Will the Split-Roll Property Tax Destroy California?

Eight hundred fifty thousand signatures have been gathered in California in support of a voter initiative that would supposedly increase property taxes by 2020 for commercial and industrial properties to get around Proposition 13 property tax protections.  The initiative would leave small business and residential properties alone.  It is called the California Schools and Local Communities Funding Act.  But raising property taxes on leased commercial properties would result in lower tax revenues.

What Is Split-Roll Property Tax?

A split roll tax means applying a tax formula for commercial and industrial properties different from the formula applied for residential properties.  The tax roll is an official breakdown or list of all the properties to be taxed.

California Proposition 13 protects property-owners from very high or very low re-assessed property values each year by increasing the base value of a property by not-to-exceed 2% per year for inflation.  The market value of properties is taxed at a 1% base tax rate and is re-assessed upon re-sale, not each year.  Activists want the reassessments pegged to market value appreciation not a fixed 2% each year.

Existing:

Base Market Value: $2,000,000
Base Tax @1%: $20,000/year

Annual Adjustment @2%: $20,400 – 1st year

Annual Adjustment @2%: $20,808 – 2nd year 

Income Property Markets Work Inversely to Taxes

Most policy-makers think higher tax rates result in greater tax revenues.  But income-producing property markets work inversely by lowering property values when taxes are increased.  This market adjustment process is called by the term "tax capitalization," which means converting the net income of a commercial property into a higher or lower value depending on the change in net income. 

Split Roll Added Tax Estimate Omitted "Tax Capitalization"

The California Legislative Analyst (LAO) has forecast that a split roll property tax would generate $10 billion annually in net additional taxes.

The state Legislative Analyst's Office (LAO) was contacted to inquire if its tax revenue estimate considered market capitalization of the higher property tax.  Brian Uhler of the LAO stated in an email:

We did review the economic literature on tax capitalization and there is empirical evidence suggesting it occurs in California (for example, here [1] and here [2]) ... tax capitalization likely would reduce commercial market values under a split roll scenario.  This would offset somewhat the revenue gains from assessing the properties at market value.  But this offsetting effect probably would be minor relative to the size of the revenue gain from market value asset.

The empirical evidence of tax capitalization cited by the LAO deals with non-income-producing single-family residential properties and is thus irrelevant.

Former Alameda county assessment appraiser Charles B. Warren, American Society of Appraisers (ASA), Pleasant Hill, California, stated:

There are four problems with the split roll.

1. More taxes > less value for income producing properties.

2. Competently valuing properties is a proven challenge for today's assessors (see SEC v City of Victorville). Doing actual the revaluation isn't going to happen overnight.

3. When implemented, some businesses will simply close. Some will relocate. If some relocate that will create an oversupply of commercial space on the market and higher vacancy rates, which would create a compound decline in commercial property rents and values.  Some may find a way to reorganize as non-profits to escape unequal tax burdens (e.g., Hobby Lobby, credit unions).

4. Even if properly administered, tax assessments will follow the market roller coaster ... down as well as up.  Are the jurisdictions prepared for a shrinking property tax base?  In 2008 to 2009, commercial property values declined by about 35% due to the larger economic recession.  These wild value swings are what led to the passage of Prop. 13 in the first place in 1978. 

Leased Commercial Properties Caught in a Vise

During the first few years of the new proposed law commercial and industrial property leases may not be able to increase rents to pay for the higher property taxes until leases are renewed (typically five- to ten-year intervals).  Commercial leases have rent stop cap clauses that do not allow rents to exceed monetary inflation.  So leased income producing commercial properties would be caught in a vice between higher property taxes and rent caps with the only option being to decrease property values dramatically.

Will Split Roll Tax Increases Exceed 2% per Year?

The new proposed tax is a bet for inflation and property appreciation greater than 2% per year.

Nationwide, Moody's Real Capital Analytics Commercial Property Price Index (CPPI) grew by 5.6% annually from 2001 to 2016, but with three negative years: 2001 (-2.2%), 2008 (-8.5%), and 2009 (-25.6%).  How much of the 5.6% per year average annual price appreciation will be reduced by the new added tax is anyone's guess.

