How Prop 13 Changes will Hurt Investors
“All things being equal…”
Actually, that’s a good place to stop that thought.
Because “all things being equal” is one of the primary reasons California’s budget is perennially problematic. It’s why, as a result of that, real estate investors likely face a regime change that will ripple through our property portfolios.
What I’m talking about here is the renewed and aggressive effort to reform Proposition 13, our infamous law that has been both a savior and a bane to the state.
What does Prop 13 mean for California?
Under a proposed ballot measure now getting a lot of play in Gov. Gavin Newsom’s administration, today’s Prop 13 would see the current tax roll split into two, assuming voters approve the initiative for the partial repeal in the November 2020 election.
On one side of the split: homeowners and small-business owners would continue to pay property taxes based on existing Prop 13 rules. For more than 40 years, those rules have limited property-tax increases to no more than 2% a year. This helps to prevent the state’s runaway real-estate prices from inadvertently pricing people out of their own homes as rising property values impose ever-higher tax burdens.
On the other side of the new ballot initiative: commercial and industrial property would no longer benefit from Prop 13’s tax-moderating impacts. Tax agencies would regularly reassess commercial and industrial property and would no longer cap property-tax increases at 2% on those properties.
It’s that second side of the proposed measure we care about as real-estate owners. If this new vision of Prop 13 does become law, then we will need to rethink our portfolios in terms of which properties really make sense to hold and which properties we might look to exchange out of.
But before we strategize, let’s step back a second and understand the impetus for this initiative and the likelihood of it passing into law.
Good intentions lead to problems
Prop 13 was born out of good intention: to keep aging Californians from losing the family home to tax payments they could no longer afford simply because their property values were escalating at an impossible pace in the 1960s and 1970s.
The problem is that lawmakers back in the day tossed every piece of California property into the same bucket. The little old lady from Pasadena was on par with Disney, Chevron and Wells Fargo. In short, “all things being equal” is exactly how lawmakers viewed the California property market.
The result is what we have now: a state with egregious budget problems because the government has been unable to collect enough property taxes to adequately funds costs such as education, healthcare, pensions and the various social safety nets that exist. So, we lurch from one crisis to the next, with politicians looking for ways to radically boost state coffers, yet afraid to touch Prop 13 because the backlash can (and does) ruin political careers.
Still, the question remains: why should Disney benefit from a rule that was designed to protect homeowners from losing their property through no fault of their own?
That little old lady from Pasadena has no way to ramp up her income in retirement as her property values – and, thus, her property taxes – skyrocket. But Disney? And Apple? And Wells Fargo and Chevron and every other commercial and industrial property in the state? They have the pricing power to varying degrees. They have operations all over the state, the country and the world. They can funnel profits earned in one jurisdiction to cover expenses, like property taxes, in another. They are for-profit organizations that in the last 40 years have grown in value by billions of dollars.
And, yet, in terms of property taxes, they’re treated like a homeowner.
We can argue the merits of whether that’s fair all day long. And, yes, there are pros and cons on each side of the question. But as a sober-minded real-estate investor who must take an objective view of all risks to my business, here’s the fact I care about: Prop 13, without argument, has created vast inequalities. And these are inequalities that Californian’s recognize and, more important to my business, inequalities that the government wants to undo.
Just consider the state’s aggressive legal battle with the City of Huntington Beach over a state law that requires cities and counties to set aside sufficient land for new residential development. The lawsuit, effectively, pits state government against the rights of local citizens to define what they think their city should be. Huntington Beach certainly seems within its right to build the city it wants to be. Yet Gov. Newsom’s office takes the (not illogical) position that rising housing costs threaten the economy and deepen inequality and that it is up to the state’s cities and counties to mitigate this.
The point here is that California’s new crop of lawmakers are aggressively attacking this notion of inequality at all levels. They rightly sense that the state’s electorate (increasingly Democratic and increasingly angry that California’s educational system is falling short) is in a different place mentally today. As such, there seems to be real momentum to redesign Prop 13.
Splitting the tax rolls so that homeowners retain the benefit from Prop 13 while businesses cough up the property taxes that, some estimate, would generate $11 billion annually … well, in the current climate, that seems like a no-brainer. Indeed, I’d be willing to bet that proponents of a split-roll Prop 13 succeed in getting the initiative onto the November 2020 ballot … and that voters will approve the measure, even if by the slimmest margin.
