Will Commercial Brokers be Replaced by Technology?

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Much has been written about disruption in the commercial real estate industry. Millions of dollars have been invested to eliminate our role in a transaction.

So, the question I explore today is "will we be replaced by technology?" My simply opinion is - not in the immediate future. Please indulge me while I share my reasoning.

Reasons why not:
Commercial real estate is not a commodity. Unlike a share of stock - ETrade or Schwab, a hotel room - Priceline, a simple will or LLC - Legal Zoom, or even an auto insurance policy - Geico - no two parcels of commercial real estate are the same. You could have two industrial buildings with similar square footage in the same city that have far differing values. A long term, under-market lease can cause a declination in worth. Boost the electrical service into a building and you can sell for more.

Commercial real estate firms share data differently. We provide information on our listings to data aggregators such as CoStar, Catylist, the Association of Commercial Real Estate, and Loopnet. Subscriptions to these services then bake our listings into a broker searchable format. But, the only consumer facing service is Loopnet. If you've ever tried to perform a search in Loopnet - you have quickly become frustrated as commercial searches pale in comparison to residential searches. Residential firms are contractually bound to share their data with a realty board - who then aggregates the data and allows consumers to view and download available information.

Commercial real estate transactions are complex. Standardizing a sale or lease is challenging as there are so many variables to consider - contingency periods, financing, tenancy, city permitting, title issues, tenant improvements, environmental evaluation. Ten-X has done a decent job automating the marketing and execution process of a sale - but still require a listing broker be involved. I am unaware of a service that has automated lease marketing - leases account for approximately 75% of all commercial real estate deals.

Technology has nibbled at the edges. Never have the steps involved in a deal changed. Commercial real estate professionals must source, find, qualify, control, execute, bill and receive payment. Many of the technological gems we see help us "execute" deals or automate our "sourcing" - but don't seek to extract us. Regardless of technology - ours remains a hyper local industry - where local knowledge is golden.

Reasons so:
Billions of dollars are at stake. The company who cracks the code to the walled garden - figures out a way to eliminate brokers - will rake in billions. Costar revolutionized the way in which brokers search for property. Once precluded from doing deals in other locales - because we didn't have access to the available inventory - we can now trade around the world. Loopnet has give a portal - albeit a small one - to consumers of our listings. Ten-X, formerly Auction.com piloted the disposition of hundreds of distressed or bank owned assets through their auction platform.

Look at our residential counterparts. Many of the tasks residential realtors once provided can now be performed without the assistance of an agent. Not too long ago, you had to call or email to get details on available houses. Now if you are curious about that new sign across the street? Just Google the address or visit Realtor.com and voila - information abounds. A house shopper can practically conduct 100% of the research necessary - analyze the neighborhood, check on the schools, review recently sold properties, see what else is available, tour the interior virtually - before engaging an agent.

Five BIGGEST Mistakes Owner Occupants Make

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If you own commercial real estate you either occupy the buildings with your company - owner occupant - or you rely upon the rent paid by a tenant - investor. I have clients that are both owner occupants and investors - they own the building from which their company operates AND they own additional commercial real estate which is leased and provides a nice income to supplement their day job.

With that differentiation as a benchmark, I want to describe the biggest mistakes I've seen owner occupants make.

Not having a current lease agreement. Generally, an entity owns the building and a related entity occupies the space. In the case of an owner occupant, the two entities may be tied by a common individual - Allen C. Buchanan, LLC owns the building and Allen C. Buchanan Company is the resident. Cool. Many times - because Allen, LLC is collecting rent from Allen Company - no official lease exists. After all, money is going from the left pocket to the right - no need to have that in writing. The fun begins when something happens to the individual and now his heirs must piece together the understanding. I actually witnessed a manufacturing company be forced to move when the heirs smelled dollars and no lease had been executed.

Over improving. You know that house down the street from you that is larger than the lot will allow? Yeah. We have the same with industrial real estate. When the physical space will no longer allow for growth - adding employees or machinery - many owner occupants add square footage to their building through second stories or production mezzanines. If a building was not designed to have an upstairs and one was added  anyway - the resulting product becomes difficult to sell.