Stabilized Market Adjustment:

Base Market Value: $2,000,000
Base Tax @1%: $20,000/year

Annual Adjustment @5.6%: $21,120 – 1st year

Annual Adjustment @5.6%: $22,302 – 2nd year

If annual adjustments are going to be market-based rather than a fixed 2% per year, it would be more workable to adjust assessed values on a ten-year average than on actual up-and-down market changes in value each year.

An example of how increased taxes lower values would be to assume that a property with a current $2-million market value is currently under-assessed at $500,000 due to Prop 13 restrictions.  The current taxes at a 1% tax rate of base value would be $5,000 under Prop. 13, but taxes should be $20,000 (1% of $2 million).  However, if taxes are increased by $15,000 assuming a 5% cap rate, the resulting value would be $1.7 million, or $300,000 (15%) undervalued.  So the state would never achieve their minimum tax.  It would probably fall short by 15%. 

If we can assume that historical commercial property appreciation will average 5.6% per year over ten years, it could take ten years for a commercial property to recover its value.  It would take about two to three years before any added taxes could be collected.

If California were seriously interested in raising commercial property taxes, the state would merely lower the existing 2%-per-year inflation adjustment to, say, 1.5%.

A Split Roll Property Tax Would Not Be Equalized

The proposed tax increase would exempt properties of businesses with 50 or fewer employees.  According to the California Employment Development Department, as of 2017, there were 58,419 businesses in California with 50 or more employees, constituting only 29.3% of all businesses.  So an unequal 30% of all businesses would bear the added tax burden.

And this would apparently leave the commercial properties of California's 268,096 non-profit organizations with total assets of $758 billion and reported total income of $454 billion per year, untouched by the added tax even if they rented space in the same commercial building with taxable businesses.

Split-Roll Property Tax Is Incompetently Designed

California has a history of what is called "perfect storms," where everything that can go wrong will go wrong.  Witness the property tax crisis of 1975 that resulted in Proposition 13, the California Energy Crisis of 2001, the State Budget Crisis of 2008 to 2012, or the 2017 Oroville Dam failure.  The next crisis may involve the split-roll property tax.

Wayne Lusvardi is a real estate and public utility appraiser and former chief appraiser at California's largest urban water district.

Eight hundred fifty thousand signatures have been gathered in California in support of a voter initiative that would supposedly increase property taxes by 2020 for commercial and industrial properties to get around Proposition 13 property tax protections.  The initiative would leave small business and residential properties alone.  It is called the California Schools and Local Communities Funding Act.  But raising property taxes on leased commercial properties would result in lower tax revenues.

What Is Split-Roll Property Tax?

A split roll tax means applying a tax formula for commercial and industrial properties different from the formula applied for residential properties.  The tax roll is an official breakdown or list of all the properties to be taxed.

California Proposition 13 protects property-owners from very high or very low re-assessed property values each year by increasing the base value of a property by not-to-exceed 2% per year for inflation.  The market value of properties is taxed at a 1% base tax rate and is re-assessed upon re-sale, not each year.  Activists want the reassessments pegged to market value appreciation not a fixed 2% each year.

Existing:

Base Market Value: $2,000,000
Base Tax @1%: $20,000/year

Annual Adjustment @2%: $20,400 – 1st year

Annual Adjustment @2%: $20,808 – 2nd year 

Income Property Markets Work Inversely to Taxes

Most policy-makers think higher tax rates result in greater tax revenues.  But income-producing property markets work inversely by lowering property values when taxes are increased.  This market adjustment process is called by the term "tax capitalization," which means converting the net income of a commercial property into a higher or lower value depending on the change in net income. 

Split Roll Added Tax Estimate Omitted "Tax Capitalization"

The California Legislative Analyst (LAO) has forecast that a split roll property tax would generate $10 billion annually in net additional taxes.

The state Legislative Analyst's Office (LAO) was contacted to inquire if its tax revenue estimate considered market capitalization of the higher property tax.  Brian Uhler of the LAO stated in an email:

We did review the economic literature on tax capitalization and there is empirical evidence suggesting it occurs in California (for example, here [1] and here [2]) ... tax capitalization likely would reduce commercial market values under a split roll scenario.  This would offset somewhat the revenue gains from assessing the properties at market value.  But this offsetting effect probably would be minor relative to the size of the revenue gain from market value asset.

