USA: Regional Real Estate 2018 Comparisons

Last Updated June 08, 2018

Law and Practice

Authors



Allen Matkins Leck Gamble Mallory & Natsis LLP is best known for representing clients in the real estate industry and clients for whom real estate is an important part of their success. It has a longstanding reputation as one of the leading real estate law firms in the United States, having assisted clients in the development, management, financing, acquisition and disposition of real property assets. Because Allen Matkins has one of the largest real estate departments on the West Coast – more than 100 attorneys – it can bring to every deal a vast network of resources and relationships with major players in the real estate industry. Key clients include global real estate owners, operators and developers, REITs, private equity firms, state pension funds, life insurance companies and Fortune 100 technology companies. The firm's five offices are located in four major metropolitan areas of California: Los Angeles (Downtown and Century City), Orange County, San Diego and San Francisco.

Real estate law is moving at a faster pace than ever. Clients demand highly skilled practitioners with keen knowledge of the markets in which they work, and a deep bench for large, complex deals. The US West Coast, taken as a whole, is the most dynamic real estate market in the country, thanks to the insatiable appetite for space from growing technology companies. Clients in these deals are accustomed to top business acumen and platinum-level service. 

The growth of US technology companies has transformed the West Coast real estate market, particularly West Los Angeles, Northern California, which includes Silicon Valley, and the greater Seattle metropolitan area. Vacancy rates are down, rents are at record highs, and buildings built “on spec” are often fully rented before completion. Further growth is constrained only by the availability and affordability of housing and sufficient transit infrastructure. 

Tenants like Google and Facebook have massive power and influence in deals, and can reshape markets. Amazon held a national “request for proposals” for a home for its second headquarters, a race that was covered on the front pages of national newspapers and resulted in generous, unprecedented tax-friendly bids from potential host cities.

“Co-working” spaces, in which a large tenant takes a lease and offers shorter-term subleases to smaller tenants and startups, have transformed the leasing market. At the time of writing, WeWork in San Francisco signed the largest lease of 2018, for 251,000 square feet. Los Angeles is the second-largest co-working market outside Manhattan.

In Los Angeles, the media and entertainment industries are market movers responsible for some of the largest deals and the redevelopment of communities, such as Inglewood.

Industrial space near cities is also at a premium, as online retailers look for “last-mile” distribution hubs. Some large Southern California industrial parcels have seen a 35% increase in price per acre.

Lastly, retail space is undergoing huge transitions as consumer shopping habits change. Shopping malls with high vacancies are being transformed into mixed-use spaces. 

Significant Deals and Projects

In January 2018, Apple opened its USD5 billion campus in Silicon Valley, one of the costliest buildings in the country, which will eventually house 12,000 employees, and Salesforce began occupancy of the 61-story Salesforce Tower in San Francisco. As the tallest office building west of the Mississippi, it has remade the city’s skyline. 

In March 2018, WeWork inked the largest lease deal of the year thus far, for 251,000 square feet in San Francisco. Facebook is expected to announce a large San Francisco project, and Google is looking at a very large transit-centric project that would remake downtown San Jose.

In the largest lease in the city’s history, Dropbox leased all 736,000 square feet of a speculative office project in San Francisco developed by Kilroy Realty. 

In 2017, Blackstone Group purchased a majority stake in a 3.3 million square-foot office portfolio, valued at USD1.7 billion. Tenants include Warner Bros, Walt Disney, and Sony.

The 2017 “Tax Cuts and Jobs Act” is the most significant change to US tax law in 30 years, lowering the maximum federal corporate tax rate from 35% to 21%. According to the Winter/Spring 2018 Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey, the tax bill is expected to increase the rate of return on commercial real estate and make investment more attractive, as it reduces taxes for commercial real estate owners and developers. 

1031 Exchanges Remain for Real Estate

While there was talk of eliminating this advantage, real estate capital gains remain tax-deferrable to the extent a qualified investment is timely made in like-kind replacement property.

Business Income 

Developers who organise their businesses as pass-through entities, such as partnerships and LLCs – as most do – can now take a deduction of up to 20% of their "qualified business income," subject to limitations. This does not include short- or long-term capital gains, but it does include certain REIT dividends. 