And that will have impacts on those of us who own commercial and residential property.
Will California become unaffordable for everyone?
California’s governor and legislature have no interest in protecting California’s real-estate investors. These Prop 13 changes they’re backing, and the lawsuit against Huntington Beach are examples of what the future holds for all of California’s businesses – including small-time real-estate investors.
At some point, companies such as Facebook, Uber, Airbnb and other unicorn tech firms – all mostly in favor of this equality push – might be the only businesses that can afford to remain in California. For us, then, we have to consider our options now in light of the warning shots being fired.
1031 Exchange to the Rescue.
What I propose real-estate investors consider is a strategy of selling off our worst inventory by way of a 1031 exchange.
That will allow us to get out of a subpar property and to put every penny of proceeds back to work in a better property, with better returns, and in a market with better demographics, without losing any money to capital-gains taxes (including recapture, long-term gain, and CA state taxes).
I pay a lot of attention to Bruce Norris, over at the Norris Group. He’s a long-time California real-estate investor and California specific real estate economist. He has been spot-on with his timing with respect to the last 4 peaks and troughs. In 1996, he correctly foresaw a boom in California property prices starting in 1998. In 2005, he warned of the impending downturn – fueled by easy credit – that would pop the local real estate bubble. And in 2011, he once again recommended investors buy California real estate for a boom that was set to push prices higher through the end of the decade.
Now, we’re at the end of the decade, and property prices have, indeed, been strong over the last many years. Yet, now Bruce sees the same storm clouds gathering that I see – clouds taking the shape of a Prop 13 reset.
Bruce’s research doesn’t lead him to the same expectations he foresaw in 2005 when the Great Recession birthed a dramatic unraveling of real-estate prices. Nevertheless, Bruce believes that apartments and commercial property in California could be particularly hard-hit if Gov. Newsom and the Democratic super-majority in the state legislature successfully split the tax rolls, as the new Prop 13 ballot initiative seeks to do.
What would change with Prop 13?
If they are successful, commercial real estate would see tax hikes that are, potentially, substantive and sustained. And depending on how it all shakes out, that could include single-family homes and condos/town homes that are held for investment purposes, since they are the definition of “commercial property” or at least “investment property” – land held for rental income and/or capital gain.
This is a big risk we face as California real-estate investors.
I know I’ll pay higher tax rates on the properties I own, and that could substantially skew the investment dynamics because I probably would not be able to easily recoup the added tax burden through rental- rate increases. The potential size of the rate hikes would likely drive away tenants, an ironic side-effect of the “split roll” initiative, given Prop 13’s original intent to keep people in their home.
I look at an investment condo I own near the water in North Laguna Beach. I don’t want to sell that property. But when I look at the numbers, I stop and think about the opportunity cost of holding on in light of the Prop 13 risk we now face.
For the same value, I can own three single-family homes on the ocean-side of Highway A1A in Vero Beach, Fla., each bringing in the same rent (let’s call it $4,000 a month) as my North Laguna property.
Or, I can own a house in Vero Beach and two or three management-free, multi-family properties in any of numerous MSAs in Florida, Phoenix, Nashville, Atlanta or the Carolinas.
The same equity with triple the income
Thus, it’s quite possible that from the same equity I’ve got locked up in the Coastal California property market, I could generate three times the income. Given the risk to values, and what would likely be the increased cost structure of my Laguna property in a post-Prop 13 California, I really have to question that dynamic.
All California real-estate investors, I think, have to question the same dynamics in their portfolio.
It very well might make a whole lot more sense to begin offloading certain properties in California, and 1031-exchange the proceeds into a mix of investment properties and/or management-free income properties held in business trusts, in markets that are trending up because of demographic shifts now underway in America.
Honestly, I never understood why the legislature originally applied Prop 13 to commercial and investment property when the intended impact was aimed at alleviating the financial pain California’s property market was imposing on older homeowners and those on fixed incomes. But that’s relevant now only to the point that today’s legislature is in the mood to right this historical wrong – and there seems a very good chance they succeed.
As real-estate investors, we have to weigh the likelihood of this change. We must gauge the impact on each property in our portfolio, and then make the wisest decision we can about whether to stay put and absorb the financial impact. Perhaps the time has come to begin an orderly exit so that we can reinvest where the economics of owning rental property is more favorable.
