In Washington, D.C., as in so many jurisdictions throughout the country, commercial property assessments and taxes have steadily increased for the last five years. For large office buildings in the District, real estate taxes now constitute an approximately 45 percent slice of the expense pie. It is not surprising, then, that these tax hikes are generating mounting concern from landlords and tenants, with each side seeking to minimize the impact on the bottom line.
Triple-net leases enable landlords to pass increased property tax expenses to tenants, yet that situation tends to be the exception. Most office tenants in Washington and other major markets lease space on a full-service basis, so that occupants are typically responsible for increases in real estate taxes only over a pre-established base.
Given this prevailing lease structure, tenants are become increasingly sensitive to how the base is structured. During the past two years, we’ve noticed a significant uptick in requests from landlords for help with structuring, interpreting and negotiating base years. The best advice can be summed up as: “Be prepared, be precise and be flexible.”
Real estate taxes are generally the single largest expense for almost any owner, no matter the state in which the property exists.
During negotiations, landlords should recognize the significance of this cost to the tenant, and assume that the tenant will do the same. This means that a landlord needs a clear understanding of the property’s current and projected real estate tax situation.
For stabilized properties, current property taxes are a reliable indicator of future taxes, prior to adjustments for changing market conditions. For new construction or recently renovated properties, however, property taxes can spike in the years following substantial completion. Understanding a property’s current and likely future assessment will place the landlord in the best possible position during negotiations.
Too often, however, landlords reach out to property tax counsel at the tail end of lease negotiations, after tenants and landlord have already exchanged lease language. Rather, landlords should consult counsel at the outset of negotiations so that owner and adviser understand the property’s current and projected real estate taxes.
As with any lease clause, precision matters in property tax provisions. Base-year disputes most often arise when leases use boilerplate language which is either open for interpretation or simply does not apply to the local jurisdiction. Often this language relies on standard broker/landlord leases and uses generic terms or those that do not clearly apply to the assessing jurisdiction.
Moreover, imprecise language increases the likelihood that costly disputes will arise. Concerns about base-year language often stalls dispositions or scuttles them altogether. To minimize the chances of such mishaps, tax-related language should be tailored to the property and jurisdiction. Again, consulting local property tax counsel is crucial.
Flexibility is Key
There are many ways to negotiate a real estate tax recovery clause. In the Washington, D.C., metro, standard practice is to set either the first year of the lease or first full calendar year of the lease. While this standard practice has some superficial logic, it may result in a base year that comprises multiple fiscal years. For example, Washington’s fiscal year runs from October to September. As a result, any base year patterned on the calendar year will necessarily require two assessments and could spark a dispute if those assessments differ significantly.
Mindful of this possibility, some landlords and tenants prefer to set base years on the District’s fiscal calendar so that only one assessment will be implicated. Sometimes, however, the parties are unable to agree on a time period for the base year. In such cases, taxpayers should shift from a temporal approach to a numeric approach.
For example, if the parties are at loggerheads over whether the base year should be 2016 or 2017, they can simply set a specific assessment or tax amount. Taking that step can reduce the influence of chance in establishing the base.
Given the outsized importance of real estate taxes to the bottom line, managing these costs is imperative. While this calls for engaging local counsel to review and appeal the property’s assessment, it should also include working with counsel at the front end to assist in developing appropriate lease language.