Not fully utilizing. The opposite of over improving is not fully utilizing the space that exists. Frequently, a re-work of the manufacturing flow or warehouse racking will find much needed and under-utilized space.

Keeping the building when the operating company is sold. I wrote about this in a recent column entitled "Be Careful If You Sell Your Business and Wind up the Landlord of a Vacant Building". Inherent in this issue is the belief that if you sell the business and the business buyer is prepared to continue leasing the building - you are golden. Weighing your options - sell the building or keep the building - revolves around this question - would I want to own the building if it was vacant?

Using the real estate as an ATM. Frequently, banks view real estate as better collateral than other business assets - goodwill, account receivables, inventory, equipment. Observed are cases where the amount of money owned against a location are far in excess of the sale value. Maybe not an issue unless you are forced to sell the building.

No Response to Your Offer - Now What?

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One of the most frustrating things we encounter as commercial real estate professionals - and you as a buyer of commercial real estate - is a "no response." Zilch, nada, zero, crickets, anyone - Bueller?, all describe that sinking feeling you suffer when an offer is made and hours or days pass with no feedback.

Believe me, buyers, we feel your pain as a "no response" is much more difficult to explain than a quick "no thank you!"

A great deal of emotion is expended deciding to pursue a property. When  met with nothing - the agony of defeat looms large.

So, why, you may ask, is my offer not receiving the red carpet welcome you believe it deserves? Indulge me as I proffer a few hypotheticals.

Your offer may not be very good. Many times, these days, asking prices make no sense are are not based on a real view of the market - I refer to these as arbitrary owners. Your well intentioned, researched and comp based offer may just not be enough to move the seller needle.

Competing offers may be in play. If a deal is priced right and there is no "hair", multiple offers prevail - and in some cases at above asking price. Occasionally, a seller will wait until he has several offers and then respond to one or all with a "best and final" request.

Seller decision making may be convoluted. Frequently, a commercial property is owned with an entity with multiple owners - thus decision makers. Allow a disagreement in direction to occur within the ownership ranks and - you guessed it - gridlock.

Something entirely un-related may have occurred. A death, extended vacation, business set back, a new lender requirement will cause a seller to re-think his strategy and delay a response.

Your offer may be too good. If a seller receives a full price offer immediately after listing - with limited contingencies, all cash, and a quick close - something curious occurs. Sellers may believe they've priced their offering too low and delay responding until a review of comps and availabilities can occur.

The seller may not have a destination for the money. As I have previously opined, sales of commercial real estate can create large tax liabilities. Tax burdens can be deferred with a 1031 exchange but if the seller is un-prepared for this shock - if I can't find anything to buy, I owe how much?- your offer may languish.

The seller may not have a place to move. Our market is encumbered with the lowest number of vacant buildings in history. Similar to not having a place to deploy the sale proceeds, if the owner occupant cannot find a place to move his business - a quick response is fantasy.

3 Purchase and Sale Agreement Pitfalls

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You’ve found the ideal building to house your business. Convinced are you that you’ve negotiated a fair deal with the seller as armed with your lender pre-qualification letter you volleyed until match point. 

Now, the seller has served, into your court, an agreement - eleven pages of single spaced boiler plate - which requires your signature to proceed. And to think - this all started with a handshake.

Ok. So now what? Well, you’ve several options. You can simply scan the document and locate the deal points - price, contingency, closing time frame, etc, sign away and figure the rest will take care of itself - not recommended.

Or, you can employ a real estate attorney to scour the document and craft language which will benefit only you to the detriment of the seller - also not recommended.

Or, you can seek advice from your agent - which will generally be met with a disclaimer about his inability to provide legal counsel because he’s not qualified.

Recommended, therefore, would be a combination of the three - scan for deal points, ask your agent what areas should concern you as the buyer, and then seek legal counsel for those specific areas.

Let’s spend a few minutes and discuss some points that generally get negotiated in a commercial real estate purchase and sale agreement. As a back drop, I will assume you’ve been asked to sign a standard purchase and sale agreement - most commonly the AIR CRE form.

Representations and Warranties. This section - more than any - gets the most attorney play. Seller counsel will argue his client is representing nothing - not even the address is correct. I jest, of course, but barely. Buyer counsel would have the seller warrant all current and future faults - forever. Once again, hyperbole. Central here - the seller has authority to enter the agreement, perform the duties of seller, and transfer title.