Business Interest Deduction

Under the new law, the business interest deductions of a taxpayer with average annual gross receipts of more than $25 million are limited to the sum of business interest expense plus 30% of "adjusted taxable income" (roughly compared to EBITDA in years through 2021 and EBIT beginning after 2021). Disallowed deductions are carried forward. Real estate businesses can opt out of the limits by slightly extending the period over which they depreciate real property.

Extension of the “Carried Interest” Holding Period

Under the new law, the holder of a “carried interest” in a partnership or LLC is taxed at long-term capital gains rates on their allocable share of any gain recognized by the partnership on the sale of its investment property, but only if the property was held for more than three years (rather than one year under the prior law). 

State property taxes are governed by California’s Proposition 13. Passed by voters in 1978, Prop. 13 caps annual property tax increases at 2%, meaning a property is only reassessed for tax purposes at the time of sale. While there is perennial debate about reforming Prop. 13 to eliminate its application to commercial real estate, which could allow for more equitable tax burdens while increasing the share borne by commercial real estate, there are no legal changes pending. Reformers say they hope to introduce a ballot measure changing the law in 2020. 

Most real estate is held in a single-purpose entity, which may, in turn, be a fund, a joint venture, a limited partnership operating partner (LPOP) or a publicly traded real estate investment trust (REIT).

The ownership structure above the entity level will be dictated by the needs of the particular investment structure for ultimate ownership. That can be tax-driven, or driven by the operational and investment needs and nature of the parties (whether there are foreign investors, for example) and other factors.

The property-level, single-purpose entity will likely be a Delaware limited liability company that is qualified to do business in California.

Transfer of title in California almost invariably happens through a grant deed. Exceptions would include easements or ancillary rights to real property that are often transferred through a quitclaim deed.

Transfer of full ownership (as opposed to certain partial transfers) triggers city or county transfer taxes. These forms and taxes are typically handled in escrow. The County Recorder collects taxes when the new deed is recorded. This also triggers a tax reassessment of the property.

To avoid state and federal tax withholding, transfers require the seller to disclose its domestic (or non-foreign) status by filing a declaration under the Foreign Investment in Real Property Tax Act (FIRPTA) and California Form 503-C.

There are certain California disclosure requirements in connection with a sale, which can be contractually acknowledged and/or waived, unless there is a public policy reason against it. The buyer acknowledges receipt of all seller disclosures in the purchaser agreement, in order to document satisfaction of the obligation. There are additional obligations in condominium, residential and hospitality transactions.

A notarised grant deed is recorded with the County Recorder’s office, typically co-ordinated through the title company and its escrow services. Due to the timing of the actual filing, which in many counties happens the morning after escrow delivers the documents to the recorder, sellers will sometimes sign a “gap indemnity” to allow the title company to issue a title policy (a condition to the closing) prior to the actual recordation. The gap indemnity protects the title company, through a seller indemnification, against any recordation of an alternate grant deed during such "gap."

Buyers want to validate the income-generating potential of the property and the rents being paid, so will review all leases for anything that could affect that income stream, such as termination rights, free rent periods, abatement conditions, etc. They also look for anything that would limit their ability to eventually re-sell the property. Buyers will also want to review any environmental issues, entitlements and easements, and any zoning changes that might affect how the property can be modified, rebuilt or redeveloped. Additionally, the buyer will want to know if the property is in a district subject to additional taxes for neighborhood improvements, and will want to search for any liens against the property. In sum, they want to ensure the title is free and clear.

Depending on the sophistication and capacity of the client, buyers often rely on their lawyers to conduct much of this diligence. Some experienced clients handle their own lease review, generally limiting lawyer review to key non-economic risk issues relating to the leases. Oftentimes, lawyers perform a detailed review of the largest leases, and the buyer reviews the rest.

Due diligence regarding the physical condition of the building and other inspections are handled by consultants or engineers, typically hired by the buyer, though sometimes hired by the law firm. Lawyers may become involved, depending on the nature of the entitlement and environmental conditions affecting the site.

California is a contract law state. Unless restricted by public policy, all duties and obligations can be written into the contract. Unless the agreement contractually imposes specific representations and warranties, they do not otherwise exist, and the impact of breaches may be limited by maximum exposure limits and time periods. However, public policy prevents a contractual arrangement limiting liability resulting from an established fraud.

