Why Are You Leaving California?

After recently announcing I am leaving The Golden State this June, several colleagues and friends wanted to know why. Rather than share my personal preferences or anecdotes, I explained why I believe real estate investment (my day job) will become less profitable and more uncertain in California.??

1) Political Climate. With housing affordability declining and the wealth gap increasing, the California electorate will continue to support, and eventually approve, more taxes on the “ownership class”. Specifically, the measures listed below will negatively impact investors, and ultimately, the housing supply.

a) Rent Control: the statewide Tenant Protection Act went into effect in January 2020, limiting rent increases and reducing a landlord's ability to evict. At the time, the rent increase caps seemed reasonable: 5% + a cost-of-living adjustment of no more than 5%, for a maximum increase of 10% annually. With inflation and CPI climbing sharply in 2022, the entire state met the 10% threshold. Expect tenant rights advocates to consistently challenge lawmakers and push for more restrictive caps and additional limitations on evictions. After all, if housing is a fundamental human right, how could any eviction be morally justified? (Note: in cities and counties that have enacted their own rent control measures, stricter limitations will apply. For example, San Francisco only allows increases of 60% of CPI, so instead of a 10% cap, Landlords must limit increases to 2.94% per December 2022 figures.)?

?b) Split Roll Property Tax: it seems every two years we see another ballot measure seeking to differentiate residential properties from commercial ones. Doing so would allow homeowners to retain the protections of Proposition 13 while giving municipalities the power to solve any budget shortfalls by raising property taxes on commercial landowners.

?c)?Transfer Taxes: in the 2022 Los Angeles County Midterm Elections, voters approved a new and additional tax on real estate valued at more than $5 million . I predict there will be unintended consequences, like higher rents for retailers, who will increase prices for essentials like food and clothing, which will be borne by the average Angelino. Academic reports say this tax will only impact the wealthy; however, anyone who has lived long enough recognizes that is a very naive view of economics.

2) Uncontrollable Operating Expenses.

a) Property Taxes: in addition to the Split Roll challenge listed above, County Assessors have been aggressively pushing valuations, presumably in response to the high per-square-foot sales prices from a year or two ago when money was cheap. Valuation appeals take time and require full property tax payment while pursuing a reduction. Hopefully, this trend will reverse in time, but properties must be bought or sold in this new economic environment to provide meaningful comparisons for County Assessors’ Offices across the state.

b) Property Insurance: over the past two years, we’ve seen successive 20% premium increases over the prior year, due in part to wildfires and expanding fire zone boundaries. Some tenants are required to reimburse Landlords for the increased expense; however, most are not.

c)?Rising labor costs: per the U.S. Bureau Of Labor Statistics, compensation costs for private industry workers increased by 5.7% in Los Angeles YE 2022. This means onsite personnel, third-party vendors and repair services are going to cost more.

3) Electrical infrastructure. Developer John McNellis recently published an essay titled Going All Electric at our Peril . As the author stated, we already have rolling blackouts several months of the year and during our last winter rainstorm, over 224,000 customers were without power in California. In addition to the points made in John’s essay, allow me to illustrate further.

a) Natural Gas: the banning of natural gas in commercial buildings (started in Berkeley in 2019) has significantly increased demand on the electrical grid. It’s not just the ovens and cooktops inside the apartments. Consider the need to heat water for 100 residential units. Previously, this could be easily accomplished with a gas-fired boiler the size of a large office desk. Now we use electric boilers, which take longer to heat water and recover temperature, so larger elements are required. In addition, we need to provide multiple storage tanks to meet the demand during peak hours.

b) Natural Gas (part 2):?what about that mixed-use, ground-floor commercial space intended to house a restaurant? Previously ovens, grills, fryers, and water heaters would all be fed by natural gas. Now every fixture will require power, usually at high voltage (208 or 240), and will cost more to operate. If a restaurant’s utility cost is higher than expected, do you think they may try to pass that expense on to the customer?

c) EV Charging: in addition to all the homeowners installing a 30-amp charger for their Tesla, all multifamily projects are required to provide EV charges in the parking garage. While the percentage varies by city, one recent project required 40% of the spaces to be supplied with power for EV chargers. The demand was so great, an additional transformer was required for this project. One must wonder if PG&E will be able to supply the power necessary once the project is fully constructed in two years.

While these are my top three concerns, this list does not address other, well-known real estate challenges like securing municipal approvals, cumbersome CEQA regulations, and the always-popular Nimbyism. It's also difficult to quantify risks associated with natural disasters, such as wildfires, earthquakes, sea-level rise, droughts, flooding, and mudslides.

Of course, I believe it's valuable to own assets in a supply-constrained market, but one could argue California is driving institutional investors to seek opportunities elsewhere.

Disclaimer: The views expressed herein are my own and do not represent any employer (past, present, or future) and should not be construed as investment advice. As they say in crypto, DYOR (Do Your Own Research). Ironically, I did some research and still lost money on Bitcoin and Ethereum. I'd have done better buying a trailer park in Tornado Alley...even if a disaster strikes, you still own the dirt!