Commercial Real Estate Advice - When Do You Need It?

Seemingly an easy retort? Certainly. I need advice when I’m buying, leasing, or selling. These three circumstances would apply to either side of the aisle - whether you are an owner or an occupant of commercial real estate. Ok. Done for this week. Well, not quite and since I’ve a few more words - indulge me as I share a few more situations in which commercial real estate advice may be necessary.

A transition. Twice last week, I counseled occupants that shared this circumstance. Both enjoy the benefit of owning the buildings their companies occupy. When the buildings were purchased - Bill Clinton was president. Ownership of the business and building were synonymous - albeit with different entities. Flash forward. Due to a couple of untimely deaths - the LLC building ownerships only have one common link to the operation’s management. Plus, in one case, the company finds itself with too much space - in other words the building no longer works. Where before both occupant and owner sang from the same song book - now the music is a bit off key. Needed is a careful parsing of objectives and a clear path forward.

Efficiency discussion. How do you get the very most productivity out of your manufacturing location, your suite of offices, or your retail store front? Often, the answer is not a move but a re-tool of the flow of the operation. Countless times I’ve toured a warehouse distribution building with the premise - the operation is out of space. Sure. The floor is consumed but the inventory is only stacked to half capacity. This “cube” space is free if you can utilize it. You see, commercial real estate is billed by the square footage. Simply, you pay for the floor area - not the volume of the building. A better investment - vs a move - might be in a new forklift to reach the heights of the building’s ceilings.

An alignment of motivation. What is optimal? Often, I find an in-depth discussion leads to a solution no one had considered. For instance. If operating capital is needed - why sell a building you own with no debt - only to suffer the consequences of Uncle Sam’s outstretched hand. A better cure may be a re-finance of the building’s equity. Another circumstance. Why hold out for the last dime with your occupant who is approaching the expiration of his lease? A simple math exercise should show you how costly replacing his tenancy will be. Share the savings. If he renews - even at less than a market rate - you both win.

What is ahead. Many of my meetings these days start with the question - how is the market? My response. We are seeing signs of cooling - variance in closed amounts vs asking prices, more time on the market, fickled investors, a more cautious - “let’s wait and see” attitude from occupants. The crazy thing - this slow down in activity hasn’t resulted in a rise in our vacancy - but it will. You heard it here.

Allen C. Buchanan, SIOR is a principal with Lee & Associates Commercial Real Estate Services. He can be reached at 714.564.7104 or abuchanan@lee-associates.com  his website is allencbuchanan.com

The “Brady Bunch” of Facilities

Our week was highlighted by two meetings which were of particular interest - thus my desire to share. Common among both operations with whom we met was the recent acquisition of a competitor.

Akin to the comedy sitcom of the 1960’s - The Brady Bunch - where two families were melded into one - both companies now find themselves with the task of managing the excess or inefficient capacity.

As you know, if you’ve watched reruns - Marsha, Greg, Bobby, Cindy, Peter, Jan, Mike, Carol, and Alice ultimately co-habituate peacefully - although five seasons and 117 episodes were consumed telling “the story of a man named Brady.” A similar saga occurs when two businesses are joined at the hip.

In the first case, growth had occurred organically - with great products marketed to a number of customers who saw the value and bought more. With an increase in sales and the need for more space - each operator looked to proximate buildings to house the explosive up-tick in orders. Each enterprise functioned - albeit a bit clunkily.

Flash forward. Packaged were two groups that essentially served the same buyers but from different operating facilities. The “marriage” created a behemoth of inefficiency - with receiving, manufacturing, storage, shipping, sales, marketing, accounting, and management essentially quintuplicated. 

Now considered is a consolidation into one facility - essentially moving the Bradys into a house in Studio City. Carefully vetted in the weeks ahead will be the disruption of production, moving costs, future needs, available buildings, disposing of the existing lease obligations, and return on investment. Should be fun!

Our second group achieved its size through acquisition. Consumed was any competitor in its path. Awesome. But the wake is similar to the Brady union - you’ve two sets of kids - pairs of whom are the same age. In commercial real estate parlance - the business has duplicated its distribution footprint serving the same geography. Complicating the equation - a trend in logistics - higher ceilings and larger truck courts. Allowed is the occupation of fewer square feet - stacked higher with product and accessed by longer trucks containing more inventory.

 Ultimately, a distributor can occupy fewer square feet and store the same amount of stuff. We now must figure out where the employees live, proximity of the centers to their customers, and the right sizes for the mirrored buildings. Just a simple puzzle to solve!

Stay tuned in the week’s ahead for an update on our progress.

Allen C. Buchanan, SIOR is a principal with Lee & Associates Commercial Real Estate Services. He can be reached at 714.564.7104 or abuchanan@lee-associates.com  his website is allencbuchanan.com

The Downside of a Move out of State

Yesterday, I concluded a meeting with a local manufacturing and distribution company. Family owned and operated by two California born and raised principals - the business has experienced exponential growth over the last couple of years.