Typically, the seller will try to limit its representations and warranties to those items a diligent buyer cannot independently verify. Typical entity-level representations and warranties include that the seller has the authority to sell, and that no third party consents are required (unless otherwise disclosed) in order to effectuate the sale. The seller will also represent that it is not bankrupt or insolvent. Operational representations will relate to validating the income-producing potential of the property, for example, that true and correct copies of any contracts and the leases for all tenants have been shared, and that the seller has turned over all notices from any government agencies. Both seller and buyer will represent that they are in compliance with the Order of Foreign Asset Control (OFAC).

Lastly, a seller will represent that it will notify the buyer if any material changes occur to the representations or warranties during escrow. Typically, the parties will negotiate what constitutes a material change. When the buyer waives contingencies, much of the risk of change shifts from the seller to the buyer, and this shift is typically reflected in the contract.

If there is a breach of one or more of the representations and warranties, the buyer will have several options. It can terminate the contract and recoup some of its costs, such as attorney and consulting fees, pursue specific performance, or elect instead to close over the known breach. Sometimes, the parties will agree to toll the closing for a short period to the extent the breach is curable and the delay may allow time to remedy it. If a buyer discovers a breach after closing, it can choose to pursue a claim against the seller, within certain time limits and caps. There is a window of liability, which is negotiated; typically, this is six to 12 months (most often nine). Additionally, damages are capped, typically at 2-3% of the purchase price (the larger the value of the property, the smaller the percentage and vice versa). This is also negotiated.

There are limitations on ownership and sale if a foreign owner owns a controlling interest in the property. There are also separate tax considerations. To avoid those, many foreign investors will limit their investment to a joint venture interest of no more than 49%.

Once on the chain of title, an owner of real property is a potential defendant to subsequent environmental tort claims, regardless of whether or not they were the polluter or discharger. Owners have exposure to liability for pre-existing conditions and events, even after the sale; this exposure needs to be included in the diligence and underwriting. Environmental disclosures are important, and environmental liability insurance should be considered if there are known or suspected conditions. Options and costs need to be identified in the due diligence phase, if not earlier, as they will effect underwriting. There are statutory disclosure requirements relating to known conditions.

Land use lawyers or consultants will review public zoning information, review the public record for any proposed changes, request the seller to provide any written documentation received from government agencies regarding proposed changes, and investigate applicable uses, such as use or height restrictions.

In certain development situations, an owner may enter into a development agreement, which is a contract between the city and developers, or a disposition development agreement. This will establish parameters for what needs to be developed and any waivers of otherwise imposed zoning requirements. The owners' rights under such agreements are often assignable to a purchaser.

The likelihood of a condemnation or taking in connection with most commercial properties is very remote, with two exceptions, both related to transit. If a commercial property is close to a freeway, there may be plans to create or modify entrance and exit ramps or widen streets. This could affect lot size or setback requirements. In the latter case, the owner may be granted relief, with existing improvements being a “permitted nonconforming use.” Nevertheless, the taking can effect what can be rebuilt on the site, due to lot size reductions. If the property is near a transit-oriented development, the municipality could potentially condemn an older property and take possession to allow for disposition to enable construction of more dense redevelopment with greater public benefit.

California counties and most cities levy a transfer tax whenever 50% or more of the interest in a property is sold. It will almost always apply to a fee-title change of any real property. In most jurisdictions, sellers pay the transfer tax, which ranges from 11 to 56 basis points in most California jurisdictions. While an outlier, the City and County of San Francisco impose transfer taxes of 300 basis points, or 3% of the purchase price.

An exception occurs under an IRC 1031 exchange, which allows an investor to defer revenue recognition and avoid capital gains taxes if the proceeds are invested into replacement, like-kind property within 180 days.

If an investor desires to acquire a replacement property before selling its current investment property, it can engage in a reverse exchange. Essentially, this involves lending funds to an “accommodator,” which purchases the property the investor would like to acquire, holding it until the investor can sell its current property and then using the subsequent sale proceeds to pay off the loan. In that case, to avoid a second set of transfer taxes, the investor then provides documentation to the county tax authorities to establish the reverse exchanges in a single transaction, done in two stages.

The classic real estate financing vehicle is a real property secured loan, which is secured by a first deed of trust. This technique is used for 95% of investments.

