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The city of Los Angeles’ real estate market has been upended in recent months due to the passage of major new tax legislation, Measure ULA or commonly referred to as the ‘Mansion Tax’.  Measure ULA, approved by Los Angeles city ballot on November 8, 2022, is intended to raise funds for affordable housing and projects to prevent homelessness. The tax has attracted nationwide attention especially as it impacts one of the nation’s most expensive luxury housing markets but the tax impacts all types of commercial real estate sales.  The impact on CRE is important to watch especially as it arrived at an already challenging time for the market with interest rates at their highest levels since just before the Great Financial Crisis.

What is the Measure ULA Tax and what does it impact?

The Measure ULA tax impacts all types of properties that are sold after April 1, 2023 and applies only to certain sales price thresholds. The Measure ULA rate is 4% for properties conveyed over five million dollars but less than ten million but rises to 5.5% for properties conveyed over ten million dollars.  While the tax has largely made the news for impacting luxury residential (hence its nickname as the ‘Mansion Tax’), it applies to all commercial and residential property sales as well as land sales taking place over these price thresholds and only within the city of Los Angeles. Future thresholds will be adjusted annually by the city of Los Angeles depending on the movement of the Consumer Price Index (CPI).

What is its current impact and anticipated future effect?

If the tax had been in place during the 2021-2022 period, Measure ULA would have generated $923 million according to a UCLA white paper published last year. Expectations were that the tax would actually generate $672 million per year (or an estimated $56 million per month), but according to April’s receipts the actual tax collected fell substantially  short of that—just $3.6 million was captured in the tax’s first active month.

However, there are indications that there was a rush to close transactions before the tax went into effect. Analysts were not surprised that the collected tax is falling short of expectations, as transaction activity has subsequently dropped. This is supported by CompStak’s data—the average sales price of sales transactions in the city of Los Angeles spiked well above the historical average in the first quarter of 2023, preceding the onset of the new tax rate on commercial sales with prices of $5 million or above. Additionally, the share of commercial property sales closing at $5 million or above rose above one-third in the first quarter of 2023. According to CompStak’s data, from the first quarter of 2021 through the end of 2022, just over 16% of all property sales closed above that threshold.

This bump in share of sales going to higher-priced transactions notably occurred at the same time that overall property sales are slowing nationwide as a result of rising capital costs from climbing interest rates and concerns of a recession on the horizon. 

The Federal Reserve has now raised interest rates ten times but took its first pause since March 2022 after May’s Consumer Price Index data showed signs of slowing inflation. While it isn’t clear if the Federal Reserve has reached peak tightening, interest rates still remain at the highest level since 2007. 

Therefore, the onset of this tax may further depress commercial real estate sales activity in Los Angeles. The added pressure of Measure ULA could further exacerbate the mismatch between buyer and sellers’  pricing expectations in today’s market. Sellers may seek a higher sales price to mitigate the cost of the tax while buyers have the reverse need – wanting to negotiate prices lower as their borrowing costs have increased. 

What could a recession mean for the Los Angeles market and for CRE?

Employment

The Los Angeles metro has already recovered more slowly from pandemic job losses than the United States to date; private sector employment is up just 1.0% from February 2020 in the Los Angeles Metro while it has grown by 4.3% nationally.  As of May 2023, the Los Angeles metro’s office-using employment has fallen by 25,400 jobs or 2.2% since its post-pandemic peak reached in November 2022. This markets’ recovery in office-using employment specifically has also trailed the nation; the U.S. overall has experienced just a 0.4% drop from its post-pandemic peak (also reached in November 2022). 

Industrial Sector 

The Los Angeles – Inland Empire industrial market is expected to weather a potential recession better than other sectors, but the double-digit rent growth recently charted is anticipated to slow. Both Los Angeles County and the Inland Empire have experienced record rent growth; average starting rents for closed transactions grew by more than 90% and 140%, respectively from 2019 to today (transactions closed 3Q 2022 to present). These markets have had among the most robust industrial rent expansion nationwide but the pace of starting rent growth contracted slightly for the last two quarters.