That seven year lease signed in 2015 - which was to adequately house the operation - has now become a liability - as the operation is bursting at the gills. All measures have been taken to efficiently use the space available - creative material handling, automation, storing product off-site, outsourcing - but the fact remains. The company will have to move before the lease terminates in 2022.

Three options are now on the table - a relocation down the street to a space 50% bigger or a move out of California - to either of two business friendly states. Moving a mile or two down the road is a simple fix with measurable benefits - more space, less disruption, employees retained, done! However, this ownership has seized the opportunity to consider another - more forward thinking and long term solution - a move east - like well east of the 57 Freeway.

As previously described - a move out of California carries significant upside - a more business friendly environment, fewer regulations, cheaper housing, no state income taxes, and utility subsidies.

But with the ying of reasons to move - there is also the yang of negatives. That downside - dear reader - is the subject of today’s column. So, before you load that moving van - please consider the following.

Lack of available buildings. Even with the desperately low availability of commercial real estate these days - we still have created a base of existing buildings which totals billions of square feet. Anaheim alone has close to 100,000 million square feet of existing industrial buildings. A visit to Allen, Texas or Greenville, South Carolina and you’ll find acres of vacant land - but very little standing inventory. The oweness is placed upon you to build your own facility. Even with a land gift and streamlined permitting - you’re looking at 12 to 18 months of construction. Don’t forget the land freezes in certain places east of here. Oh, yes, and consider other delays - such as rain.

Skilled labor shortages. If your operation requires a level of expertise to operate computer numeric machines or tool medical devices - you may be sorely disappointed in the pool of employees. Granted, states are working with community colleges to train people with the necessary chops - but you’re still looking at a deficit.

It’s difficult to move back. Once you decide to sell that home in Corona Del Mar and move to Nashville - the barriers for re-entry are akin to an Apollo spacecraft returning from Lunar orbit. Sure, you can keep your place here - but our golden state will want a taste of the company’s profits - which defeats the purpose of an out-of-state location.

Cultural differences. There is no place quite like California - even with its warts. This from a man who lived his formative years well south and east of here. It’s said in the South - “folks will treat you nicely - but, won’t trust you unless they trusted your grandfather.” Where do you think the “old boy network” originated? My 85 year old mom still refers to her neighboring Cooper Rubber execs as the Yankees up the street. The family moved there in 1965! Just sayin.

The WEATHER! Folks who have never experienced six weeks of sleety ugliness each year take for granted the 300+ days of sunshine we enjoy. What’s overlooked is the loss of employee productivity where weather is a factor. Sure, four seasons are cool - unless you have to live through them. If you want to see leaves turning - or snow - just make a weekend jaunt to Oak Glen. There! Seasonal fix administered.

Allen C. Buchanan, SIOR is a principal with Lee & Associates Commercial Real Estate Services. He can be reached at 714.564.7104 or abuchanan@lee-associates.com  his website is allencbuchanan.com

If Your Building Sells - What Happens?

This week our team was contacted by an owner. Desired is to sell his building and re-deploy the equity into a college education for his children. A noble cause - to be sure - but one with some considerations.

Are you taxed? Yes! You see, once the sale closes, the Federal government will tax the long-term gain - appreciation of more than a year. Taxed at a higher level will be the depreciation re-capture. Don’t forget the new Affordable Care Act tax for any asset sold for more than $250,000. Oh yeah, and then our Golden State will want a taste as well. For those keeping score, all of the taxes can amount to almost half your gain! Ouch!

Outlined above is the first thing which occurs once your building sells - you’re taxed out the wazoo - unless of course, you employ some tax deferral strategy - which defeats the use of the equity for a college education.

What happens to your tenants? In our example, the real estate is occupied by three businesses - two of which have leases and one that doesn’t. The easy answer is - so long as the tenants with leases continue to pay their rent and abide by the terms of their contract - no interruption in their occupancy occurs. Assumed is the role of landlord by the new owner. Simply, he must adhere to the terms and conditions of the lease agreement(s) in place - the rent, term, increases, extension rights, etc. 

A much different story unfolds for the poor dude without a lease, however. You see - he is vulnerable. His rent can be jacked up or he can be asked to vacate. Best case, the new owner allows him to stay and offers a new lease with the same rent he enjoys - highly unlikely in today’s super-charged market.

Gotchas? Sure. Again, the tax man. Upon sale, the real estate is re-assessed for property taxes. Generally, property taxes are re-booted to the selling price. So who pays the increased amount? Yep. Generally, the tenants - assuming of course the leases allow for this “pass-through” - which most commercial leases accommodate. Who cares? Well, you should! You’re strapping your loyal occupants with an increase in their monthly out-flow. Or, short of the “pass-through” provision - the buyer pays you less because he must swallow the new property tax.