If an acquisition is large enough, there may also be pledges of ownership interest in the borrower as well, in addition to a first deed of trust; this makes it easier to foreclose. This is called mezzanine financing.

In addition to real property security interests, there are frequently security interests in personal property. If the real estate collateral is a hotel, the investor can take a Uniform Commercial Code (UCC) security interest in the personal property and intellectual property related to the hotel.

There are a host of regulations affecting foreign lenders and foreign-chartered banks.

Transfer taxes, or “documentary taxes,” are only applicable on transfer of ownership. Creation of collateral does not cause a taxable event, as creation of a deed of trust does not amount to a transfer of ownership interest.

Lenders must create a valid lien against the property by recording the security document – the deed of trust – in the official records of the county in which the deed is located.

Lenders must follow the proper procedural rules in enforcing their rights. They need to give notice of default and then sale, in addition to any rights given to the borrower in the loan documents. Borrowers typically have notice and opportunity to cure a default in five to ten business days. Once those have been exhausted, a lender can give a 90-day notice of default and thereafter a 21-day notice of sale. Other than a tax lien for non-payment of property taxes, the lender’s security interest takes priority over all after-acquired security interests.

It is possible for secured debt to become subordinated, but only under unusual circumstances, such as the modification of the debt when there is secured junior indebtedness. In that event, the senior lender may lose its priority, unless it gets the consent of the junior lender.

In general, the buyer of a real estate asset will be responsible for soil or environmental pollution, even if they did not cause it. Under California law, secured lenders can take steps to protect themselves from such liability.

Ordinarily, a borrower cannot create security interests after it has declared bankruptcy. Lenders cannot exercise remedies until allowed to do so by a federal bankruptcy court. Filing bankruptcy creates an automatic stay of all proceedings.

Municipalities frequently have control over the design, appearance and method of construction of new buildings. Historic buildings are typically subject to additional regulatory protections.

Certain of these controls and regulations require ministerial approvals; others may require discretionary approvals. Discretionary approvals trigger the applicability of the California Environmental Quality Act (CEQA). Additionally, there is current legislation pending that would remove municipalities’ ability to exercise discretionary approvals over projects that are properly zoned and near transit facilities, thereby eliminating the applicability of CEQA with respect to those projects.

Local municipalities typically regulate the development and use of individual parcels of real estate, but there may be other regulatory structures. For example, construction within the coastal zone is subject to regulation by the California Coastal Commission. Certain sensitive environmental properties, such as wetlands and lands located in or adjacent to state or federal parks, will also be subject to regulation by the applicable environmental authorities. All discretionary approvals are subject to regulation by CEQA.

The process for obtaining entitlements will vary depending on the size of the project, its location, the applicable municipality and whether more than one government agency is involved. If discretionary approvals are necessary, there will be public hearings. Third parties have the right to participate and object to a project that is subject to discretionary rather than ministerial approval.

Decisions by planning commissions are typically appealed to the city council, while county planning commission decisions are appealed to the county Board of Supervisors. With respect to discretionary decisions, there may also be an ability to resort to judicial process under CEQA, and challenge the project in court. It is relatively easy to challenge projects on environmental grounds, which can tie up development for years.

Developers can enter into infrastructure agreements and obtain service commitments for the supply of water and electricity, or “will serve” letters. Some local codes permit the transfer of development rights. They are not regulated under state law, but by municipal codes. It is possible to enter into development agreements with applicable municipalities.

Municipalities can exercise their police powers and obtain injunctive relief against offending projects.

There are three main legal entities: corporations, partnerships, and limited liability companies (or LLCs). LLCs are generally the preferred entity to hold real estate.

Corporations are generally subject to double taxation: both the earnings of the corporation and dividends distributed to shareholders are taxed. Partnerships are pass-through entities, whereby income and earnings are passed through to the partners and taxed at the partner level. LLCs are by default treated like partnerships for tax purposes (ie, as pass-through entities), and are very flexible in that they can reflect myriad arrangements for economic, management, and exit considerations and strategies. Additionally, any liability that the LLC may incur generally stays in the LLC, shielding its members.

Corporations are subject to double taxation and are very limited in how profits can be shared. They are generally thought to be tax-inefficient for holding real estate or appreciable assets, and are better for holding operating businesses, although this thinking may change somewhat with lower corporate tax rates.

