November 2018

Government Controls Over Property Rental Rates

On November 6, 2018 voters went to the polls, and Proposition 10 was defeated which keeps the current laws effecting residential rental rates to remain somewhat constant.

The City of Los Angeles Rent Stabilization Ordinance protects tenants from excessive rent increases on multi-family apartments built before1979. However, it lets landlords increase the rents every year to a reasonable amount.  The rent increases are determined on the consumer price index, according to the Los Angeles City website.  The rent increase caps on rent stabilized apartments in Los Angeles City is currently 3% this year and has been 3% for about the last 10 years, according to the website.

The City of Los Angeles cannot cap rental rates when a tenant moves out of a building built before 1979.  The Costa-Hawkins Act of 1995 made it illegal for cities to enforce caps on multi-family rental rates when a new tenant moves in.  

The owner can raise the rent to as high as the market can bear after the tenant vacates the apartment.  As a result, Los Angeles City has the fourth highest median apartment rental rate in the country behind  number one San Francisco and San Jose number three, according to National Rent Report November 2018.   The Median price for a one bedroom in the City of Los Angeles is $2,430.  One bedroom rent in Los Angeles City is up 15.7% since November last year the Zumper report said.  

Proposition 10 would have repealed the Costa-Hawkins Act of 1995 and given Los Angeles and all California cities back the power to cap rental rates on all multi-family and single-family rental units for new tenants moving in; however, voters rejected it.

Rent control works for tenants who want to remain in their apartments or homes with minimal rental rate increases. This law is not favorable for landlords who want to bring their rental properties up to current market values.

The only time that the rents can be brought up to market value is when the tenant vacates the rental unit. The current law protects the tenants and allows the landlord to only look forward to a possible vacancy when rents may be increased.  

As a result, existing multi-family vacancy rates are extremely low in Los Angeles.  Renters don’t want to leave their current apartment, because they may have to pay more rent if they move into a different apartment in Los Angeles.  In addition, it makes it extremely difficult for a new renter to find a decent apartment for the median price in Los Angeles.

Proposition 10 would have placed another layer of government controls by restricting rents when a vacancy occurred to a fair market value. The mechanics of the way the City of Los Angeles government and other California cities would determine a fair market value when a rental unit was vacated was uncertain if Prop 10 had passed.

In Contrast, there are no restrictions on rental rates in the commercial real estate market and the market determines the rates. For many years, commercial rental rates were stagnant and even decreased during the great recession. These mechanics of market determining rental rates has worked out very well without government control for commercial real estate.

Certain sectors of commercial real estate are now showing a similarity of a shortage of available space. The industrial real estate market in many areas of Los Angeles County is down to a 1% vacancy rate. Therefore, there is very little space available for tenants to relocate. Further, rental rates in many areas of Los Angeles County have increased by as much as 12% in the last year.

There is virtually no new space under construction to resolve the vacancy, so the market will adjust when the economy cools.  Many commercial companies simply cannot pick up and move to another state; in contrast, a single residential tenant may find a job in another state where residential rents are lower and there are plenty of vacancies.

The essence of this blog is to point out that there is no need for excessive governmental controls in the commercial real estate market; however, there should be controls for residential units. It is my concern that governmental controls may be placed upon commercial real estate in the future.

Alternatives for a 1031 Tax Deferred Exchange

Many of our Segal Commercial clients own commercial income producing properties.  These properties include but are not limited to shopping centers, industrial, office buildings and free standing retail properties.

A good sound commercial income producing property with positive cash flow is a difficult asset to replace.  Positive cash flow is the crown jewel of owning an income producing property.  Why would someone sell a property that is generating a positive cash flow?

Reasons for Selling a Cash Producing Property

There are numerous reasons for selling a successful income producing property.  I have listed a few reasons below:

•    The area has changed demographically
•    The property is not consistent with the marketplace
•    Death of an owner
•    Cash flow is not consistent with the size of the equity in the property
•    Depreciation has been depleted which can cause income taxes to rise
•    One or more tenants are a nuisance

The seller should do his or her own due diligence on the property and examine why they want to place the property up for sale.  The seller’s legal counsel or real estate agent should provide them with a checklist to examine the property very carefully prior to placing it on the market.  

1031 Property Exchange

The seller can defer capital gains taxes in a 1031 Property Exchange.  A 1031 Property Exchange allows Commercial Real Estate Investors to defer capital gains taxes by buying like-kind property immediately after a sale; however, the lack of supply can be a problem for commercial investors.

Commercial real estate owners have the opportunity to postpone or defer property capital gains taxes by following the rules of the 1031 Property Exchange.   One of the Internal Revenue Service rules is the 45-Day Rule which requires a seller to identify the proposed purchase property in writing during the last 45 days of the close of escrow of the original property.  A seller who identifies the property after the close of escrow will lose the 1031 property exchange benefit.

