Should I Buy THIS Building?

Image Attribution: www.chinabamboocentre.com

I received a call from an attorney last week. We recently completed a lease for his law firm and we swap referrals. 

This time the conversation centered around an opportunity with which he had been presented. 

In short, a friend of his is eyeing a building and approached my friend on becoming a partner. 

The counsel I gave the counselor was post worthy – so here goes.

First, compute the potential revenue. In this case, my friend was not going to occupy the building with his business. So, the opportunity will strictly be an investment. Also, the real estate is currently vacant. Considered should be the rent a tenant(s) will pay – not a puffed-up version – but a real true number. Next – how long will it take to lease the space. Finally – what concessions will have to be given to attract a paying customer? Oh yeah, if 100% is every tenant paying every month on time – you might want to figure in a shrink factor of 5-10% in case someone slow pays or stiffs you.

Next, add up the expenses. Biggest in this line of figures is property taxes. Insurance, maintenance, and utilities tag along as well. Don’t forget – the property taxes will rise in accordance with your purchase price. Make sure you take this into consideration.

Now, subtract the expenses from the potential revenue. The difference is a return – also known as a Net Operating Income. However, from this amount you’ll need to make sure you allocate some dollars for a new roof or a blown AC unit – lest you are swiping your Visa Card when your tenant is broiling on a July day.

OK. Now we have realistically modeled our income, subtracted real expenses, and created a reserve for major repairs.

Most would now do some math – return divided by the purchase price. This simple formula allows you to see what your percentage return is for an all-cash purchase – with no loan. In today’s market – this percentage should be 5.5% at a minimum. Frankly, I like 6%+ much better. Because, likely the purchase will be financed and with creeping interest rates – you don’t want the advantage of leverage to be a disadvantage. Said simply, if your borrowing costs exceed the all-cash return – YOUR spendable amount – after you pay the bank - will be much less.

Now, take a reality check. Remember, you have made some assumptions on the market rent and time it will take you to fill the vacancy. Will the deal still make sense if the lease up time is double? What if you can only get 75% of the rent you anticipate? Remember 2008? Yeah. Me too.

It’s the numbers, stupid! Investing in real estate is all about the cold analysis of the deal. Please don’t fall victim to the “but I love it” syndrome. 

Are Commercial Real Estate Brokers Un-necessary?

Image Attribution: www.reco-play.com

Recently - in this space - I opined about commercial real estate technology and whether technology will replace the role of a commercial real estate broker.

If you missed the post, shame on you! But, here's the punchline - Not likely, due to a myriad of reasons.

Today, I endeavor to discuss the function of a commercial real estate broker - in a deal - and to what extent that participation is necessary.

Before we address the question, a bit of background. Most commercial real estate transactions - be they a new lease, a purchase, or a lease renewal in an existing space  - employ two sides - a procuring agent - those representing the buyer or tenant and an owner's agent - those representing the owner of the building. In California, agents are allowed to represent both ends of the transaction - also known as dual agency.

Each side has a purpose.

Tasked with finding a tenant or buyer is the owner's agent. This effort is filled with all manner of marketing initiatives - to brokers and prospects. Sometimes an owner believes he can short-circuit the search for a buyer or tenant by planting a sign on the fornt yard and digitally advertising. Problems arise when the inquiries pour in, tours are required, and a negotiation ensues. OK, an agreement has been reached - now what? Certainly, a broker's role on the seller's side is crucial.

Conversely, a procuring agent's goal is to locate a space for his client - the occupant. If a list of available buildings was easily accessed by a business looking for space - the contribution made by a procuring broker would be lightened - not eliminated but diminished. Residential agents face this challenge as all listed houses are public facing through sites such as Zillow, Realtor.com, and Redfin. A homebuyer can find out what is available with a swipe of an app. The only consumer-facing commercial real estate site is Loopnet. Accuracy of complete availability is limited as there is no governing realty board to create accountability for the submissions. So, a key to the walled garden of commercial real estate availabilities is secured through an agent.