Partnerships and LLCs generally allow partners and members to move in and out of real estate investments that have appreciated with relative ease, minimizing taxation. In some jurisdictions, an LLC may be prohibited from holding a real estate license or general contractor’s license, while a corporation may be permitted to do so. Corporations may be less flexible in how profits can be shared, however.

Partnerships and LLCs offer flexibility in reflecting the business arrangement of the partners or members. LLCs are useful in documenting varied economic arrangements, and are also very flexible in assigning day-to-day control, management and implementation, such as the right to sell property, refinance, or change business plans or budgets.

Partnerships and LLCs also allow for individually tailored exit provisions for partners and members.

Corporate shareholders, like LLC members, are generally shielded from liability, as liability remains fixed in the corporate entity. In partnerships, only the general partners or sometimes all the partners may be subject to liability. For this reason and those above, the LLC is often the preferred and most widely utilized vehicle for real estate investments.

Corporations are subject to double taxation: earnings of the corporation may be subject to tax, and dividend distributions may be taxable to the shareholders.

Partnerships and LLCs are pass-through entities, whose profits are generally taxed only at the partner and member level.

Corporations may be less costly to document than a partnership or LLC. All of the substantive terms of a partnership or LLC agreement may be subject to negotiation, which would make it more costly to document. Additionally, in certain situations, corporations may be the preferred vehicle for foreign investors of real estate because of the nature and interaction of US and foreign tax laws.

Corporations require articles of incorporation to be filed in the state or jurisdiction where it is being formed. Incorporating in Delaware is popular because the jurisdiction allows for the waiver of fiduciary duties, which can then be defined and limited by contract. Delaware has a highly developed body of business law that generally defers to the defined contract terms.

The bylaws of a corporation set forth shareholder rights, provide for management through a board of directors, and set out officer provisions. The board is elected by the shareholders and is responsible for setting policy. Officers implement the policies of the board of directors.

For partnerships, a partnership certificate is generally filed in the state in which it seeks to be governed, and then the partners enter into a partnership agreement.

LLCs generally file a certificate of formation or articles of organization. LLC and partnership agreements are often very similar in substance.

Delaware entities that own California real estate generally qualify to do business in California by registering with the California Secretary of State and paying an annual $800 minimum franchise tax.

A lease allows a tenant to occupy a property under certain terms and conditions for a set period of time. There are ground leases, master leases, and space leases. Ground leases, in which a tenant leases the ground and develops the property, are becoming more common, and are generally 55 to 99 years long. Master leases, in which a tenant leases the entire building and then finds subtenants, are rare. Space leases, in which a tenant leases a particular space, dominate the market.

There are office, industrial and retail leases of commercial property. 

Office leases are the most highly complicated and thus highly negotiated leases, and can run to hundreds of pages. 

Industrial leases are less complicated, as the properties are used primarily for storage. Due to space limitations, industrial tenants are highly constrained and do not have much room for negotiation; hence these leases are shorter. Retail leases focus on terms and conditions to help maximize the retailer’s ability to sell product.

Commercial rents and lease terms are not subject to government regulation, but are dictated solely by market forces.

Traditional lease terms specify the size and location of premises, the rent, operating and tax expenses, the length of the term, the construction that the landlord will do to the space, and allowances – ie, funds given to the tenant to improve the space. The length of a lease is usually five to ten years, and sometimes 15 years. 

Tenants repair their own premises. Landlords are responsible for all other repairs. This can be subject to negotiation – for example, whether a particular roof repair is considered building maintenance or a tenant responsibility. The best leases specify such costs in detail. In reality, landlord costs are passed through to the tenant in the form of rent.

Rent is paid monthly, due at beginning of the month, as well as operating expenses and taxes. Some leases may require one month’s rent in advance as a security deposit. 

Rent escalates, typically by 3-4% on a yearly basis. These terms are written into the lease. 

Rent increases during the term of the lease are by a negotiated percentage, as detailed in the lease. At renewal, the value of the space and thus the rent is determined by the fair market value.

In some jurisdictions, the property owner pays a gross receipt tax on rent. Because Prop. 13 has kept real estate taxes artificially low, some municipalities (especially those without real estate taxes) tax the rent. These costs tend to be passed through to tenants as part of the overall cost of the lease.