“As Is” Purchase. Generally, this clause gets misunderstood. Sellers believe they are selling the premises with all faults and that the buyer MUST accept the condition of the building in its present condition. Buyers see this clause and worry about a latent issue. Reality is, most deals contain a contingency period. During this time a buyer is able to study all aspects of the real estate and approach the seller if something untoward is discovered. The “as is” typically refers to a buyer relying upon its own investigation and not relying upon a seller representation.

Waiver of Contingencies. If, during a contingency period, a buyer discovers a “show stopper” - a roof in need of repair, an easement that diagonals the parcel, an appraisal that is short of value - he may disapprove the condition. Remedies range from cancellation and full deposit refund to seller agreement to mend the issue. Commonly, these objections must be done in a time frame and should notify all parties in writing.

So, use this framework to prevent getting aced out of your agreement negotiation.

How to AVOID Rent Increases

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Last week, the subject of the post was "Are YOU prepared for a commercial real estate rent increase?" Listed were the reasons which would cause your rent to rise this year - increases in operating expenses, pre-set rent increases throughout your lease term, the sale of your building, and the expiration and renewal of an existing lease.

If your situation mirrors any of the preceding and you are facing a rent re-set this year, prepare for a shock as we have witnessed a dramatic escalation in lease rates throughout Orange county.

Today, I want to spend a minute and discuss some strategies you can employ to AVOID rent increases.

Audit Operating expenses. As previously discussed, op-exes include everything from property taxes to landscape maintenance. You pay these expenses in addition to your base rent if you signed a triple net lease and these charges are included in your base rent if you are obligated to a gross lease. Generally, landlords budget for these expenses annually in October and November. Come January 1, you get an estimate of these charges included with your rent invoice. You typically have the right to audit these expenses and your landlord is obligated to provide back up. As property taxes are the biggest component of operating expenses - and they will rise significantly if the building is sold - try and negotiate some protection from tax increases in the event of a sale. Most landlords will balk at this request. However, maybe your owner will limit the increase with a "not to exceed" clause - which can help.

Monitor pre-set increases throughout your term. If your lease contains annual bumps - which most commercial real estate leases do these days - take a look at your base rent. Do you pay operating expenses in addition to or included in your base amount? A simple format change to how these mandatory increases are applied can save you thousands. A base rent increase should apply ONLY to the base rent and not to the operating expenses. Remember op-exes increase on their own. Don't place yourself in the situation of a double whammy.

Don't sign long term leases when the market is robust. This seems so simple yet I see this mistake made quite frequently. When real estate values are frothy, business normally is as well. Compelled by confidence, business owners commit to long term leases during these times - rents at market highs with high increase pre-sets will cause you to gasp if the rent market adjusts. A better strategy is to negotiate extension options - you can stay long term if you desire but you're committing for a shorter term up front. If the rent market adjusts, you are now in a position to combat a large increase in your rent.

Are YOU Prepared for a Rent Increase?

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You've opted to lease your business location - which means every month you pay rent to a landlord. Several considerations led you to the decision to lease versus own your building. We will leave the lease versus own conversation for another day.

Today, my goal is to discuss the dynamics that will cause your rent to increase - sometimes dramatically! Hopefully, the topics discussed here will prepare you for the call that your rent will soon balloon.

When a commercial real estate lease originates, the number of years - term, rent amount, rent increases, concessions - such as abated rent, building improvements and the like are spelled out in the document you and the landlord sign.

As the term of your commercial real estate lease can dictate increases in your rent, a brief explanation about length of leases is important to review.

Depending on the size of your space, lease terms range from month-to-month to ten+ years. A smaller space - fewer than 5000 square feet - normally means a shorter term - fewer than two years. Why, you may ask? Tenants that occupy small blocks of space are frequently start-up companies without the benefit of years of financial history. In some cases, these businesses are a payment risk. Landlords counter this risk by limiting the lease term - the overall amount of rent to which a tenant is obligated. Additionally, growth trajectory is tough to quantify with a new enterprise. Therefore, these operators are reluctant to commit long term lest they outgrow their digs.