I once heard the reason flight attendants are on board an aircraft during your cross-country flight - is in case of an emergency - not to serve you honey glazed peanuts. A similar set of crash precautions is contributed by the agents in a deal. Problems arise and a skilled practitioner can counsel you through various solutions. We recently guided a seller through a buyer's request for repairs. What started as a high six-figure ask was whittled down to a mid-five-figure take - all because of our web of contractors. Don't ever underestimate the power of a great network when it comes to solving a problem.

So, unfortunately, dear reader, a commercial real estate professional is a necessary evil in a transaction.

Dispute Resolution between Brokers

Image Attribution: www.opndoor.com

Akin to the wild, wild, west, commercial real estate agents are sometimes referred to as cowboys - I'm not certain why - but we are. Maybe it's our entrepreneurial spirit, our freewheeling demeanor, work hard - play hard attitude, or the way in which "we eat what we catch" - a phase associated with commissioned sales professionals.

Regardless, we cowboys sometimes disagree - about a lot of things but most commonly about how we are paid. Fortunately, as commercial brokers, our differences are not settled by squaring apart ten paces at sundown.

When a dispute arises - between agents - we have ways to resolve our complaints - dispute resolution - which is the topic of today's post.

Single biggest on the topic of disputes would be a fee disagreement. My general rule - fee squabbles are easiest avoided by having a clear written understanding at the front end of a deal. Also, transacting with honorable practitioners lessens the risk of a misunderstanding. If there are listings, offers, responses, leases, escrow documents and the like - written agreements are easy. If not, you may find yourself with a problem.

As previously discussed, commercial agents are generally not members of the California Association of Realtors - some certainly are, but typically no. Therefore, we are not Realtors and not subject to the mandatory arbitration and mediation - between agents - as called out in C.A.R. affiliation. However, most commercial brokers are members of the Association of Industrial Commercial Real Estate - AIR CRE. AIR CRE gives agents a platform to settle disputes through mediation, or arbitration.

Commonly, the office in which an agent resides also has - through their independent contractor's agreement - some means of mediating or arbitrating fee fights.

So moving up the DefCon ladder - from least to worst:
First, Professionals would first try to work out their differences among themselves - DefCon - 5
If no resolution can be reached, the issue would be discussed interoffice or intraoffice with managers  - DefCon - 4
Still, no meeting of the minds, a mediation with a single arbitrator would be conducted to smooth the ruffled feathers - DefCon 3
A room full of crossed arms and clenched jaws results in binding arbitration - DefCon 2
Finally, the parties lawyer up and seek to litigate the issue in a court of law - DefCon 1 - today's version of the OK Corral!

In my experience, disputes rarely see the light of day - that of a mediation or arbitration - or worse - a lawsuit. Hands are generally shaken in the privacy of an agent's office.

You've Really FOUR Choices with your Commercial Real Estate

Image Attribution:www.torontorealtyblog.com

This week, I had the pleasure of advising a family. Held as income properties were two parcels of commercial real estate which had been in the family for years.

As the ownership morphed over time due to succession, the heirs were looking for counsel - thus they contacted me. The conversation which ensued I believed was column-worthy - so here goes.

As a qualifier, these folks are arms-length investors - they reap the rent the buildings generate and do not occupy either building with a business.

So, if you own commercial real estate as an investment, I believe the ownership directions are fourfold:

Continue to own and manage the buildings. Vacancy throughout the term of ownership has been minimal - the family has managed to keep the spaces filled by offering below market rents. This is a great strategy for a long-term hold. Avoided is the origination of a new tenancy which costs time - abated rent and vacancy - and money - tenant improvements and broker fees. In some instances, originating a new lease can consume 25% of the expected rental revenue! Wow. That's a big bite just to nudge a tenant up to a market rate and risk them moving.

The next three scenarios could potentially generate a taxable gain - which is the subject of another column.

