Commentary

On April 1, 2023, a new transfer tax on all real estate transactions in the city of Los Angeles went into effect. The tax is 4 percent on the sales price between $5 million and $10 million and 5.5 percent on sales proceeds over $10 million. Although the impact of this tax on each class of real estate needs careful analysis, our focus will be on Class A office space.

The fact that this new transfer tax only affects real estate transactions located in the City of Los Angeles makes this tax particularly onerous. Whenever something is taxed, you’ll get less of it. But that’s especially the case if investors can simply allocate their funds to areas outside the city of Los Angeles and therefore avoid the Los Angeles city transfer tax on the investor’s ultimate sale.

The timing of such a tax couldn’t be worse. Inner-city office markets are in free fall. Vacancy rates are rising, and lease rates are dropping rapidly. As office building-backed loans come due this year, property owners are already expecting to pay substantially higher interest rates as compared to the rates when these office buildings were originally financed. In addition, property owners are facing challenges in securing refinancing as banking and lending institutions tighten their loan requirements and are hesitant to lend on distressed real estate.

It’s likely, though, that many owners will find it more expedient to allow their mortgaged office buildings to go into foreclosure rather than deal with the perfect storm of lower occupancy levels, lower lease payments, and higher interest rates. The perfect storm in the City of L.A. becomes even more perfect with the new transfer tax on the sale of a building. That transfer tax has resulted in an immediate reduction in the value of the underlying office properties.

In February, one publically held real estate company defaulted on $784 million on two Los Angeles office towers. In March, the day before the effective date for the new transfer tax, a real estate office investment trust closed escrow on the sale of a Los Angeles office building for $104 million after putting the property on the market for more than double that amount in 2021.

The problem is not confined to building owners and their lending institutions. Tax revenues to city coffers are very much dependent on the economic health and vitality of their central business districts. L.A.’s business core is already reeling from the combined effects of homeless people living on public sidewalks, increased crime, and workers increasingly opting to work remotely. Retail stores, eating establishments, and other businesses that depend for their survival on a vibrant core are closing their doors.

The new Los Angeles transfer tax on real estate will provide new revenues to help the homeless. Contemporaneously, the reduction in property taxes from the deteriorating value of the office building market, including the new transfer tax, will reduce property tax revenues and therefore impact city services. It can be expected that property tax appeals will be very significant in Los Angeles based on the current market deterioration as well as the new transfer tax.

Our research at Chapman University points to other problems facing the Los Angeles economy. The Chapman-UCI Innovation Index has allowed us to track and measure the progress of 50 metropolitan areas (MSAs) in creating jobs, wage growth, and the number of new establishments in “Advanced Industries.”

Our database, perhaps the largest in the nation, encompasses a broad range of advanced industries, including high-tech, software development, aerospace, scientific research, medical products, and pharmaceutical research. The high-value-added nature of these jobs is reflected by the fact that in 2022, advanced industry wages in the U.S. were $140,000 versus $78,000 for all jobs, or 80 percent higher.

To gauge how Los Angeles County is doing in creating jobs in these high-value-added sectors, we calculated advanced jobs in the county as a percent of all advanced jobs in the 50 MSAs we track. The sad state of the L.A. economy is revealed by the fact that since 2017, L.A. County has lost market share. Even more discerning is that the county ranked 49 out of 50 MSAs in a ranking from high to low in generating new advanced jobs. Only New York City ranked below Los Angeles.

Earlier this year, the mayor of San Francisco presented weak-kneed proposals to reinvigorate its urban core. They mainly involved setting up committees to look into the problem. A better approach would have been to remove its own real estate tax. The City of Los Angeles should follow suit.