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This November, I’m voting yes on California’s Proposition 15. I hope you will too.
There’ve been many concerns expressed about the impacts of Prop 15 — some made in good faith, some in bad — and in this post I’d like to tackle some of those that seem, at first blush, to be most legitimate or complex. What we’ll find is that all of these concerns are ultimately unfounded.
What Prop 15 does: the basics
Before I get into specifics, let me address the basics of what Prop 15 is and what it would do. It’s a ballot initiative that would change how we assess the value of commercial and industrial property in the state, creating a fairer and more competitive property tax structure. It would raise about $11.5 billion per year in new funding for local governments and schools. It doesn’t affect residential properties at all.
Some background: Following the 1978 approval of Proposition 13, property taxes were capped at 1% of property value throughout the state and an individual property’s assessed value could only grow by a maximum of 2% per year until the property was sold or transferred. When it changed hands, it would be reassessed based on its sale price. Because property values in California have outpaced the 2% per year growth cap on annual tax assessment increases, people who’ve owned a property for a long time pay lower effective tax rates than people who’ve bought property more recently. A property purchased for $150,000 in 1985 might be worth over $1 million today, but it would only be taxed as though it was worth $300,000 (a two percent increase compounded over 35 years). The owner would pay $3,000 in annual property taxes, but someone who purchased an identical property next door for $1 million in 2020 would pay $10,000 per year.
This restriction on taxable value was sold as a way to protect homeowners from being forced out of their homes by rising taxes — a genuine problem for some homeowners in the 1970s, especially for those living on a fixed income. (If you want to read more about the impacts of Prop 13 on the residential market, I wrote about that here and here.) What was less appreciated at the time was that these protections also apply to owners of commercial and industrial property. Now, more than 40 years after the passage of Prop 13, the tax breaks accruing to long-time commercial and industrial property owners are costing the state upwards of $11 billion per year. Proposition 15 eliminates these tax breaks for most large commercial and industrial properties.
There’s no rational basis for the special tax treatment of these properties. There are surface parking lots in Downtown LA that are worth $10 million but taxed as though they’re worth $500,000. These properties should be redeveloped to a higher and better use, generating homes and jobs and transit ridership, but their low tax basis means the owners can hold them indefinitely, waiting for prices to climb to $12 million, $15 million, $20 million — all while paying only a few thousand dollars per year in taxes for some of the most valuable land on the planet. Disneyland still pays property taxes based on its valuation from 1975. The tax discounts on that property alone cost the state at least $10 million per year in revenue, and probably much more. If a business has owned their property for a long time, Prop 13 gives them a competitive advantage over newer businesses who have to pay the full tax rate. The older businesses and property owners can undercut their competitors and stymie the establishment of newer and more innovative businesses. It’s bad all around.
Very simply, Prop 15 would ensure that most large commercial and industrial property owners pay the same property tax rate. As we get into the details of specific concerns and objections, it’s helpful to remember that Prop 15 only asks these property owners to pay a rate that many of their competitors are already subject to. A rate that you, if you bought property today, would be subject to yourself.
Enough background. If you want to read more about the basics of the proposition and reasons for voting yes, I recommend this LA Times editorial board endorsement.
Now for some specific questions.
Won’t the costs of Prop 15 be passed on to small businesses?
If opponents of Prop 15 are to be believed (and they generally are not), property owners will simply raise lease rates on their tenants in order to cover their increased taxes. This would be a problem in any economic environment, but especially so in the midst of a historic pandemic and economic crisis: many businesses genuinely can’t afford any extra costs at this time. There are a few reasons this concern is overblown.
First, property owners can’t just arbitrarily raise their lease rates. Rates are set by the intersection of supply and demand — by scarcity — not by tax burdens. If I bought an office building at an inflated price in 2007, the fact that I’m losing money in 2010 isn’t going to convince my tenants to pay more for their lease. If I try to raise my rates beyond what the market will bear, beyond what my competitors are charging, tenants will find a more reasonable price elsewhere.
And because lease rates are set by the market rather than by tax burdens or other costs, current beneficiaries of Prop 13 have no reason to offer a better deal to their tenants. They just pocket the difference because… why wouldn’t they? This is our status quo.
