Contributed By Allen Matkins
Real estate law moves 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.
If the current US economic expansion continues through June 2019, it would break the record for the longest period of growth since the government began keeping records in the 1850s, according to Deloitte. The real estate sector has also entered uncharted areas of growth, leading certain analysts to question whether the market has reached its peak. While some investors are bracing for a possible downturn, cracks have not yet appeared in California’s commercial real estate market.
California’s office market continues to expand, driven by major tech, entertainment and media, and life sciences leases and sales. Co-working remains a key area of growth in the office sector, with some traditional landlords, like Tishman Speyer and Hines, moving into the space. Annual office vacancy rates declined and rents increased across key West Coast markets over 2018. Tech companies have been involved in some of the largest recent office deals in California, such as Google’s $1 billion acquisition of the 51.8 acre Britannia Shoreline Technology Park near the company’s headquarters in Mountain View. The continued growth of highly skilled jobs in California has driven expansion of the office market, but the state continues to grapple with an affordable housing crisis.
High housing prices in California are keeping potential buyers out of the market, with some residents moving out of expensive Bay Area and Southern California communities to nearby counties or out-of-state altogether. Governor Gavin Newsom has pledged to dramatically increase the state’s housing supply to alleviate the problem, going so far as suing certain cities for allegedly failing to address local affordable housing shortages. Private players, such as Kaiser Permanente, have also stepped in, dedicating millions to combat the housing shortage and homelessness.
Demand has outpaced supply for California multifamily assets over the past year. The West Coast continues to dominate in this sector, with five of the top ten multifamily markets located in California, according to data from Yardi Matrix. A controversial statewide rent control measure failed in the November 2018 election, but rent control remains a hot topic in the state. Investment has increased in co-living start-ups, which offer apartments with shared common areas in part to reduce rental costs. However, the trend is not expected to disrupt the multifamily market in the same way co-working has shifted the office leasing landscape.
The California industrial market continues to outperform other real estate sectors, driven by the growth in e-commerce, with demand exceeding supply, increasing rental rates, and declining vacancy levels. Strong competition for Los Angeles industrial assets has led to a boom in nearby secondary and tertiary markets, such as the Inland Empire. According to CBRE data, the Inland Empire saw 20 of the nation’s top 100 warehouse leases of 2018. The greater Bay Area is also one of the leading industrial markets in the country.
News reports over the past year have been dominated by tales of retail bankruptcies and store closures, but some landlords are responding by repositioning assets into mixed-use spaces, with a possible redevelopment and renovation wave on the horizon. Non-traditional tenants are also taking advantage of newly vacant retail space. In one example, Google agreed to lease almost all of the struggling Westside Pavilion mall in Los Angeles from Hudson Pacific Properties and Macerich in early 2019 for use as office space.
Opportunity zones, which offer capital gains tax incentives for real estate investments in designated low-income neighborhoods, could lead to a new multifamily development boom in the state. California is home to 879 of the 8,700 opportunity tracts certified by the US Treasury Department, but the pace of development could be tempered by the state’s relatively complex entitlement process.
Significant Deals and Projects
In the largest Silicon Valley office lease of 2018, Facebook, Inc. rented 1.05 million square feet in the Moffett Towers 2 office complex in Sunnyvale under development by Jay Paul.
In the single largest lease in San Francisco’s history, at the time of writing, a joint venture between The John Buck Company, MetLife Investment Management, and Golub & Co. leased the entire 755,900 square foot, 43-story Park Tower at Transbay to Facebook Inc.
In one of the most expensive office sales in the US of 2018, Google purchased the 51.8 acre Britannia Shoreline Technology Park near the company’s Googleplex headquarters in Mountain View from HCP Inc. for $1 billion.
In the second biggest California office sale of 2018, Boston Properties and Canada Pension Plan Investment Board acquired the 21-building Santa Monica Business Park in Santa Monica from Blackstone Group’s Equity Office Properties for $628 million.
In major multifamily deals, Related California and CORE broke ground on The Grand, a $1 billion 39-story apartment tower in downtown Los Angeles, in early 2019.
One of the big financial opportunities to come out of the Tax Cuts and Jobs Act, signed into law in December 2017, was the creation of Opportunity Zones, offering a new tax incentive program that encourages investors to make long-term financial investments in Qualified Opportunity Zones (QOZs). In exchange, the investor received a number of benefits related to the deferral or elimination of capital gains taxes. In California, 879 QOZs that include more than three million Californians were nominated by Governor Jerry Brown and certified by the US Treasury. The QOZs were selected by focusing on only the poorest areas of the state – these areas either have poverty rates of at least 20% or median family incomes of no more than 80% of statewide or metropolitan area family income. Areas with at least 30 businesses were also prioritized to distinguish primarily residential tracts from those that are zoned to encourage more business investment, and to encourage more business investments in these communities. Potential investors can use a mapping tool made publicly available through the US Treasury to determine if a piece of property is within an area designated as a QOZ: https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml
At present, the opportunity zones rule does not provide any California income tax benefits, so there is no gain deferral or reduction for the purposes of California income tax. The only tax benefits are federal income tax benefits.
