Triple-Net or Triple-Unfair? When Commercial Tenants Pay Property Taxes on Their Landlord’s Redevelopment Potential

Triple-net leases are common throughout British Columbia’s commercial real estate market. Under a typical triple-net (or “NNN" lease), the tenant pays a base rent to the landlord and is also responsible for its proportionate share of the property’s operating costs. These additional costs commonly include property taxes, building insurance, maintenance and other expenses.

The concept seems reasonable: if a business occupies 30% of a commercial building, it pays approximately 30% of the building’s operating expenses. But property taxes can create a significant problem that is often overlooked.

What happens when the property is worth substantially more for redevelopment than it is for its existing commercial use?

In that situation, a tenant may find itself paying property taxes attributable not to the premises it occupies today, but to the landlord’s future redevelopment potential.

The Assessment Versus Existing-Use Problem

BC Assessment generally assesses real property based on market value as of the applicable valuation date.

For many conventional commercial properties, the value of the existing land and improvements reasonably reflects the property’s ongoing commercial use.

However, consider an older one-storey retail building located on a major commercial corridor. The property may currently contain 8,000 square feet of retail space, but new zoning could permit a six-storey mixed-use development containing retail space at grade and residential apartments above.

From a real estate valuation perspective, the property may now have a highest and best use substantially more intensive than its existing use.

As land values increase, the assessed value may begin reflecting this redevelopment potential. That is perfectly logical from an assessment perspective.

From the tenant’s perspective, however, it can create a problem.

The business may occupy exactly the same retail space, generate exactly the same revenue and receive exactly the same utility from the property as it did previously.

Yet its property tax contribution can rise dramatically because the underlying land has become more valuable for a use the tenant does not enjoy.

An Illustrative Example

Assume an older commercial property has a current-use value of approximately $2 million. Because of increased density and redevelopment potential, the market now values the property at $4 million. Assume, strictly for illustration, that the applicable combined Class 6 property tax rate is $20 per $1,000 of assessed value.

At $2 million, the annual taxes would be approximately:

$40,000

At $4 million:

$80,000

A tenant occupying 50% of the building under a conventional triple-net lease could see its tax contribution increase from approximately:

$20,000 to $40,000 per year.

Yet nothing about the premises occupied by that tenant has changed.

The additional $20,000 annual expense is effectively attributable to the increased redevelopment value of the landlord’s real estate. Eventually, the landlord may sell the property to a developer, refinance it based on its higher value or redevelop it themselves.

The tenant does not participate in that capital appreciation. But under an inadequately structured triple-net lease, the tenant may help pay the annual carrying costs associated with it.

This Is Primarily a Lease Issue

The natural reaction may be to appeal the assessment. That can certainly be appropriate where an assessment appears excessive or unsupported by market evidence. But an assessment appeal does not necessarily solve this particular problem.

If market evidence demonstrates that the property genuinely has substantial redevelopment potential, a higher land assessment may be reasonable.

The real issue then becomes:

Who should pay the taxes associated with that redevelopment value?

That question needs to be addressed in the lease.

How Can Commercial Tenants Protect Themselves?

Tenants negotiating triple-net leases should consider several protections:

1. Exclude redevelopment value from the tenant’s tax obligation

The lease can specifically exclude property taxes attributable to unused density, redevelopment potential, air rights, rezoning, development approvals or other future uses not enjoyed by the tenant.

2. Establish a current-use tax value

A particularly logical approach is to calculate the tenant’s tax obligation based on what the property would be worth assuming continuation of its existing use and improvements. The tenant would pay its proportionate share of taxes attributable to that value. The landlord would be responsible for taxes attributable to the incremental redevelopment value. Where necessary, an independent commercial appraisal could establish the current-use value.

3. Negotiate a cap on tax increases

Another solution is to limit the amount by which the tenant's property-tax contribution can increase annually.

This provides cost certainty and protects a tenant against a sudden assessment increase unrelated to the operation of its business.

4. Require transparency

Before signing a significant triple-net lease, tenants should obtain and review:

• Current property assessments;

• Historical assessments;

• Property tax notices;

• Land and improvement values;

• Existing zoning and permitted density;

• Official community plan designations; and

• Pending rezoning or redevelopment applications.

The lease should also provide the tenant with ongoing access to assessment and taxation information.

British Columbia Has Recognized the Problem

Interestingly, British Columbia legislation expressly acknowledges this issue.

Section 198.1 of the Community Charter permits municipalities, in qualifying circumstances, to provide reduced municipal tax rates on eligible Class 5 and Class 6 land where development potential is creating an excessive tax burden on existing commercial occupiers. The legislation actually defines “development potential” by comparing assessed value with the value considering only the property’s actual use.

That is remarkably close to the problem commercial tenants can face under triple-net leases. However, the provincial framework does not eliminate the need for good lease drafting. Municipal participation and property eligibility are subject to specific requirements, and relief may not cover every component of the property tax bill.

Look Beyond the Base Rent

Commercial tenants often spend considerable time negotiating whether their base rent should be $20, $22 or $24 per square foot. That negotiation matters.

But on certain properties, understanding the definition of “Additional Rent” may ultimately prove just as important. A tenant considering a long-term lease should understand not only what the property costs to operate today, but also what could cause those costs to change during the lease term. Where significant redevelopment potential exists, property taxation deserves particular attention.

T

he Bottom Line

Triple-net leasing is based on a sensible principle: tenants should contribute to the costs associated with the property they occupy. But there is an equally sensible counter-principle:

A commercial tenant should not unknowingly be paying property taxes attributable to the landlord’s future redevelopment profit. Identifying the difference requires an understanding of property assessment, highest and best use, land economics and commercial lease structure.

At Jackson & Associates Ltd., these are exactly the types of issues we examine when providing commercial real estate valuation and advisory services throughout Vancouver Island.

Before signing a long-term commercial lease, understand not only the rent you are agreeing to pay, but the real estate value you may inadvertently be agreeing to carry.

This article is intended for general information only and does not constitute legal or tax advice. Commercial tenants and landlords should obtain appropriate legal advice when negotiating lease provisions.