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Taxing Times

To fill California's gaping budget deficit, the government may squeeze retailers and retail real estate owners.

As if conditions aren't tough enough for California retail property developers — particularly those seeking tenants amid so much vacant space — a troubling specter looms. As lawmakers struggle to rectify the state government's gaping $26 billion budget deficit, they are setting their sights on potentially raising taxes on commercial property while at the same time gutting the budgets of local economic development agencies.

As it stands, legislators and Gov. Arnold Schwarzenegger have already opted to divert 31 percent of California's redevelopment property tax revenues from local economic development efforts. Most of that money is going to the state's education system — a priority few would quibble with. After all, the situation in California got so bad that the state was issuing IOUs from early July to early September. As of mid-August, it had dished out more than 325,000 IOUs totaling $2 billion to vendors, service providers and taxpayers awaiting refunds.

The state has also instituted cuts that border on the draconian. California cut spending by $15 billion, including $6 billion from schools, $3 billion from colleges, and $1.2 billion from prisons. (Schools are to be repaid $11 billion if and when the state's economy turns around.) Medi-Cal, the state's health program for the poor, was cut by $1.3 billion.

And the budget cutting may not be over. The state is already projecting a $7 billion to $8 billion deficit for the 2010-11 fiscal year that starts next July.

The net result of this for commercial real estate sector is that more than 350 redevelopment authorities are losing $1.7 billion in tax dollars that would otherwise help fund city and county investments during the 2009-10 fiscal year. Another $350 million will be diverted the following fiscal year. Much of that would have been aimed at revitalizing commercial districts. That's a problem because redevelopment agencies are the primary economic development drivers in the state.

For example, the Community Redevelopment Agency of Los Angeles is losing $85 million in the 2009-10 fiscal year, estimates CEO Cecilia Estolano. Other large redevelopment bodies will likewise lose big bucks: the California Redevelopment Association estimates San Jose is set to see $62.2 million diverted in 2009-10, San Diego $55.6 million.

Mary Jane Ohlasso, Ontario, Calif.'s economic development director, can't say yet how the nearly $20 million loss her Inland Empire city's redevelopment agency faces over the coming two years will impact ongoing projects. But as a longtime economic development official and licensed CPA, Ohlasso calls the state budget strategy downright “incomprehensible.”

“Going forward it's going to affect our ability to fund and assist with infrastructure for projects that create jobs,” Ohlasso explains. “And if we're not bringing in new jobs, we won't see a pickup in residential or commercial development.”

If that's not enough to worry about, the state could look to raise revenues through new taxes. A high-level state panel is now considering whether California's 30-year-old landmark “sacred cow” property tax limitation statute (Proposition 13) should be revised to bring in more revenue from retail and other commercial properties (See sidebar on p. 31).

The climate is dire enough to make retailers and retail estate firms nervous about how the situation is playing out. On one hand there will be fewer incentives coming from municipalities. On the other, higher sales taxes or property taxes would be painful at a time when retail sales continue to suffer, net occupancy income is down and property values are plummeting.

Even before the latest crisis, California's notorious business climate scared off businesses. In a recent CNBC survey, California ranked last in “cost of business” and 49th in “business friendliness.”

“We've been told by tenant rep brokers for years that they have clients who just won't come to California” due to ever-volatile budget matters, Ohlasso says. “The corporate world wants a stable political environment, which is something we can offer on the local level,” she says. But the state's all-too-frequent fiscal nightmares give decision-makers cause for pause, “and that's a difficult objection to overcome.”

Sudden impact?

While it's impossible to fully gauge the budget shift's impact on retail development and sales activity, the inevitable consequence over the coming couple years is that many redevelopment agencies won't be able to fund critical infrastructure projects, says John Shirey, executive director of the California Redevelopment Association in Sacramento. “Retail, industrial, housing — all those sectors will be affected by this incredible take of money from redevelopment agencies,” Shirey says.

If there's a silver lining to the current situation, it's that the general slowdown in the retail sector has temporarily reduced the need for these infrastructure improvements and slowed new development to a trickle — a scenario that is unlikely improve anytime soon. So the lack of funding for redevelopment agencies isn't a pressing issue. “Most retailers just aren't seeing the sales per square foot they need to start expanding,” says Harvey Green, president and CEO of Encino, Calif.-based Marcus & Millichap Real Estate Investors Services.

In addition, Amy Wetzel, regional senior vice president with Ft. Worth, Texas-based retail consultant Buxton, thinks it is unlikely that retailers currently in the state will begin a mass exodus because of the current situation. And she says, to some extent retailers that are in California know that the state can be a difficult place to do business and that the budget process is always an adventure. Firms that have decided to stick it out do so because of the opportunities that exist in spite of all the difficult business environment. As a result, the budget mess is not likely to make them change their minds.

Next Page: Blue interiors

Still, that's little consolation to professionals in the market. Development deals in California can be a nightmare to get done. Approvals are difficult to secure and the regulatory process is grueling. The loss of redevelopment funds from the state for infrastructure will only make deals — when they begin to materialize again — that are much harder to see through.