Special circumstances? Certainly. Before racing out to the market with that sale package - carefully consider your tenant(s) extension rights - options to renew their leases, ability to take over additional space, or ways to cancel. ALL of these circumstances can affect the value of your building. Did you agree to allow your occupant to buy the building through an option to purchase, a right of first refusal, or a right of first offer? If so - you must follow a protocol tantamount to a NASA launch sequence before openly marketing your holding.

Is your tenant the BEST buyer? Quite possibly. Short of any “rights to buy” you may have granted - the company who pays you rent each month could surprise you - and offer you the most. After all, they “live“ there and have for some time. In many cases, your tenant knows the building better than you do. Faced with a move vs converting their lease to ownership - buying can make sense.

Allen C. Buchanan, SIOR is a principal with Lee & Associates Commercial Real Estate Services. He can be reached at 714.564.7104 or abuchanan@lee-associates.com  his website is allencbuchanan.com

Why Hire a Broker - Just do it Yourself!

Selling a commercial real estate asset is akin to planning your daughter’s wedding - sure, you can do it yourself but things go much more smoothly if you have a wedding planner - AKA a commercial real estate professional.

Certainly, you can do a quick Loopnet search, establish a price, purchase a For Sale sign at Home Depot and wait for the phone to ring - set the date, book the church, rent some tuxes and order the cake - this is easy!

Vista Print will create a glossy brochure of your building, mail a few to the neighbors and the inquiries will start to flow - Wow! They do wedding invitations too? Cool! Invite aunt Marjorie and a few dozen friends and let’s do this!

Just got your first hit! They want to see the building next week. Oh wait, you’ve a day job and can only meet the buyers on weekends or evenings. Hmmm, this doesn’t work for the buyers- now what? I guess you could slip out during lunch - but what if the buyer is late or stiffs you? Time wasted - and on an empty stomach.

OK, you get them through. They like it. An offer will be forthcoming. I’ll bet you’re glad you’re saving that 6% you’d have paid the broker. Why don’t more folks do this themselves?

Your prospective buyers call. Do you have a recent appraisal? Does the roof leak? When will the tenant vacate? What will be left when the occupant leaves? I noticed the building doesn’t have central air. Do the cracks in the floor portend something serious? Would you consider seller financing as we have a small credit blip - a bankruptcy? Oh, by the way, my wife has her agent’s license - so we will be deducting 3% from our offer. Next!

Three different agents - who comb the area - call. We have qualified prospects who would like to see your building. Will you pay us a fee if we bring you a buyer? Can you forward to us any marketing collateral you have? Any idea how much electricity feeds the property? - as one of our buyers is a machine shop. One of our guys stacks products high in the warehouse. Will the sprinkler system handle high-piled storage? What is the zoning? Our buyer is a trade school. Will the city allow that occupancy without a conditional use permit? Hmmm. Feeling a bit overwhelmed?

Finally, your perfect buyer appears - dressed as Prince Charming. Let the wedding bells ring! After all, a commercial real estate deal is a union of sorts. You gloat a bit as your email buzzes with a full asking price offer. No financing required, quick close, as-is - alright! Done. But, not so fast. You see, this buyer has made three full price offers to three separate owners. His plan is to tie up all three - and jettison two of the three. Will you be saying I do? Or, I wish I had - hired that broker.

May I Make Changes to a Commercial Lease?

We just completed a very simple - or so it seemed at the outset - lease transaction on an industrial building in the City of Orange.

Well over half of our deal volume is in leasing and the other portion is sales. Unlike our residential counterparts - leasing is a BIG part of what we do!

So what added the complexity to a straightforward deal? The lease and appurtenant comments by tenant's counsel!

This episode begged the question - can changes be made to a commercial real estate lease? The easy answer is - certainly! Everything in a transaction is negotiable. The more difficult concept is "when" you should request changes to the lease language. That - dear readers - is the subject of today's post.

Recently, I authored a column entitled "Gotcha clauses in a Commercial Lease". At a minimum, you should ensure you have a complete understanding of how your lease addresses these items.

Next, carefully consider a few things.

How badly does my company need the space? You see, the expansion needs of your business can easily trump - sorry - the addition or deletion of a clause in your agreement. In other words - if you are adamant plumbing repairs be the landlord's responsibility - and you lose the space because the owner is unwilling - that could be costlier than unclogging a toilet.

Are there backup suitors willing to snatch your position if you attempt to die on the freeway of lease language? If so, you might want to tap the brakes on the tenor of your language negotiation - lest you end up in a heap on the 405.