The empirical evidence of tax capitalization cited by the LAO deals with non-income-producing single-family residential properties and is thus irrelevant.

Former Alameda county assessment appraiser Charles B. Warren, American Society of Appraisers (ASA), Pleasant Hill, California, stated:

There are four problems with the split roll.

1. More taxes > less value for income producing properties.

2. Competently valuing properties is a proven challenge for today's assessors (see SEC v City of Victorville). Doing actual the revaluation isn't going to happen overnight.

3. When implemented, some businesses will simply close. Some will relocate. If some relocate that will create an oversupply of commercial space on the market and higher vacancy rates, which would create a compound decline in commercial property rents and values.  Some may find a way to reorganize as non-profits to escape unequal tax burdens (e.g., Hobby Lobby, credit unions).

4. Even if properly administered, tax assessments will follow the market roller coaster ... down as well as up.  Are the jurisdictions prepared for a shrinking property tax base?  In 2008 to 2009, commercial property values declined by about 35% due to the larger economic recession.  These wild value swings are what led to the passage of Prop. 13 in the first place in 1978. 

Leased Commercial Properties Caught in a Vise

During the first few years of the new proposed law commercial and industrial property leases may not be able to increase rents to pay for the higher property taxes until leases are renewed (typically five- to ten-year intervals).  Commercial leases have rent stop cap clauses that do not allow rents to exceed monetary inflation.  So leased income producing commercial properties would be caught in a vice between higher property taxes and rent caps with the only option being to decrease property values dramatically.

Will Split Roll Tax Increases Exceed 2% per Year?

The new proposed tax is a bet for inflation and property appreciation greater than 2% per year.

Nationwide, Moody's Real Capital Analytics Commercial Property Price Index (CPPI) grew by 5.6% annually from 2001 to 2016, but with three negative years: 2001 (-2.2%), 2008 (-8.5%), and 2009 (-25.6%).  How much of the 5.6% per year average annual price appreciation will be reduced by the new added tax is anyone's guess.

Stabilized Market Adjustment:

Base Market Value: $2,000,000
Base Tax @1%: $20,000/year

Annual Adjustment @5.6%: $21,120 – 1st year

Annual Adjustment @5.6%: $22,302 – 2nd year

If annual adjustments are going to be market-based rather than a fixed 2% per year, it would be more workable to adjust assessed values on a ten-year average than on actual up-and-down market changes in value each year.

An example of how increased taxes lower values would be to assume that a property with a current $2-million market value is currently under-assessed at $500,000 due to Prop 13 restrictions.  The current taxes at a 1% tax rate of base value would be $5,000 under Prop. 13, but taxes should be $20,000 (1% of $2 million).  However, if taxes are increased by $15,000 assuming a 5% cap rate, the resulting value would be $1.7 million, or $300,000 (15%) undervalued.  So the state would never achieve their minimum tax.  It would probably fall short by 15%. 

If we can assume that historical commercial property appreciation will average 5.6% per year over ten years, it could take ten years for a commercial property to recover its value.  It would take about two to three years before any added taxes could be collected.

If California were seriously interested in raising commercial property taxes, the state would merely lower the existing 2%-per-year inflation adjustment to, say, 1.5%.

A Split Roll Property Tax Would Not Be Equalized

The proposed tax increase would exempt properties of businesses with 50 or fewer employees.  According to the California Employment Development Department, as of 2017, there were 58,419 businesses in California with 50 or more employees, constituting only 29.3% of all businesses.  So an unequal 30% of all businesses would bear the added tax burden.

And this would apparently leave the commercial properties of California's 268,096 non-profit organizations with total assets of $758 billion and reported total income of $454 billion per year, untouched by the added tax even if they rented space in the same commercial building with taxable businesses.

Split-Roll Property Tax Is Incompetently Designed

California has a history of what is called "perfect storms," where everything that can go wrong will go wrong.  Witness the property tax crisis of 1975 that resulted in Proposition 13, the California Energy Crisis of 2001, the State Budget Crisis of 2008 to 2012, or the 2017 Oroville Dam failure.  The next crisis may involve the split-roll property tax.

Wayne Lusvardi is a real estate and public utility appraiser and former chief appraiser at California's largest urban water district.