You've Really FOUR Choices with your Commercial Real Estate

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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

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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?

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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

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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.

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.