Other than rent, tenants pay a security deposit or credit enhancement, typically one or two months' rent. If a tenant has no credit history, it may be required to supply a guarantor or, more commonly, a letter of credit from a bank. Once tenants take possession, they need to pay insurance premiums and fund improvements. 

Typically landlords pay these costs, but are reimbursed by tenants on a pro rata basis, either on top of the rent, or as costs built into the rent. Any increases in those expenses during the term of the lease would be paid pro rata by the tenants. 

Telecommunications costs are typically paid directly by the tenant. Subject to reimbursement by the tenants, the landlord will typically pay utilities unless the tenant’s premise is separately metered, but this can be prohibitively expensive. If a tenant is leasing an entire building, it will typically contract directly with the utility supplier.

In retail properties, each tenant has a separate account, and the landlord pays for utilities and services for the common areas. In office buildings, the landlord pays these costs, subject to reimbursement by the tenants, typically based on their square footage. Water, sewer and garbage fees are paid by the landlord and subject to reimbursement via rent, on an equitable or proportionate basis.

Typically, the landlord insures the base, shell and core of the building. Improvements in the premises – the build out, which is typically tenant-specified – are covered by the tenant’s insurance. Tenants also insure their own personal property. In addition to casualty insurance and liability insurance for common areas, most landlords have earthquake insurance, and some have terrorism insurance. Casualty insurance is usually full replacement coverage, but earthquake coverage and deductibles vary widely. 

California is a contract law state. Landlords typically limit tenants to the anticipated use for which the building was intended. Covenants, conditions and restrictions (known as CC&Rs) will outline acceptable and prohibited uses. Some may be imposed by jurisdictions. For example, there are municipal-specific laws about the types of businesses that can be near schools. Areas zoned for office use can only contain offices; R&D (research and development) areas can only be used for R&D. Some municipalities seeking to promote certain industries have further restrictions. For example, some areas in California are zoned and developed specifically for life sciences use. 

Generally, aside from pre-approved cosmetic alterations, a tenant is restricted contractually from making alterations to premises without the review and consent of the landlord. Reasonable changes to paint, carpet and finishes are often negotiated, providing they do not affect the base, shell or core of the building.

Outside of zoning and use provisions and specific requirements that are part of a development agreement, there are generally no specific regulations or laws. In commercial settings, there is usually a waiver of the default provisions in the code that would apply to residential tenants. 

Federal bankruptcy law prioritizes creditors, and could leave the landlord as an unsecured creditor. The court can compel the assignment of the lease through the bankruptcy court, which may circumvent many otherwise applicable landlord controls over an assignment. Any cash security deposit will likely be remitted to the bankrupt estate.

Under state law, Civil Code section 1951.2, a landlord is entitled to all of the consideration for the remaining term, less the amount that the tenant can reasonably establish the landlord would be able to offset, depending on the market, by re-leasing the property.

Bankruptcy claims are capped at 12 months of rent, or 15% of the total consideration remaining. While that establishes a maximum claim, the landlord remains an unsecured creditor. Further, the lease will be subject to an assignment if there is a new tenant entity, and contractual obligations may not apply.

Security can take the form of a cash security deposit, a third-party performance payment guarantee, or a letter of credit.

A tenant does not have the right to occupy the property after its lease expires or terminates, but a landlord can create a month-to-month tenancy. Any “holdover” occupancy would be subject to fines or higher rents, such as 150% of the rent. A tenant can also be liable for actual damages from loss of a subsequent lease due to inability to deliver possession to a subsequent tenant. 

A landlord can provide the appropriate notice and file an unlawful detainer action, which is an eviction.

A landlord can terminate a lease when there is a material casualty for which the repairs will exceed a reasonable period of time, or a condemnation that materially affects the ability to conduct business. Casualty and condemnation events typically give either party the right to terminate the lease. A lease can also be terminated if a tenant defaults on payment or fails to satisfy the insurance requirements outlined in the lease. Further, economic or material non-economic defaults, such as violating the use provision, beyond applicable notice and cure periods can trigger termination. Landlords can be in default, too, for not making timely repairs, for example, or not providing consistently working elevators.