In order to reap the benefits of investing in QOZs, an investor must invest capital gains into a Qualified Opportunity Fund within 180 days of the sale or exchange that resulted in said gains. Unless relief is granted, the Fund’s assets must then be invested in business properties located in QOZs. In addition, the Fund must substantially improve the property, or the original use of the property invested in must commence with the Fund. Substantial improvement to the property must occur over a 30-month period. In California, where some projects can take years to entitle, investors can be faced with challenges to meet these timeline requirements. As a result, most of the current QOZ property opportunities in California tend to be in pre-entitled projects that have been sitting on the shelf and happen to reside in QOZs. The types of properties that qualify include directly owned apartment buildings, hotels, mixed-use properties, retail strip malls and fast food chains. Certain “sin businesses” cannot be owned through a QOZ stock or partnership interest held by a QOZ fund, including country clubs, massage parlors, hot tub facilities, racetracks, health clubs, or stores whose principal business is the sale of alcoholic beverages for consumption off premises.
Most real estate is held in a single-purpose entity, which may 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, which 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 the 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, to document satisfaction of the obligation. There are additional obligations in condominium, residential and hospitality transactions.
A notarized grant deed is recorded with the County Recorder’s office, typically coordinated 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. To do so, they 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. Often, 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 contractual arrangement of 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 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, a shift 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 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 if there are known or suspected conditions, environmental liability insurance should be considered. Options and costs need to be identified in the due diligence phase, if not earlier, as it 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 of the seller 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 that latter case, the owner may be granted relief, with existing improvements being a “permitted nonconforming use”. Nevertheless, the taking can affect what can be rebuilt on the site, due to lot size reductions. If the property is near a transit-oriented development, there is the potential the municipality could 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 11-56 basis points in most California jurisdictions. While an outlier, the City and County of San Francisco imposes transfer taxes of 300 basis points, or 3% of 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, in addition to a first deed of trust, there may also be pledges of ownership interest in the borrower. This makes it easier to foreclose, and 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. The creation of collateral does not cause a taxable event, as the 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 nonpayment 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, a buyer of a real estate asset will be responsible for soil or environmental pollution, even though 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 they are 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, which 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 are 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. However, 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 the 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 (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; income and earnings are passed through to the partners and are 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 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, either 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. Profits are generally only taxed 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 filed in the state or jurisdiction where the corporation 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 forth 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 the partnership 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. These leases are 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 fie 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 the 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.
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 month’s rent. If a tenant has no credit history, it may be required to supply a guarantor or letter of credit from a bank. Letters of credit are more common than guarantors. 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. The landlord will typically pay utilities, subject to reimbursement by the tenants, 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, and it is subject to reimbursement by the tenants, typically based on their square footage. Water, sewer and garbage are paid by the landlord and are 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. 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, minus 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. Furthermore, 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. However, a landlord can create a month-to-month tenancy. Any “holdover” occupancy would be subject to fines or higher rents, such as 150% of rent. A tenant can also be liable for actual damages from loss of subsequent lease due to inability to deliver possession to a subsequent tenant.
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. Furthermore, economic or material non-economic defaults can trigger termination, such as violating the use provision, beyond applicable notice and cure periods. 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 the value of their 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, 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.
Many different methodologies are 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 can not 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.
Contractors are often 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.
Unless a contractor is extremely well capitalized, and most are not, it is common to seek parent guarantees, performance bonds, and completion bonds. Third-party sureties, or payment and performance bonds, are common. Escrow accounts are not common. 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 a lien against the property, they will have a 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 the real estate is sold, and 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, 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, the capital gains rate will apply. California state income tax rates do not differentiate between capital and ordinary gains, and the highest rate real estate gains could be taxed at is 13.3%. Cities and counties in California do not generally have an 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 installments, 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. 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 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 claim 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 may also 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 the investor’s 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 was 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 other taxpayers to deduct 20% of their "qualified business income," subject to certain limitations and restrictions. This deduction is available for income recognized by a partnership or S-Corporation and allocated to the partners or shareholders who are not C-Corporations.
The tax reform also put in place certain carried-interest rules. Under these rules, an investor generally is eligible to receive long-term capital gain treatment for carried interest if the carried interest was held for more than three years, or if the partner is allocated gain from a capital asset that was held for more than three years.
If a taxpayer recognizes capital gain and invests this gain into an opportunity zone fund, that gain may be deferred and reduced. The precise tax benefits depend on how long the taxpayer holds the investment in the opportunity zone fund. To obtain the maximum benefits, the taxpayer must invest in an opportunity zone fund in 2019. The opportunity zone fund rules also allow a taxpayer to avoid recognizing gain from the sale of its investment in the opportunity zone fund if the taxpayer holds the investment for at least ten years.