Take a neighborhood where a commercial lease costs $40 per square foot per year. Property A was purchased 30 years ago and pays $1.00 per square foot in annual property taxes, and Property B was purchased this year and pays $5.00 psf/year. If the properties are otherwise identical, will the owner of Property A charge $4 less for his space? Of course not. They’ll charge $40 psf/year just like Property B and keep the extra money as profit. Maybe they’ll charge $39.75 just to undercut their neighbor, but $3.75 is a lot of tax revenue to forego in exchange for maybe securing a 25 cent discount on a private lease. If we’re that concerned about lease rates then we should just collect the full tax and redistribute it as subsidies to businesses; we’d help a lot more people that way.
Beside all that, the current tax structure is also unfair to the owner of Property B. Landlords who recently purchased their properties are already paying at or near a 1% tax rate and still managing to earn a profit. Equalizing the rate for long-time property owners simply puts them on a level playing field, not at a disadvantage. The distinction between property owners (landlords) and business owners is really important here. Prop 15 affects property owners. Some businesses also own their property, but Prop 15 only affects them in their capacity as property owners, putting them on a level playing field with other property owners and non-property-owning businesses.
Additionally, while this isn’t really a positive thing, the global shift away from retail and the increase in working from home means there’s a lot of available commercial space. Supply is far in excess of demand in many, many places, at least relative to where it was six or twelve months ago. That puts more power in the hands of tenants, and gives landlords absolutely no leverage to pass along higher costs.
A Koreatown strip mall.
But what about triple-net (NNN) leases?
With triple-net (NNN) leases, costs are passed along directly to tenants, including property taxes. If your business has a NNN lease and your landlord’s property taxes suddenly increase by $3 per square foot, your lease rate is going to grow by that same amount. That would be a big deal, and unfair since these businesses are probably already paying the same overall lease rate as their competitors who are renting in buildings with smaller Prop 13 tax breaks.
Fortunately, several important exemptions and policy design choices make Prop 15 unlikely to affect most small businesses.
One is that the reassessment of commercial and industrial property values doesn’t even begin until mid-2022, and for buildings where at least 50% of the businesses employ 50 people or fewer, the reassessments don’t start until mid-2025. The large majority of small business leases will have expired in the interim (a standard commercial lease has a term of three to five years), allowing business owners to renegotiate so their rates don’t spike when reassessment occurs.
In addition to this phase-in period, properties owned by business owners with less than $3 million in holdings in California will be exempt from reassessment altogether. In my view this exemption is too broad and too generous, but it certainly achieves its goal of shrinking the pool of businesses that experience some kind of cost increase as a result of Prop 15. The initiative’s authors went to great lengths to avoid negatively impacting small businesses.
Won’t this encourage cities to de-emphasize housing development even more?
Another common concern about Prop 15 is that it will (further) discourage cities from building housing. Local governments already prefer commercial development to residential because households generally have more public service needs than businesses, and businesses also create other revenue streams for cities, and assessing commercial and industrial properties based on their market value will discourage residential development even more.
If Prop 15 were the only thing happening in California public policy then this would be true, at least to a small extent. Fortunately, it’s not. Two recent statewide housing bills mitigate this concern: SB 828 and SB 35.
SB 828, passed in 2018, reformed the Regional Housing Needs Assessment (RHNA) process, significantly increasing the amount of housing that cities need to plan for in the next eight-year housing element. It’s the reason that the housing production target for the Southern California Association of Governments went from 410,000 for 2013-2021 to 1.34 million for 2021-2029. Similar updates are underway across the state. Many cities will continue trying to block housing by any means available, but they will have to zone for much, much more housing than they have in the past and the state Department of Housing and Community Development is watching over their shoulder to make sure their zoning plans have a realistic shot at leading to real-world housing production.
The housing production impacts of SB 828 will far outweigh any countervailing incentives from the passage of Prop 15. And remember, a lot of underutilized parcels are suddenly going to be taxed at market rates. Cities will be under great pressure to rezone these parcels for residential use, if it’s not permitted already, and property owners will be under pressure to redevelop them into a higher and better use.
