Friday, March 27, 2015

FIVE Ways to Avoid Commercial Real Estate Rent Increases

Image Attribution: www.multifamilybiz.com
I have written recently about the increase in commercial real estate values in Orange County, California...specifically sale values. For months, I have predicted that lease rates would soon follow as the Econ 101 principal of supply and demand had to engage at some point.

You see, demand for commercial real estate in Southern California has far outstripped supply. Currently, ninety six to ninety seven of every one hundred buildings are occupied in Orange County.

Consequently, the rental rates had no where to go but up! This fact became painfully apparent this week for me as I sat in front of a dear client and friend whose commercial real estate lease expires in August of this year. He negotiated a killer deal in 2012 when the commercial real estate market was awakening from the ether. Now, at renewal time, he is faced with a thirty percent increase!

So, looking back, how could this have been prevented and what can you do to avoid a hefty increase in your commercial real estate rent?

Own your commercial real estate. If you have been in business five years or more, have been profitable for the past two years, can benefit from the property's depreciation, have some capital available that is not needed to grow the business, AND can predict your space needs for the next five years...YOU SHOULD OWN! Ownership of commercial real estate can eliminate the fluctuations of your rent because the purchase is financed over twenty five to thirty years. At today's super low interest rates, your rental costs are fixed at super low lease rates. My client checked every box but the space prediction. Because he couldn't forecast his space needs, I believe it would have been derelict to sell him a building three years ago.

Structure longer term leases. In my client's case, the culprit was a three year lease that commenced in 2012 and matured in 2015...awful timing. Had we entered into a five or seven year lease, who knows? We purposely opted for a three year lease because my client predicted he would outgrow the building in three years and didn't want to be saddled with remaining lease term on a building that he had outgrown. Had my client entered a longer term lease in 2012, he would still benefit from cheaper rent than the market rate today...but you know what is said about hindsight!

Negotiate extension rights. During the tough, down times owners will agree to extension options at fixed increases, or rights to extend at favorable terms. Once the market heats up, fixed rate options are a distant memory. In my client's case, we had negotiated an option to extend...but at market rates. The option was an afterthought because...once again...he believed he would not be renewing in three years and would be moving to a bigger building.

Understand the cycles. Generally speaking, commercial real estate moves in seven to ten year cycles. Our recent trough was 2009. Adding seven to ten years would place the peak at 2016-2019. However, some believe we are at the peak and we can only tumble from here. Regardless, consider where you are in the cycle and base your term of lease upon this...I guarantee you sophisticated commercial real estate owners time lease terms on where they believe we are in the cycle.

Know the owner's situation. If the ownership entity of the commercial real estate you lease is a private party (as was the case with my client), there should be a bit more flexibility in the terms he can negotiate. Although my client was hit with a thirty percent rent increase, the increase could have been much worse as the market could justify a fifty percent increase in his rental rate. The more institutional the ownership, the less flexibility.