How much is the total consideration of your lease? This figure is easily computed. Take the monthly rent multiplied by the annual escalations times the number of years. As an example, if the year one base rent is $10,000 and you've agreed to a rent increase of 3% annually for 3 years - the total consideration is $376,362 - a big amount of money - but an owner may be unwilling to spend attorney dollars changing a standard lease agreement. Conversely, if you're talking about a 15-year lease for $5,000,000 on an owner lease form - an investment in counsel is a good one - for both parties. 

Finally, consider the owner of your building. If the landlord owns numerous square feet of space and is used to change requests - a few minor tweaks may be in order. If you are dealing with a mom and pop who own one building - changes may be more difficult. A multinational owner with millions of square feet will have an arsenal of attorneys ready for an arm wrestle - so lawyer up!

My Property Didn't Appraise - But Why?

Recently, I counseled my sister-in-law. She is selling her house and the appraiser was scheduled to visit.

Although this column is commercial real estate focused, some of the same appraisal principles apply - plus my associate suggested I write something about the process and how slight assumption variations can cause wide swings in value.

So to all y'all out there with a bad number, here's why.

Reason one. Lender review. Since the financial music stopped in 2008, banks have been very careful to ensure appraisers don't have un-tethered reign. Consequently, appraisers are engaged by the lender - not the buyer or seller - and a strict review process is conducted once the appraisal is submitted. I've had appraisers assure me we were OK - only to have the review disagree.

Reason two. Rear view mirror. Comparable sales and leases are tantamount to a fair valuation - and are known in appraiser speak as the market approach. However, past history - done deals - only show you where you've been - not where you're headed. In an up-trending market, a sale that occurred three months ago may dramatically understate the current conditions.

Reason three. Assumptions. Market approach - has a second cousin - the income approach. Necessary for a proper look are recent lease transactions and the capitalization rate investors are paying. You remember capitalization rate - or cap rates, right? - a percentage measure of the net income divided by the purchase price. Well, in order to get there, an appraiser must assume a lease rate - tough to do because lease comps are not readily shared by commercial real estate professionals and a cap rate. As a cap rate is a measure of risk - the higher the risk, the higher the cap rate - the rate used can swing a valuation dramatically. Simple math - Income of $100,000 with a cap rate of 4.5% yields $2,222,222. But increase the cap rate to 5% and we get $2,000,000 - a delta of almost a quarter million dollars.

Last year - in this space - I provided four solutions if find yourself on the short-end of a valuation. In case you missed it, you can quickly catch up by clicking this link. The punch line - Seller reduces the price, buyer ups his down payment, parties cancel the deal, and/or compromise.

You've Really FOUR Choices with your Commercial Real Estate

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

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.

Five BIGGEST Mistakes Owner Occupants Make

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?

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.

Are YOU Prepared for a Rent Increase?

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?

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.

Buyer's WILL Pay for these Commercial Real Estate Features

Last week, in this space, I discussed the amenities contained within your commercial real estate that do not "move the meter" with buyers - AKA, buyers don't care and won't pay a premium for the benefit.

You may wonder - are there, in fact, features that will create a greater worth for the real estate?

Absolutely!

In no particular order they are:

Extra land. Generally, a greater price will be paid if extra land exists. In our congested county, extra land is a rarity. However, I must define "extra". We use the term excess and surplus interchangeably - even though we shouldn't - to describe extra land. You see, if the extra land doesn't serve the use contained, but cannot be separated and sold, the land is actually surplus land. In this instance, an occupant who had a large outside storage need would ante up. If the surplus could house additional building square footage - voila! In the absence of these two circumstances, no increase - because fronting cash for future advantage is costly. Conversely, if the extra land was excess - I can separate it and sell it - eureka!

Warehouse ceiling height. Rents and sales prices are quoted in floor area square footage. Ignored is the cube space that exists in a warehouse. I wrote about that here.  In effect, if the warehouse ceilings are higher than what's normally found in the market - an occupant can stack their goods higher and benefit from space for which they aren't being charged.

Loading doors that allow large trucks. Large trucks cannot make deliveries to a warehouse door that is lower than the truck bed - without a lot of excess material handling. Therefore, buildings equipped with "truck high loading doors" are valuable. If the warehouse ceiling also allows high stacking - you've got a duo in higher demand than Batman and Robin!

Fenced outside staging or storage areas. A typical manufacturer can benefit from outside storage of raw materials or finished goods. Logistics companies enjoy fenced and secured parking for their trailers. If your building has either, plan on jacking up that asking price.

Heavy electrical service. Much is involved with upgrading an electrical service into an industrial building - permitting, capacity, SCE studies, cost, time delays. If you own a building that has survived the agony of adding power, congratulations! This is a feature that will sell!

Fiber optic feeds. Many of the buildings in Orange County were built before the digital age. Consequently, few of them are wired for today's mass use of on-line commerce. Akin to the description of heavy electrical service additions, adding fiber suffers the same challenges and the same appreciation if the hurdles have been crossed.

operating expenses