The other bill, SB 35, passed a year earlier, complements SB 828. It streamlines the approval process for housing in cities that aren’t meeting their RHNA goals, making most mixed-income housing “by-right,” effectively eliminating their ability to reject housing proposals that conform to zoning requirements. Because of the new, higher RHNA goals, many cities will be subject to these streamlining requirements.
Will Prop 15 increase the cost of multifamily housing?
Will Prop 15 apply to multifamily housing? The intuitive answer is “no” because they’re residential properties, not commercial. And to be clear, this is also the correct answer.
But the Federal Housing Administration only offers “residential” loans for multifamily properties with four units or less, so there have been questions about whether larger projects would be considered “commercial” by that definition. And what about mixed-use properties, like those five-to-seven-story apartment buildings with ground floor retail found in many neighborhoods? Would these buildings be considered commercial, residential, or something else? Among other things, treating such buildings as commercial would raise their costs relative to new single-family housing, which would be bad for housing production and encourage more sprawl development.
Upon close reading of the ballot initiative, it’s clear that multifamily housing is not subject to Prop 15.
The initiative explicitly states that it doesn’t apply to residential property (Sec. 2.5.(a)(2)), which includes both single-unit and multi-unit structures (Sec. 2.5.(c)(4)(A)). It also states that for mixed-use property, only the portion of the property that’s used for commercial or industrial purposes is subject to market value reassessment (Sec. 2.5.(c)(4)(B)). It even says the legislature may choose to fully exempt mixed-use properties from reassessment if at least 75% of the square footage or value is residential, but we can’t know in advance whether they’ll exercise that option.
Here’s some of the relevant text from the initiative (you can read the whole thing here):
Language from Proposition 15.
If Prop 15 passes, doesn’t that make it harder to reform the residential components of Prop 13?
As someone who thinks Prop 13 is rotten to the core, I’m very sympathetic to this concern. By eliminating one of the most indefensible aspects of Prop 13 — tax breaks for an arbitrary set of commercial and industrial properties — aren’t we weakening the case for reforming the residential components of the law?
Very likely not. This feels a little bit like the argument that rejecting Hillary Clinton in the 2016 general election would make electing Bernie Sanders or another true progressive more likely in 2020. How’d that work out?
Maybe failure of Prop 15 would galvanize voters to finally tackle the entire spectrum of Prop 13 inequities, but maybe, instead, it’d shatter any hopes for Prop 13 reform — of any kind — for another generation. This latter outcome seems far more likely to me. After all the effort that’s gone into this initiative, it would bode very poorly for residential property reform if we failed to pass even these commercial ones.
Cleaving off the commercial and industrial beneficiaries of Prop 13 also means they’ll have less incentive to wield their considerable financial and political power on later reform efforts. If we try to tackle everything at once then big business would spend big on opposition, as they’re already doing, and they would use that money to scare homeowners into voting no. They’re already use this tactic based solely on the slippery slope argument that approving Prop 15 will increase the odds of additional future reforms, and the “yes” side is only barely ahead with 51% in support, 40% opposed, and 9% undecided. There’s no question that the polling would be worse if homeowners were also affected by the initiative, and there’s very little wiggle room as-is.
Proposition 15 polling from September 2020 (link).
Conclusion
To wrap things up:
Higher property taxes will be absorbed by property owners currently enjoying a windfall profit at the expense of California taxpayers, not the vast majority of small businesses.
Even most triple-net commercial lease-holders won’t see their rates go up, mainly because many reassessments won’t begin until five years after the initiative’s passage, which is at the upper end of the standard lease term.
Commercial development will become somewhat more desirable to local governments, but they can’t block new housing like they used to thanks to SB 828 and SB 35, and a newly-aggressive state housing department.
Prop 15 doesn’t apply to any residential properties, including multifamily housing. Only the commercial portion of mixed-use buildings will be subject to market-value reassessment.
Passing Prop 15 doesn’t make it harder to pass future Prop 13 reforms. In fact, it probably makes it easier, and failing to pass it could deter future reform efforts for a generation.
This is by no means a complete list of concerns, so feel free to reach out with additional suggestions or additional thoughts and revisions on those already discussed. I hope to keep this as a living document until the election on November 3rd. I’ve deliberately avoided some of the more obvious arguments for and against the initiative since those are covered elsewhere, but if you’ve heard something you feel warrants a deeper look, please let me know.