The office sector had a difficult couple of years. This isn’t just bad for office building owners; cities rely on the tax revenue from property taxes collected from office buildings. Municipalities around the country are trying to get a handle on how declining office property values and the resulting reduction in property tax revenue may impact government budgets. At the same time, companies planning their budgets and looking for ways to reduce costs are reviewing their office space’s assessed property tax value to determine whether the property is appropriately assessed. This becomes even more relevant if they are considering making changes to the way the property is used.
Several factors contributed to 2022’s decline in office values, and many of those factors are still impacting the economic environment in 2023. Inflation has risen dramatically after 20 years of a historically low inflationary environment. In May 2023, the Federal Reserve raised interest rates for the tenth time in a little over a year. Rising interest rates have resulted in higher capitalization rates, which have increased costs for borrowers and reduced property values. These and other factors have led many economists to predict a 61 percent chance of a recession in 2023.
Even if a recession does not occur or only occurs for a short time, the rise of hybrid work has greatly diminished the demand for office space. According to CBRE, about 10 million square feet of office space was available for sublease in February 2022 compared to about half that in March 2020, when the COVID pandemic began and “ushered in hybrid working arrangements.”
According to Ted Egan, Chief Economist for the City and County of San Francisco, this trend is expected to continue. In his Memorandum to the San Francisco Board of Supervisors, he observed that “office attendance has declined significantly relative to pre-pandemic levels” and is one economic indicator that has not returned to pre-pandemic levels. Egan opined that if the work-from-home pattern permanently lowers office rents or keeps vacancy rates elevated, “property taxes from office buildings will, eventually, be reduced in proportion.” In the short term, however, he says that cyclical factors, such as rising interest rates and their impact on property values, “create more of a downside risk,” at least for San Francisco. Egan further notes that San Francisco has experienced the largest increase in office vacancy among major office markets, from around 5 percent before the pandemic to 24 percent in the third quarter of 2022. He predicts that San Francisco office capitalization rates will stay in the 7 to 8 percent range between now and 2028 instead of the 5 to 6 percent range that prevailed during most of the 2010s. Compounding the decreased need for office space is the fact that several companies, anticipating a recession, have laid off thousands of employees since 2022.
In many states, property taxes are based on the highest and best use and/or fair market value as of a particular lien date. For instance, in California, Proposition 13 sets the base year value upon a property’s change in ownership or when new construction occurs. By law, on each subsequent lien date of January 1, the assessed value can increase no greater than 2 percent. However, if the fair market value is less than the factored base year value, the lesser value can be enrolled, according to Proposition 8. Similarly, in Arizona, the Limited Property Value, or taxable value, is capped and is not to exceed the full cash value of the property. Other jurisdictions, such as Oregon and Washington, enroll the fair market value on each lien date.
By changing the use of their property as well as reviewing their property tax obligations, office property owners can potentially reduce some of the factors that are negatively impacting their property values. While these property owners may have different considerations when evaluating their current property use and existing and future property tax liabilities, there are some common approaches that may be worth considering.
Office property owners looking to reduce costs might consider making updates to help attract new tenants. Still, they will want to consider the property tax impacts of updating or changing the use of the property. In California and Arizona, for example, new construction is a re-assessable event, which could increase a property’s base year in California or limit property value in Arizona. In other jurisdictions, assessor offices will consider changes to the property characteristics and effective year when revaluing to market value on the lien date.
Subleasing may be an option to allow owners to capitalize on extra square footage, although, with the amount of available square footage currently, there is downward pressure on sublet rents. Sublease rents decreased between the first and second quarter of 2023. If office owners lease at a lower rate, however, it could be evidence to support a reduction in the property’s tax value.
Office owners could also consider converting the property to a different use, which could bring higher rent but also can mean making a large investment in construction costs, resulting in increased property taxes, depending on the jurisdiction. The most common conversion has been from office to housing since there is such a shortage in many parts of the country, but life sciences, hotel, and mixed-use are also types that are seeing conversions. A new California bill, the Office to Housing Conversion Act or Assembly Bill 1532, aims to streamline the conversion process. It would make conversion a matter of right regardless of zoning and incentivize office-to-residential conversions by making them exempt from impact fees.
Even if owners don’t want to put in the money needed to renovate or change the usage of office buildings, it may be difficult to sell properties during the upcoming year since the demand for office space is at an all-time low. In its San Francisco Office Market Report for the last quarter of 2022, Colliers reported that in the fourth quarter of 2022, it only had three closed office transactions. If the future sees reduced office valuations due to high vacancy and high cap rates, as well as difficulty in obtaining office financing, property owners may be challenged to sell. In the short term, office property owners may want to request having their property tax values reduced to reflect these factors.
Declining property tax revenue on office space is just the latest hurdle that office property owners are facing. With ongoing recessionary concerns and evolving hybrid work policies, property owners must understand how newfound office market challenges can impact their property’s long and short-term value. Those who find different considerations when evaluating their current properties (such as converting their office space, sub-leasing, or reviewing tax obligations) will be able to re-assess their value and ensure longevity for their space.