Furthermore, Wayne Schell, president and CEO of the Sacramento-based California Association for Local Economic Development, fears that it will be hard to get redevelopment kick-started again if funds aren't restored at the local level in future state budget negotiations. “It looks like we may have lost the best tool we've ever had” to support economic development in the state, Schell says. Shirey worries as well, afraid that government spending cuts could become a vicious cycle. “Once state government starts taking local government revenues for its own budget purposes, it's like crack cocaine,” he adds. “Once you start it's hard to quit.”

This would be a shame because in recent years redevelopment agencies have played crucial roles not only in revitalizing blighted districts and establishing attractive retail environments, but also in actively recruiting retailers to fill vacant spaces, says Randall Lewis, executive vice president of Upland, Calif.-based Lewis Group, whose Lewis Retail Centers unit has been one of California's most active shopping center developers in recent years.

“All of us here in the Inland Empire especially feel fortunate that our cities have been so aggressive in trying to attract retailers,” Lewis says. If that funding isn't restored when California's budget woes are eventually solved and the economy stabilizes, it could become more difficult to recruit retailers.

What to do?

One response to the budget-driven revenue shift is to get creative from the legal perspective. On behalf of its members, the California Redevelopment Association in Sacramento intends to file a lawsuit by mid-October alleging the diversion of redevelopment revenues violates the state's constitution.

Meanwhile, other municipalities are looking to finance critical projects without relying on redevelopment-generated tax-increment financing. Some are cobbling together multiple capital sources to finance public/private partnerships that develop housing, retail and other facilities inside and outside of redevelopment districts.

For instance, Los Angeles just tapped $118 million from the state's Housing & Emergency Shelter Trust Fund to help finance three transit-oriented developments and 15 infrastructure projects.

The city's redevelopment agency is partnering with private developers on some of these infill projects, including mixed-use developments featuring retail space. And, of course, agency officials around the Golden State remain active in myriad other efforts to attract retail developments and merchants such as helping match retailer needs with available space, expediting permit processing, rebating exterior upgrade expenditures and other non-financial measures.

Blue interiors

Economic development and retail property professionals alike look forward to a recovering economy to cure their respective dilemmas. And it's pretty clear market fundamentals today are far weaker in California's hotter and dryer inland markets than their expensive coastal counterparts.

According to data from Marcus & Millichap, retail vacancies at midyear were in the double digits, and continuing to rise, within the state's two primary interior population centers: Southern California's Inland Empire (San Bernardino and Riverside counties) and Northern California's Sacramento and its suburbs.

Brokerage services company CB Richard Ellis reports that the Inland Empire's East End submarket — the area's biggest at 38 million square feet of GLA — is swamped with a vacancy rate approaching 17 percent. In contrast, the midyear rate was 5.7 percent or lower in San Diego, Orange County, Los Angeles, Silicon Valley and San Francisco.

That's not to say coastal markets aren't facing their fair shares of distress. As New York City-based research firm Reis Inc. reports, San Jose/Silicon Valley and Orange County, along with Sacramento, experienced three of the 10 most dramatic declines in effective retail rental rates between the first and second quarters, among major markets nationwide.

Next Page: Lawmakers Eye Proposition 13 Reform

Perhaps predictably given the recessionary shockwaves, vacancies in all the California markets were higher at midyear than they were a year earlier. And all will be even higher by year-end, Marcus & Millichap projects.

On the flip side, landlords boasting infill locations in densely populated coastal counties typically have had a much easier time finding replacements when tenants vacate than their counterparts inland, according to Dan Samulski, a senior vice president at Grubb & Ellis in Newport Beach. Inland, amid the higher vacancies and idle subdivisions retailers know they can drive hard bargains. “If landlords there aren't lowering their rents [voluntarily], tenants are demanding that they do,” he adds.

So as bankrupt larger-format outfits like Mervyns, Gottschalks, Circuit City and the like vacate space, retailers looking to grow in the Inland markets are often encountering a bevy of attractive upgrade opportunities. Accordingly, higher-quality, higher-profile centers in struggling inland submarkets are capturing far greater interest than B and C properties these days.

The generally discount-oriented operations looking to boost footprints today aren't yet enough to back-fill all the large spaces, which has led to deals with nontraditional tenants. In addition to amusement-minded outfits such as go-cart tracks and laser-tag combat centers, churches are finding empty big-box space an economical alternative, Samulski says.

Dressed for distress

Logically in this environment, some retail real estate investors are endeavoring to raise capital targeting high-yield opportunities to acquire properties in financial distress in California and elsewhere.

According to data from New York City-based real estate research firm Real Capital Analytics, more than $108 billion in commercial real estate assets have entered default, delinquency, foreclosure or bankruptcy. Of that, some 1,420 are retail assets worth an aggregate $31.1 billion. To date, very little of that distress — $4.1 billion — has been resolved. Many in the industry have been expecting a wave of investment in such assets. Observers think the investments may begin soon with the emergence of new funds and other vehicles targeting these assets.