Subject to notice and cure provisions and unlawful detainer procedures, a landlord can force a tenant to vacate. The county sheriff handles the actual eviction. An uncontested unlawful detainer can typically result in a court order for eviction in 60 days. Successful contested detainers can take six months.

A municipality can condemn an unsafe building, forcing termination of the leases. The condemning authority is responsible for compensating the parties, based on fair market value. Landlords can seek compensation for loss of income and value of the property. Tenants whose leasehold is terminated can also make independent claims for the lost value of their leasehold. 

Construction contracts fall into two general categories: fixed price, which is sometimes called stipulated sum, and cost-plus, which is typically the cost of work plus the contractor’s fee, not to exceed a guaranteed maximum cost. In a stipulated sum contract, the contractor promises to build the project for a specified price. In a cost-plus or not-to-exceed guaranteed maximum cost contract, sometimes called a g-max contract, the contractor guarantees that the cost of work plus its fee will not exceed a guaranteed maximum sum.

Typically the design professionals (the architects and engineers) will design the project, and the contractor will build it. Sometimes, the same firm does a portion or even all of the design and construction. Those are called design-build contracts, and typically cover projects such as tilt-up industrial buildings and parking structures, where the construction company owns the design and engineering functions.

There are many different methodologies used to allocate risk on a construction project, ranging from indemnifications and warranties to insurance requirements. Ordinarily, the contractor and the owner waive consequential damages.

There are limits to losses. If a contractor is late in completing a project, an owner cannot sue for lost profits. As with any claim for damages, the claimant must prove that damages have actually occurred, typically by preponderance of the evidence. It is typical to waive punitive damages.

Typically, there are no legal limitations on assigning risk to one party or another. Waivers of claims based on intentional tort are invalid as they are against public policy in the United States.

Often contractors are awarded bonuses for timely performance, ie, meeting milestones throughout the course of construction, and achieving substantial and final completion on time. Some contracts call for liquated damages for delays, such as a specific fee per day past the agreed-upon completion date. These can be substantial. Contracts typically include clauses that the prevailing party’s legal fees will be paid, adding to the cost.

It is common to seek parent guarantees, performance bonds and completion bonds, unless a contractor is extremely well capitalized, which most are not. Third-party sureties, or payment and performance bonds, are common; escrow accounts are not. In addition to parent guarantees, significant subcontractors should also be bonded.

While there are exceptions, all contractors, laborers, designers or those involved in providing goods or labor to the “work of improvement” are permitted to lien the job. The relative priority of liens depends on the circumstances. All mechanics liens relate back to the date the first improvement was done to the property. Usually, the construction loan – the deed of trust securing the construction lender – is recorded prior to the commencement of work. If it is not, then all mechanics liens will be senior to the loan.

Property owners can record a bond of 150% of the amount of a lien claim, and the mechanics liens automatically shift from real property to the bond. Mechanics lien claimants have a claim but, instead of lien against property, they will have lien against the bond.

This will vary by municipality. Typically, the issuance of a certificate of occupancy or its equivalent will be from a municipality. After inspection of the fire and life safety systems, vertical transportation, etc, projects will be issued a certificate of occupancy or a temporary certificate of occupancy. In multi-tenant properties like office buildings, one obtains a certificate of occupancy on the entire shell and core of the building, and then temporary certificates of occupancy on each tenant space within the building, until the building is built out, when one can obtain a permanent certificate of occupancy on the entire structure.

When real estate is sold, it incurs transfer taxes when a new deed is recorded. A transfer tax may also apply if a controlling interest in the entity that owns the real estate is transferred. This local tax varies by jurisdiction, and may be quite high in certain cities, such as San Francisco and Los Angeles.

Unless otherwise agreed to contractually by the parties, transfer taxes are paid by the selling party.

Any appreciation or gain will generally be subject to state and federal taxes. Who pays that tax is determined by the ownership structure.

Gain from the sale of real estate is generally subject to federal and state income taxes when it is sold. The gain is generally the difference between what the asset sold for and the amount paid to acquire it. Who pays that tax is determined by the corporate structure. Gains may be subject to deferral to the extent a successful 1031 exchange is completed.

The gain will be taxed at either capital gains rates or ordinary income rates for federal income tax purposes. The highest capital gains rate is 20%. In general, the capital gains rate will apply if the property is not owned by a corporation and is held for more than a year in a taxpayer’s trade or business or for investment purposes. California state income tax rates do not differentiate between capital and ordinary gains, and the highest rate at which real estate gains could be taxed is 13.3%. Cities and counties in California do not generally have additional income tax on gains from the sale of real estate.