Space demand is moderating nationwide as industrial occupiers  reevaluate needs in 2023. In the LA-Inland Empire industrial market, the demand for large space requirements boomed during the pandemic leading to a rise in transaction size from the beginning of 2021, especially in the Inland Empire. As a result, average starting rents for transactions over 50,000 square feet rose faster than those for spaces below that threshold. In the fourth quarter of 2019, the average starting rent for transactions below 50,000 square feet was more than 25% higher than for spaces above 50K but by the second quarter of 2022 the trend had reversed: spaces larger than 50K command a higher starting rent per square foot on average. However, the average transaction size fell in early 2023 after rising through much of 2022 in both Los Angeles County and the Inland Empire. 

Office Sector

The office sector continues to lag nationwide with high levels of near-term loan maturities, rising defaults and special servicing rates still grabbing headlines. In addition, demand is below historical levels as companies assess their office needs amid hybrid and remote work policies.  Los Angeles’ office occupancy rate as measured by Kastle Systems is hovering around 50.0% most recently, on par with New York City’s recent levels, but both markets fall short of office occupancy in cities like Houstin and Austin, which reached marks of 60.6% and 58.3%, respectively, last week.  With these challenges, additional economic woes are expected to weigh on the office sector more than other sectors.

The Los Angeles metro ranks high among the nation’s metros for maturing CMBS loans through 2024, according to Trepp.  Market participants are concerned because these loan expirations are concurrent with a high level of lease expirations, especially from tenants who may have signed short-term extensions in the depths of the pandemic.  According to CompStak’s data, more than 27% of Los Angeles County’s office leases will expire in 2023 through 2024. In Orange County, more than 26% of all office space renewed  during 2020 will expire in 2023 or 2024 and 12.7% of those 2020 deals will expire in Los Angeles County. 

In Los Angeles and Orange County, average effective rents are down from 2019 levels in recent quarters for closed office lease transactions. Other gateway markets like the Bay Area and New York City have trended somewhat differently. The Bay Area had a shallower decline in the depths of the pandemic, and New York City’s overall average has been trending up with higher shares of activity in higher end product and new construction over the past year. 

InIn Orange County, the share of term given to free rent is up 100 basis points from 2019. Due to rising construction costs and demand for high-quality buildouts, the ratio of tenant improvement allowances given to the total value of a deal (rent received) has been on the rise in some markets including New York City and Orange County. 

Retail Sector

The outlook for retail is mixed, though retail in central business districts anchored heavily by office, is still suffering from rising vacancy. Severely challenged during the depths of the pandemic in 2020, retail sector activity has improved since then due to pent up demand and robust consumer spending, despite the challenges of inflation. The retail sector eked out positive returns in 3 of the past 4 quarters in the national NCREIF Property Index, while office and industrial had just 1 and 2 quarters of positive returns over the past year, respectively. 

According to CompStak’s data, retail effective rent growth is lagging in Los Angeles County with most recently reported effective rents still about 1% below 2019 levels, but improved from 2020’s 11% drop from 2019. By comparison, Manhattan’s average retail effective rent is close to 2019 levels in recent quarters and actually outpaced it in part of 2022.

Will the ‘Mansion Tax’ Crater the Los Angeles CRE Economy?

With just over 2.5 months passed since the onset of the tax, it remains to be seen how much of a negative impact that Measure ULA will have on commercial real  estate sales volumes and prices in Los Angeles in the long-term. The upcoming close of the second quarter could yield some insights. Meanwhile, the market is also still reacting to elevated interest rates, though the Federal Reserve paused for the first time in fifteen months and 10 consecutive rate hikes. Finally, there is mounting legal pressure and resistance to the tax which may reverse the policy entirely. Currently, there are lawsuits against the city of Los Angeles pending to halt Measure ULA from both the Apartment Association of Greater Los Angeles (AAGLA) and Newcastle Courtyards. 

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