For example, veteran investor Tony Thompson's Thompson National Properties in Irvine is seeking $1 billion in equity for a new REIT dubbed TNP Strategic Retail Trust. And a trio of veteran property pros have formed Los Angeles-based LBG Realty Advisors, which is looking to raise $250 million for a venture targeting opportunistic retail investments.

However, given California's longer-term economic strength, Marcus & Millichap's Green and Samulski question whether all that much real distress will materialize before tenant demand and rental revenues recover. “The vulture funds say they're ready to jump into it, but in all honesty we haven't really seen much in the way of distressed sales,” Green says.

With any luck, a rebounding economy will help the state government get its fiscal house into at least relatively reasonable order — and in turn allow redevelopment agencies to again retain and reinvest property taxes into successful commercial environments. That would be the smoothest resolution the California retail real estate scene could hope for. At the very least, however, the industry is hoping the 2009 budget crisis doesn't have a sequel.

Lawmakers Eye Proposition 13 Reform

As seems to happen whenever California state and local governments fall into a fiscal funk, some politicians and other interested parties are now suggesting serious consideration of raising the state's strict limits on property taxes.

And as in past times of public-sector financial crisis, much of today's discussion focuses on moving to some sort of “split-roll” system through which different tax rates and annual inflation limits would apply to residential and commercial properties.

Since the Golden State's voters approved the landmark Proposition 13 in 1978, both commercial and residential tax rates can't be higher than 1 percent — and assessments can't rise more than 2 percent annually unless a property changes hands (which returns its assessment to its market rate).

But with local and state coffers crying for more revenues, a panel dubbed the Commission on the 21st Century Economy is assessing prospects for shifting to a split-roll — among numerous other ways and means of stabilizing California's budget. The commission is scheduled to report to the governor and legislature in late September. Adjustments under consideration include varying combinations of: re-assessing commercial properties at market rate every year (while retaining the 1 percent rate), boosting the tax rate beyond 1 percent and raising the 2 percent annual limit to a higher cap.

Much of the debate boils down to whether a split-roll constitutes another threat to landlord and business profits or a long-needed rectification of perceived tax inequities. Predictably, commercial property and business interests generally oppose any split-roll system that would tend to pass higher property taxes on to tenants. “It's one thing to generate net additional revenues,” says Harvey Green, CEO of Marcus & Millichap Real Estate Investment Services. “It's another to just shift responsibilities to third parties who will ultimately pass them on to consumers.”

Split-roll proponents downplay any negative economic effects, citing a far greater impact on long-held real estate (and mostly wealthier owners) relative to newer and more recently traded properties — not to mention much-needed billions (estimates vary) in new revenues in a state relying too heavily on volatile income taxes. Indeed a split-roll would almost certainly increase the property tax component of overall revenues, implying greater reliance on a more stable source than sale or income taxes, says University of California-Davis Economics Prof. Steven Sheffrin, who has also analyzed the potential impacts of altering Prop. 13 provisions.

It's also a matter of fairness to some degree, he adds, as the greatest impacts would fall mostly on owners of older properties that haven't sold for long periods and are hence assessed at small fractions of market values.

Newer properties, and those sold more recently, for the most part are already assessed at far closer to actual market values. Hence their owners wouldn't be compelled to pass on significant rent hikes in order to maintain a reasonable income stream, Sheffrin says.

Vacancy Rates Around the State

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009* 2008 2Q 2009 2Q
Los Angeles 3.7% 4.3% 4.1% 4.0% 3.0% 2.7% 2.4% 2.8% 4.5% 6.6% 3.5% 5.7%
Oakland/East Bay 4.9 7.2 6.6 5.5 3.6 3.1 4.0 4.3 5.5 7.9 5.0 6.8
Orange County 3.4 4.0 3.8 4.0 2.6 2.8 2.9 2.7 4.3 7.2 3.2 5.7
Sacramento 5.2 4.9 4.9 5.2 4.6 4.1 4.7 6.2 7.9 11.2 7.1 10.0
San Bernardino/Riverside 7.7 7.0 6.1 6.5 7.1 5.0 5.7 6.7 8.8 11.8 7.9 10.6
San Diego 3.3 3.9 3.6 3.3 2.9 3.1 3.2 3.3 3.8 6.1 3.4 5.3
San Francisco 2.9 4.8 4.1 4.2 4.1 3.7 3.8 4.2 3.9 4.4 3.9 4.1
San Jose 3.1 3.3 4.2 4.4 2.6 3.8 3.3 3.2 3.9 6.0 3.1 5.0
U.S. Metro Total 5.9 6.8 6.9 6.8 6.6 6.5 6.9 7.2 8.4 10.5 7.8 9.5
* Forecast Sources: Marcus & Millichap Research Services, CoStar Group, Reis
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