leases and triple net leases.
Gross leases: Here, the tenant negotiates a “full service” rental rate which is inclusive of all first year building costs, such as operating expenses (except premises electric in many cases) and taxes. Starting in the second year of the lease the tenant pays for any increases in year operating expenses or taxes over the year one costs. Thus, if the gross rent in year one was $28/sf which included estimated operating expenses of $7.50/sf, and real estate taxes of $3.50, but it turns out that operating expenses were actually $7.75/sf and taxes were $3.65, the landlord would make $.40/sf less than anticipated ([$7.75 – $7.50] + [$3.65 – $3.50]) because it underestimated its expenses. In year two and thereafter, the Tenant would be charged for any increases above the $7.75 and $3.65 amounts.
In this structure, the tenant gets certainty as to its year one, “all in” rental cost and the landlord is protected against increases in operating costs and taxes above the “base year” amounts for all subsequent years. In sum, the landlord takes the risk that its projection of year one operating expenses and taxes will be more than anticipated.
However, what happens if first year operating expenses and/or taxes turn out to be less than what was expected or if future taxes fall below the year one tax amount? In many cases, the tenants do not get the benefit of tax reductions below the “base year” amount. Thus, in the previous example, if taxes are reduced to $3.15/sf in the fourth year as the result of a city wide AVI reassessment program, the tenant certainly would not have to pay any tax increase but it would also not get the benefit of the $.50/sf savings below the base year amount. The landlord’s profit simply increases by $.50/sf as the result of its costs going down. The rationale for this is that, when the lease rate was first negotiated, the tenant received a guaranty of its first year costs and the landlord took the risk that the first year operating expenses and taxes would exceed his estimate. In exchange for taking on this risk, landlords want the upside rewards if taxes turn out to be less than expected. In sum, a gross rent structure is a way of shifting risks and rewards for unknown year one costs.
Triple net (NNN) leases: Here the parties agree on a rental rate which effectively represents the net return, or profit, to the landlord and the tenant, in addition, agrees to pay its share of all operating expenses and real estate taxes for the building from dollar one. In this arrangement, the landlord locks in his return on the year one rental and the tenant takes the risk that the landlord’s estimated first year operating expenses and taxes turn out to be greater than expected. Thus, if the above example were structured as a NNN lease instead of a gross lease, the tenant would have budgeted $28/sf for year one but instead ended up paying $28.40/sf. On the other hand, in the event the operating expenses and/or taxes turned out to be less than what was projected, the tenant would have received the full benefit of these savings.
Thus, Center City office tenants who have NNN leases will generally fare better than tenants with gross rent leases if their buildings end up with lower taxes as a result of the City’s new AVI program.
For tenants who are in the process of negotiating leases before the new AVI plan is implemented and who still want to keep the downside protection of a gross lease, they need to structure their leases a little differently. If there is good reason to believe real estate taxes are going to go down, the tenant could insist on a hybrid lease which is treated as a gross lease for Operating Expense purposes but a NNN lease for real estate tax purposes. Thus, in the initial example, the rent could be quoted as “$24.50 plus real estate taxes.” In such case, if year one operating expenses turned out to be $7.75/sf but taxes were only $3.15/sf, the tenant would end up paying $27.65 ($24.50 plus $3.15) instead of $28. In other words, it would get the protection on the increased operating expenses and the benefit of the year one real estate tax savings.
Another approach would be to quote a modified gross lease. Here, the gross rent needs to state that it is based on an assumed real estate tax of “$X”; however, to the extent the actual taxes are lowered as a result of the City’s new AVI program, the gross rent shall be reduced on a dollar for dollar basis equal to the amount of such reduction in taxes. The risk here is that, in exchange for this protection, the landlord will require the opposite coverage should the building’s taxes increase as a result of the City’s new AVI program.
In either approach, there is risk that the new AVI program could result in increased taxes for the tenant’s building which would fall on the tenant. Thus, before proceeding with either structure, the tenant should have legal counsel or an appraiser determine which is the more likely scenario for the building based on the current assessment.
Finally, tenants should fight for a provision that states that they will receive the benefit of any tax savings to the extent taxes ever fall below the base year amount. If tenants take the risk of taxes rising above the base year amounts, they should be entitled to any savings on the other side.
A lot has been written lately about the City’s proposed AVI program and how it is going to disproportionately benefit commercial office buildings at the expense of home owners. To the extent this ends up being true, it does not necessarily mean that tenants will benefit. In light of the new policies being advanced by the City, tenants need to carefully consider the appropriate rent structure to ensure they receive their fair share of any savings.
For more information contact Glenn Blumenfeld