Generally, California real estate is reassessed for property tax purposes when it is sold. Property taxes are roughly equal to 1% of the purchase price of the asset. State property taxes are paid annually, in twice-yearly instalments, to the local county assessor.

If an LLC owns real estate, a transfer tax may be avoided if interests in the LLC are acquired rather than the real estate itself. Generally, the transfer of a non-controlling interest in an LLC that owns real estate will not trigger a transfer tax.

There are generally no taxes for occupying a business premise, although each municipality generally has its own set of ordinances with a variety of local business taxes. Any potential exemptions would be specific to the municipality and tax in question.

Income earned in the US by foreign investors is generally subject to a 30% withholding rate on certain income. Tenants are generally required to withhold 30% of the gross amount payable to the foreign-investor landlord. although this amount may be lower if there is a treaty between the US and the country of citizenship of the foreign investor. Foreign investors generally wish to avoid US tax reporting and the obligation to file tax returns. A foreign investor entity may form a corporation (sometimes called a “blocker corporation”), either foreign or domestic, with the foreign investor as the sole shareholder in order to avoid a direct US tax return filing obligation of such foreign investor or investors.

The Foreign Investment in Real Property Tax Act (FIRPTA) requires 15% tax of the total amount realized from the sale of real property by a foreign investor. Foreign investors may need to file for a tax refund if the amount withheld by the buyer exceeds the foreign investor’s tax liability. The 2017 Tax Cut and Jobs Act added a new provision requiring a 10% withholding on the sales of partnership interests by foreign persons for partnerships engaged in a US trade or business. This will be relevant when real estate deals are structured as sales of entity interests owning real estate rather than direct sales of the real estate.

Investors holding real estate directly or through a partnership or LLC may be able to clam an interest deduction. The asset may be depreciable, and the property taxes paid by the owner may be deductible. Other expenses from the operation of the property also may be deductible. An investor may be able to use accumulated losses from a particular real estate investment to offset other income from other real estate investments in their portfolio.

Ordinary income is taxed at a different rate than capital gains. Real property gains are generally taxed at capital gains rates, rather than ordinary income rates. Real property losses, however, can sometimes be categorized as ordinary losses, which are often more useful to taxpayers in offsetting a broader category of gains. Investors may be able to defer paying taxes on gains through a 1031 exchange, by investing the proceeds from the sale of one real estate investment in a new real estate investment.

There has been some discussion of eliminating like-kind exchanges, which allow investors to defer the payment of tax on profits from the sale of certain assets if the sale proceeds are reinvested in certain like-kind property. Section 1031 of the federal tax code remains applicable to real estate investment but has been eliminated for all other assets.

Corporations are taxed differently from individuals. The highest income tax rate for corporations is 21%, and the highest individual rate is 37%. The recent legislation generally allows for a so-called “pass-through” deduction to individuals who are partners or members of a partnership or LLC that owns real estate. Generally, “qualified business income” that passes through the partnership or LLC to the partner or member may be eligible for a 20% deduction, subject to certain limitations and conditions.

The tax reform also put in place certain carried-interest rules, under which an investor is generally eligible to receive long-term capital gain treatment for carried interest if the carried interest was held for more than three years.

Allen Matkins Leck Gamble Mallory & Natsis LLP

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Los Angeles, CA 90017

(213) 622-5555

(213) 620-8816

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Allen Matkins Leck Gamble Mallory & Natsis LLP is best known for representing clients in the real estate industry and clients for whom real estate is an important part of their success. It has a longstanding reputation as one of the leading real estate law firms in the United States, having assisted clients in the development, management, financing, acquisition and disposition of real property assets. Because Allen Matkins has one of the largest real estate departments on the West Coast – more than 100 attorneys – it can bring to every deal a vast network of resources and relationships with major players in the real estate industry. Key clients include global real estate owners, operators and developers, REITs, private equity firms, state pension funds, life insurance companies and Fortune 100 technology companies. The firm's five offices are located in four major metropolitan areas of California: Los Angeles (Downtown and Century City), Orange County, San Diego and San Francisco.

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