Are You Focused on the Tip of the Iceberg?

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We've all heard the expression, "that is only the tip of the iceberg". Made common when the Titanic met its untimely demise in the frigid North Atlantic, the expression has a commercial real estate application as well.

As occupants of commercial real estate, you focus upon a couple of things - the space and possibly the lease payment or monthly debt service. The space - does the physical space lay out well for your operation? Are there enough private offices for a collaborative work environment? Does the power into the building adequately support all of your machinery and equipment? Can  you afford the monthly payments? If these boxes are darkened, boom! You're golden, right? Maybe not so rapido.

If you focus upon the space and the payments, you only are seeing the "tip" of the iceberg. Akin to the iceberg, more than eighty percent of the transaction's issues are lurking beneath the surface and can destroy your occupancy if not properly anticipated. So what unforeseens are you navigating? Indulge me while I discuss a few.

The ownership of the building. Let's assume your operation requires a substantial capital investment by the owner of the building - you need offices built, a loading door added, or the power upgraded - does the owner have the money to accomplish this for you? If your heart is set on owning the building you're considering and the owner wants only to lease it, how will you overcome this obstacle? Finally, is the owner someone with whom you want to do business? A quick survey of the owner's tenants will tell you much about how the owner operates his properties.

Lease agreement. Generally, commercial real estate leases have "gotcha clauses". Who pays for the roof if it needs replacing? What happens if the operating expenses on the building increase? If your building owner's lender forecloses, is your lease terminated? Does the rent schedule have annual escalators? All of these issues should be fully investigated and understood before you sign on the dotted line.

Market conditions. You've heard owners are motivated these days and the market is dying to give you several months of abated rent. Or, you drive down any industrial street only to be greeted by multiple marketing signs advertising availability - there must be tons of space available, right? How many other occupants are competing to buy or lease your dream space? It's best to know where you stand before opening negotiations with a building owner.

Occupancy requirements. Your plans of opening for operation can be splintered like a ship's hull if you don't consider the city's requirements for your use of the building. A quick on-line search for zoning and allowable uses should give you an idea of any potential hurdles.

Your credit worthiness. All building owners look at tenancy and credit worthiness differently. A private owner may only care timely rent payments. A real estate investment trust may concern itself with your audited financial statement. Regardless, arm yourself with the knowledge of your space's owner and view of credit.

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What is an OCCUPANT Premium?

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Also referred to as a user premium, an occupant premium is the price an occupier of commercial real estate will pay compared to a commercial real estate investor.

As both occupiers and investors "invest" in the commercial real estate, the distinction I draw here is an occupier owns the building - owner occupant - and operates a business from the building versus an investor who owns the building, doesn't occupy it, and relies upon the rent paid by a tenant to underpin his investment.

Historically, owner occupants pay more for commercial real estate than investors - in some cases 20-25% more. So why would that be the case? I believe the following factors motivate the pricing difference.

Financing. Generally, a buyer of commercial real estate that will occupy the building has more options with which to finance his purchase. He can employ conventional bank financing which requires a 20-25% down payment, a 90% loan through the Federal government - Small Business Association loan, or private funding through friends and family. Typically, investors must rely upon debt with much lower loans to value - 60-70% - which means much more cash invested. Certainly, there are well heeled investors who can stroke a check for the entire purchase without the need for financing but these investors want a "deal" for tying up cash. OK, you may ask, why does the cost and availability of money motivate a buyer to pay more? The easy answer - payments. If money is cheaper, the resulting payment will be cheaper. An owner occupant can pay more because they can frequently borrow more.

Assumptions. An investor buys an income stream - a leased building - which is generated through a tenant paying rent. Assumptions must be made as to the sustainability of the income, whether the income is above or below the current market lease rates, and the likelihood the tenant will remain in the building after his lease expires. If an investor believes he will suffer a vacancy because the tenant can't pay the rent or believes the tenant will vacate at the end of his lease, he must hedge his purchase by paying less for the building. Because an occupant buyer is the "tenant", all of these costly assumptions are avoided.

Return on investment. The way in which an owner occupant views a return on investment is varied from the investor. An owner occupant takes a look at the payment his loan creates, adds the operating expenses (property taxes, insurance, and maintenance) and compares the total payment to a comparable market rent. If the total payment is within a reasonable range - doesn't exceed the market rents by 20% - boom! He's in. A much more complicated analysis is performed by the investor. What is the income? If the income is above market, he discounts it. How much can I borrow based upon the income - or discounted income? Now, the income must provide a sufficient return for the risk being taken by the investor - around 5-6%.

Utility. The way in which the building currently is or will be occupied is of little consequence to the investor. His concern is the marketability of the building if it becomes vacant. How long will it lay fallow? Will the building's features appeal to a wide range of prospective tenants? Can I cause the income stream to increase over time? An owner occupant views the building akin to the purchase of a machine or the addition of a key employee - will the building allow my business to grow? If so, the cost of the real estate is a cost of doing business.

The Commercial Real Estate is ALMOST Perfect - Now what?

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You have conducted an exhaustive search with your commercial real estate adviser and have happened upon the perfect space to house your rapidly growing company.

There are just a couple of deficiencies with the building that can easily be remedied - or so you believe.

What appears to you as an easy fix may in fact be a big deal depending upon the nature and motivation of the ownership.

I'll just add an office or six. Let's take for example the addition of some offices so that your key employees can operate within a private setting. You look at the existing layout and figure with the removal of a couple of walls here or moving a door there, you are golden. What many fail to realize is the cost, permitting, time, and effort required to simply add a couple of offices. Adding office is expensive! Simply moving a wall doesn't account for the air conditioning ducts that must be re-routed, the ceiling grid that is interrupted, new Title 24 energy efficiency upgrades that are triggered, the holes left in the flooring, and additional parking spaces that may be required. The offices will need to be permitted. A layer of bureaucratic challenges awaits the unsuspecting. Once the true cost of the new offices is determined, we now must negotiate who pays - you, the owner, or some combination of you and the owner. Generally, an owner will be reluctant to pay for an improvement that adds value today but may need to be ripped out in the future. Consequently, most owners will dump that cost onto you, the occupant. If an owner has the money to invest in tenant improvements, he may want to be paid back for those improvements over the term of the lease. This is known as amortizing the tenant improvements. Simply structured, the cost is multiplied by some factor of money and divided over the term of the lease to calculate a monthly amount which will be borne in addition to the base rent.

Lights, camera, action. Ok, maybe you need to increase the electrical service into the building so that your machinery runs smoothly. Easy, right? Ummm, not necessarily! Power into an industrial building originates at the transformer. In modern buildings, the power is then routed underground through a conduit into a switchgear located in the warehouse. So, adding power becomes a function of how much is available at the transformer, how large the conduit is into the building and the size of the switchgear. All boxes must be checked in order to economically upgrade the power feed into a building. If the transformer capacity is insufficient, the utility - SCE or a city power utility - will need to replace the transformer. If the feed into the building is too small, the pavement will need to be jack hammered, conduit replaced, and the switchgear changed. Yep, you guessed it - at a significant cost.

Who's next door. The space may work but is your use of the space compatible with the neighbors and allowable within the zoning? If not, you will face some cranky folks next door and a city with reams of paperwork for you to complete prior to your occupancy being approved. By the way, if you undertake a conditional use permit process, plan on the next six months of your life being consumed in minutia. Oh, and by the way, your owner may require you to lease the space regardless and place the risk of getting the use approved on your shoulders.

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