The second IRS rule is the 180-Day Rule.  The buyer has 180 days after the original property sold to close escrow on the exchange property that was identified under the 45-Day rule.   These rules are strict for the investor who has invested in commercial real estate.

An investor can sell an industrial building and exchange it for an office building, shopping center, multi-family or single family rental.  The commercial investor may choose the wrong purchase in a rush in order to meet the strict time constraints in Los Angeles.

There are very few commercial buildings for sale in Los Angeles.  An industrial investor who sells his building in a 1031 exchange will have an extremely difficult time finding a replacement in the 45 day time constraint.  The investor may have to resort to going out of state to purchase a commercial building for sale however going out of state, typically provides issues that the buyer did not see.

The importance of selecting the correct property for an exchange should be predicated on the buyers own personal background in owning commercial real estate.  For instance if the buyer has a history of owning office buildings and they are looking to purchase a shopping center, their background may not be appropriate for selecting that new investment.  Since a buyer owned office buildings, he or she has first-hand experience in operating that type of real estate.

There are many types of commercial real estate investment properties.  Below is a list and description of some investment type of properties to purchase:

Commercial Real Estate Investment Properties Types

Industrial – In my opinion, this is typically the most conservative class of investment.  Typically the tenants have long term leases and in many cases they pay for all of the expenses as well as maintaining the property.  Also, some buildings have multiple tenants; as a result, the owner can spread the risk of ownership by having many tenants.

Shopping Centers – These investments can provide good returns and have several tenants which minimize the risk.  The danger is the anchor tenants may theoretically own the landlord.  Anchor tenants usually have rental rates that are low and their leases are long.  Anchors draw consumers into the shopping center so the smaller tenants can survive.  The owner earns the income from the smaller tenants who are not usually financially strong.  However, the owner may do very well if he or she has a strong list of commercial tenants.

Office Buildings – The challenge with office buildings is to create something unique by making the environment exciting plus having restaurants and snack bars.  The key critical factor for making an office building successful is the retention of tenants.  However, costly tenant improvements for a new tenant can prevent an owner from making this type of property successful.

Sale Lease Back Free Standing – These properties are usually promoted through the internet.  A few examples would be 7-11, Walgreens, CVS and AT&T.  These are properties that may be a buyer’s last chance of hope for a 1031 Property Exchange.  These properties are expensive and the buyer is basically buying a guarantee from the tenant similar to a bond.  There is very little intrinsic value with these buildings, since the real estate doesn’t have the value of the buyers purchase price.  The buyer should make sure that there is a provision in the lease back that the tenant cannot cease doing business in the building.  Subleasing is okay provided the store does not cease business for any delayed period of time.

Opportunity Zones

In addition to the 1031 Commercial Real Estate Property exchange capital gains tax deferment program,  there is a new capital gains tax deferment program called Opportunity Zones where an investor can roll over the capital gains revenue he or she receives in the sale of a commercial real estate property into an Opportunity Fund.  The program was included in the Tax Cuts and Jobs Act bill that passed in 2017.

An investor can now roll over the capital gains money from a previous commercial real estate sale into an Opportunity Fund.  The Opportunity Fund must invest it in an income producing real estate development or renovation of a commercial building located in an Opportunity Zone.   The capital gain from the sale of the previous investment is deferred and will not be taxed until 2026.

In addition, 10% of the deferred capital gain tax is excluded entirely if the investment fund interest is held for 5 years, and 15% of the deferred gain is excluded entirely if the investment fund interest is held for seven years.

There is no capital gain tax at all on a sale of the fund interest other than the deferred gain if the fund interest is held for 10 years and the entire fund interest is sold.   The fund interest must have no recapture of depreciation or recognition of debt in excess of basis.

Opportunity Zone Locations in Los Angeles

However, there is risk involved in the Opportunity Zones.  They are located in low-income communities around the country.  There are 274 designated Opportunity Zones located in the greater Los Angeles area, according to an article in the Los Angeles Business Journal titled, “Capital Gain Deferral Opportunities abound in Los Angeles” dated July 12, 2018.  Some of these locations are in Sylmar, Sun Valley, Northridge, Canoga Park, North Hollywood, Hollywood, Culver City, Downtown LA and Long Beach.  In addition, some zones are scattered across locations in Bell, Huntington Park, Lynwood, Westmont, Compton, Torrance and Lakewood, according to the LA Business Journal article.

The Opportunity Fund must develop or renovate an income producing commercial real estate building only in these high risk areas to get the full benefit of the capital gains tax savings.

“When I was in litigation and in need of an expert on commercial property management, my co-counsel immediately recommended Lee Segal. He was extremely knowledgeable, responsive and proactive when it came to identifying and gaining valuable perspective on key issues. His credibility as an expert was instrumental in my case; I would not hesitate to work with him again in the future.”    
Lisa Pan, Demler, Armstrong & Rowland, LLP