Sell the buildings leased. Remember those rents at below market rates we discussed? Yeah. That is the downside of selling the buildings leased. You see, the value is determined by the cash flow produced - less cash flow equals less value. So, if your desire is to maximize your sales price by selling with tenants in your commercial real estate, you should consider moving the rents to market - potentially suffering the vacancy and re-letting. Easy math would analyze the expected increase in the selling price minus the cost to re-rent the buildings if necessary.

Sell the buildings vacant. Your ideal buyer for the real estate may be the tenants the buildings house. Afterall, they are in residence and may dream of owning the space they occupy. Approach them. If you receive "no interest", explain your strategy of allowing their leases to expire and locating an owner occupant to buy the buildings. Their tenor may change. In most cases, an occupant will pay more than an arms-length investor - because occupants look at utility - investors at their returns.

Scrape the buildings and sell the land. Sadly, at some point, the improvements eclipse their useful life and the underlying land is worth more than the land with a building. You'll need to take a look at the necessary upgrades - roof, air conditioning, seismic, parking lot, plumbing, electrical, etc. A review of the costs to bring the building up to "market standards" will help you determine the value of your building improvements - and whether they are worth salvaging.

Four Ways a BUILDING adds to Business Profit

Image Attribution: www.smallbusinessonfire.com

Your decision to relocate your business was well reasoned. Considered were the operation and growth trajectory. Analyzed was the best deal structure for the company - lease or own. You endured countless tours of the available commercial real estate that met your criteria. Negotiations and paperwork followed - and culminated in the lease or purchase of your new business home.

If you decided to buy - alright! echoed your rejoice when the title officer called with word your "recording was confirmed" - which meant you finally owned a building.

So now that you've moved - can the building make your business more profitable? Humor me as I build a case for profitability - you know - revenues minus expenses.

If you chose to buy a building:

Your "rent" is fixed. Expenses are generally lumped into three broad categories - the cost of sales, operating expenses, and miscellaneous. The amount of rent paid is an operating expense of the business. Whether the "rent" is paid to an alter ego of the company's ownership or paid to an arm's length landlord, matters. If the owner of the building has no relationship to the business ownership - his sole motivation is to collect as much rent as possible. At the expiration of your lease - expect an increase in rent. Conversely, if the occupant and owner are mirrors of one another - a favorable rent can be achieved. If the debt financing the acquisition is at a long-term fixed rate - even better.

Regardless of leasing or buying:

Employees are happier. Pride of ownership in your location causes employees to produce more - because they are happier. A private office, a collaborative work environment, clean lunchroom, ample parking are all intangibles that create a positive work environment.

The operation is more efficient. Lack of space or poor space utilization means you are spending time unproductively. Classically, we see this when products have evacuated the plant and are temporarily stored outside during operating hours. Paid are the people moving the stuff in and out - when they could be producing more goods. Also, by properly maximizing the height of a building, you may be able to occupy fewer square feet - fewer square feet - fewer dollars spent - more money in your hip pocket.

Customers can find you. If you can't be found - you are invisible. The right location with close freeway access can boost your business - just because more customers will flood your doorway.

Do Cap Rates Matter?

Image Attribution: www.stylproperties.com

Investors in commercial real estate - folks who rely upon the rent paid by a tenant for their livelihood - use a number of different measures in analyzing their investment.

The most common metric is a capitalization rate or cap rate. Simply stated, a cap rate is the quotient of the yearly net operating income divided by the purchase price.

If a building sports an annual net operating income - the rent minus the expenses - of $100,000 and the building is worth $2,000,000 - the resulting cap rate is 5%. Easy enough.

As you can determine from our example - if the net operating income increases - say to $120,000 - and the purchase price stays static - the cap rate also increases to 6%. However, if the net income stays the same - the purchase price decline to increase the cap rate. Therefore the value and cap rate are inverse of one another - akin to a stock dividend.

