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What Is Prop C and How Is It Influencing San Francisco Businesses?

03.16.20

Conceived as a way to funnel some of the financial successes of the Bay Area tech industry into funding social services, Proposition C (Commercial Rents) is raising the cost of doing business in the City and County of San Francisco (“the City”) for professional services firms and other non-tech companies. Here’s how the San Francisco’s new Commercial Rent tax is changing the calculus for Bay Area businesses.

With an average annual rent of nearly $85 per square foot, San Francisco commercial properties command some of the highest rents in the country. This is the result of the region’s booming tech industry, a force that has transformed the City over the past decade and cemented San Francisco’s status as a premier business destination.

At the same time, many agree the City is experiencing a rise in social ills like homelessness and economic inequality. One response to this is from voters passing measures that seek to channel some of the wealth generated by the City’s tech industry into an expansion of the City’s social welfare system.

That’s where Proposition C, the Commercial Rent Tax for Early Care and Education, comes in. By imposing a new gross receipts tax on commercial property rentals at a rate of 3.5%, the law aims to raise $146 million for guaranteed early childcare and education for residents. Office, retail and industrial space rentals are all subject to the 3.5% tax rate, an unusually high rate for a gross receipt tax, with a lower 1% tax levied on rentals of warehouse space. That’s on top of an existing 0.3% tax rate on gross receipts landlords already pay to the City.

The Real Cost of Commercial Space in San Francisco

The Commercial Rent gross receipts tax should not be confused with a similarly-minded, though distinct social measure also passed in 2018 known as the Homelessness Gross Receipts Tax which is designed to fund “Our City, Our Home Fund.”

Regardless of the intent behind these laws, one side effect has been the increasing business costs for small and midsize professional services and other non-tech businesses because of the additional tax passed on to lessees, states Tim Hogan, senior director at commercial real estate services firm Cushman and Wakefield.

“The tech industry doesn’t care what it costs to do business here,” Hogan says. “They’re going to want to be here no matter what, because this is where all the action is. It’s those smaller and midsize professional firms like insurance companies, law firms, accounting firms, consultancies — the real bedrock of any city’s business community — that are getting squeezed out.”

The heart of the issue, Hogan says, is a quirk in how the law is written that does not prevent landlords from simply passing along the 3.5% tax on commercial leases to lessees. “It shows up as a separate line item on the operating expenses receipt,” Hogan says. “And suddenly that $90 a square foot you’re paying is closer to $94.” Somewhat surprisingly, “the reimbursement of the commercial rent tax when passed to the lessee also becomes a gross receipt that is subject to the landlord’s standard gross receipts tax, so there’s tax on a tax,” says BPM Managing Director John Hayashi.

There’s little room for negotiation as well, Hogan adds. “With space in the City at such a premium, tenants don’t have much leverage,” he says. “Perhaps if vacancy rates increase, we’ll see some wiggle room. But not right now.”

While the Commercial Rent tax alone probably wouldn’t break any company’s budget, when combined with other expenses like the City’s standard gross receipts taxes and its annual business registration fee, the costs can start to become a burden for businesses with slimmer operating budgets. That may lead soon to an exodus of those firms who help keep businesses running smoothly — a liability for any city’s economy.

Prop C and the Legal Challenges

With the extra burden the various Proposition C’s have placed on an already-strained small- and medium-sized business community, it’s no surprise some industry groups are attempting to get the law invalidated, arguing both the commercial rent tax and the homelessness tax were passed in violation of California law.

Taxpayer advocacy groups have filed suit against the City, arguing the commercial rent tax constitutes a “special tax,” and under state law must get a two-thirds majority to pass. (The voter initiative process, by comparison, only requires a simple majority of the voters to pass.)

In its defense, the City points to last year’s California Supreme Court case, California Cannabis Coalition v. City of Upland, where the court upheld certain procedural rules that apply to propositions introduced by legislators that don’t apply to measures proposed by voter initiative.

But those supporting Proposition C say that because the Upland decision did not specifically address the topic of required voter thresholds, the case isn’t relevant to San Francisco’s tax.

Regardless, the fact that the tax’s legality is currently uncertain doesn’t mean businesses should bank on it being overturned, warns Hayashi.

“Obviously, if the plaintiffs’ case is ultimately successful, the tax will be overturned,” he says. “But it appears a decision won’t be made for quite a while, and businesses should make decisions about leasing space under the assumption that the tax will be collected.”

From the City to the Town

While the Commercial Rent and Homelessness gross receipts taxes are localized to San Francisco, their effects are regional. For instance, Hogan says the effective increase in rent is making other locations around the Bay Area — but especially Oakland, where the average commercial rent is closer to $60 per square foot — look more attractive.

“If you’re a landlord in Oakland you can point to those taxes as just another expense you won’t have to deal with on this side of the bay,” says Hogan.

Of course, if more businesses make the move to Oakland, that itself could end up driving up rents. Commercial asking rents in the East Bay are already rising at a rate of nearly 16% each year.

But in the meantime, Oakland represents a relative value for companies where there’s not necessarily a solid business case for them needing to be located within San Francisco city limits.

What to Know About Prop C

Hogan and Hayashi, both of whom have been focused on getting the word out to clients, agree the most important thing for businesses with regard to Proposition C is to ensure they’ve made educated decisions about where to lease.

For instance: taking into consideration the fact that the rent tax scales exponentially with yearly increase in rent.

“We’re not telling people ‘don’t lease in San Francisco,’” Hogan says. “Far from it. But we don’t want companies to be blindsided five, seven years from now with these line items further increasing their already pricey rents.”

Hayashi said there are special considerations, tax credits and exemptions for certain San Francisco’s commercial renters, including nonprofit and education centers. To find out more about the tax effects around Prop C, contact BPM’s John Hayashi at JHayashi@bpmcpa.com.

Hogan and his team at Cushman Wakefield are also standing by to help answer questions for Bay Area businesses weighing their property options. Tim Hogan can be reached at Tim.Hogan@cushwake.com.

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