With term explanation as a back drop, there are several other factors can cause rents to rise. I've ordered these from least to greatest:

Increases in operating expenses. Operating expenses include charges for property taxes, insurance on the building, common area maintenance - landscape, trash, utilities, parking lot sweeping, a share of capital expenses - a new roof or air conditioner, and in some cases property management. All of these charges are either baked into your base rent - a gross lease, or are paid for in addition to your base rent - a NNN lease. Unless your agreement specifies otherwise, as these expenses increase over the term of your lease - yep - your rent increases.

Pre-set increases throughout the term. Leases today typically carry annual increases in the base rent of 3%-4%. Gone are the days where the amount of rent paid each year increased by the change that occurs in the Consumer Price Index. Even though three to four percent annually seems steep compared with inflation - please understand, commercial lease rates have increased approximately 70% since 2009 - a staggering 8% a year! So, if you signed a ten year lease in 2009 with annual escalators of 2.5%, prepare for a bit of a jolt next year.

The sale of your building. The largest operating expense is property taxes. Recall, these are paid as a part of your base rent or in addition to your base rent. Annually billed at one percent of the assessed value of the real estate, property taxes can increase a maximum of two percent per year - unless - the building is sold for more than the assessed value. And then, WHAM! You are stuck with a huge bill.

The expiration and renewal of an existing lease. The coup de grace these days. Many leases expire and are slated for renewal - as our volume of leasing hit a peak in 2010-2013. A seven year lease originated in 2010 expired last year as did a five year lease commenced in 2012. Shock and awe are mild adjectives to describe tenant reactions to their landlord renewal proposals. Met with a limited amount of available buildings, many tenants have been forced to swallow hard and accept that their rent might increase 30-40%! Ouch!

Next week, I will discuss some strategies for limiting your rent increases - so stay tuned, faithful readers!

Would you Own your Commercial Real Estate - If Vacant?

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Frequently, if you operate a small business, owning your location can make a great deal of sense. 

Generally, it works like this - you form a Limited Liability Company personally. The LLC then buys the commercial real estate. Your business signs a lease with the LLC. Therefore, you pay rent to yourself. Brilliant! 

Ownership allows you to fix your location costs - the purchase is financed with fixed rate debt for a period of time. The occupant is under your control - after all it is your company. Personally benefited are you from the location's appreciation - if any. Finally, there are some potential tax benefits individually. Awesome!

Now, let's add a dimension which many small business owners are facing these days - someone approaches you and offers to buy your business. 

When you consider selling the business that occupies your real estate - even if the purchaser of your business signs a lease with your LLC - the question you should ask is: would I want to own this location if it were vacant? Business changes, motivation varies, locations depreciate. At the end of your tenant's lease you may be faced with a costly vacancy. 

Remember, when you are the occupant and the owner, the dynamic is different than being the owner but not the occupant. You are now an investor who must compete with many other investors for your tenant's occupancy. The cost of originating a new lease is staggering - in some cases 20-25% of your lease income. Are you prepared for that potential risk? If the answer is no, then there are steps you can take to minimize the risk of owning a vacant building. 

First, analyze your location's monthly carrying costs - debt service, taxes, insurance, common area maintenance, miscellaneous maintenance, etc. You should maintain a 9-12 month cash reserve of this total amount. 

Secondly, determine how marketable the vacant building is. A commercial real estate professional familiar with the current market can provide this for you. How many vacant buildings similar to yours exist? What is the current appetite - including market time - for such a location? What is the current vacancy rate for facilities such as yours? - like yours specifically - not a market wide vacancy of all locations. How special purpose is your space? 

Third, determine what the lease income is worth to an arm's length investor. This amount less any debt owed against the location and less any closing costs of sale and net of any taxes determines the proceeds that can be deployed into an alternate non-real estate investment. If you choose to invest in another income property, the gain may be tax deferred if the new purchase meets certain criteria. You may be wondering why you would sell one piece of real estate only to buy another? The simple answer is to lessen the risk. By selling a special purpose single tenant location and investing in a general purpose multi tenant location, the management is greater but the downside is more  manageable - akin to selling stock in a single company and buying a mutual fund of many companies.