Ok. So what? Do cap rates matter? Sure, they do. But only when taken in context and in combination with other criteria such as the cost per square foot of the building, the relationship of the current rents to market rents, the viability of the tenant, the sustainability of the income, and the trends in value. In other words - a cap rate is a still photo. When combined with the features above - it cocoons into a panoramic video.

Cost per square foot. If a parcel of commercial real estate is purchased below the cost to build it - replacement cost - generally a market rent will return a market cap rate. Trouble brews when the cost per square foot far exceeds the cost to produce.

Current vs market rents. Recall, our cap rate is the quotient of the net income divided by the purchase price. But if the rents are well above the current market rents - a distortion in the cap rate occurs.

Viability of the tenant. Market rents, great cap rate, decent price per square foot are all for naught if the tenant defaults. The costs to originate a new lease - downtime carry, abated rent, tenant improvements, broker commissions - are staggering.

Sustainability of the Income. A viable tenant with a multi-year lease spells an income stream that is sustainable.

Value trends. You're comfortable with the rents and their relationship to the market. But are the rent trends up or down trending? You don't want to get stuck with an overmarket rent come renewal time lest you must reduce your return.

Blooper Reel - AKA 8 Most Embarrassing Commercial Real Estate Moments

Image Attribution: www.jules.thegrommet.com

Today, I inject some humanity in an otherwise buttoned down industry - commercial real estate brokerage - by sharing a blooper reel.

ALL of these stories actually happened - although only a few happened to me.

I will let you, dear reader, figure out which ones are mine. So, in classic Letterman order - least embarrasing to most - here goes.

So, how much? Many times, commercial real estate professionals speak a different language than their clients. Never is this more apparent than when quoting prices. Brokers talk about a price per square foot - occupants want to know the total price. Hours of preparation end with blushing when you must whip out your calculator and do some math when a client asks, "how much?"

An alarming situation. Two brokers showed up early to preview a building. Carefully dialed was the lock-box code. Once inside, the agents realized there was no electricity As they stumbled around in the dark pretending to clear the rooms akin to a SEAL team, their spines stiffened and bowels trembled when they heard - FREEZE, hands up. Apparently, the only ones who knew there was a silent alarm - yep, two of Anaheim's finest.

Reply to ALL. A vendor was railing against an office for not updating their listings through a series of terse emails. Finally, one of the professionals responded to his manger - "how long are we going to put up with this clown?" You guessed it - the clown received the "reply to all".

You rang. An owner was telephonically expressing his dissatisfaction with an agent's marketing efforts - rather loudly. Relief was a button away as the front desk announced another caller was holding. Dissatisfied was asked to stand-by. The holding caller was engaged and received an earful - problem was dissatisfied received the earful - ooops!

Will the real buyer please stand up? As a couple of listing agents anxiously awaited the arrival of a buyer - many panhandlers approached. Concerned were the brokers. After all, would the buyer discount the offering because of the number of transients in the area? Their dismay heightened as another bum approached - except this time, he happened to be the buyer!

Lock-out. One of the first lessons a young agent learns is to twist the deadbolt when exiting a building - especially when viewing the fenced staging area - lest you lock yourself and client outside. One new broker missed the tutorial. While touring a new high rise, he managed to lock himself and his prospect on the eighth story balcony. As no other tenants were in residence and cell phones in those days lived in a car console - surprised was the passerby who heard the screams yet earned twenty bucks for springing the embarrassed broker.

Excuse me, you own it? Many swings and no hits describes a professional who had attempted countless times to appeal to a buyer. Finally, the broker was convinced he had sourced THE DEAL that would end the batting slump. You can imagine the pink face that resulted when the buyer responded - "uhh, we own that building and are trying to sell it."

A door to nowhere. A brand new German automobile was used as a tour guide of a newly constructed industrial building. As the prospects un-belted and prepared to walk the property - the proud driver encouraged them to say put. He would motor around inside the building so they could view the improvements in luxury. The tour went well. Unfortunately, the exit - through an elevated door this time - resulted in a face plant for the Benz - which from that point forward sported a "Dock-Hi" vanity plate.