Should you Acquire a Special Purpose Building?

Commercial real estate assignments ebb and flow between buyer opportunities and seller representations. Occasionally, we’re asked to market a special purpose building or find ourselves considering one for our clients to purchase. These unicorns can portend great risk and must be evaluated carefully. But before I launch in to how I caution buyers against said beasts - allow me a bit of explanation.
 
A general purpose industrial building has broad appeal to the universe of buyers. Most structures fall into this category. Such things as power, warehouse clearance, loading doors, and single story office space will be found on a typical buyer’s wish list. If an address curries favor with a narrow slice of occupants - we call these special purpose buildings.
 
We witnessed a spate of these constructed in the mid eighties as our industrial market adapted to the surge of microelectronic manufacturing. Needed was a hybrid between a high rise office and a down and dirty place where stuff was made. Enter Research and Development or R&D locations. Sporting more parking and a higher percentage of office space where engineers could work bolted onto areas used for manufacturing - this product type was dramatically overbuilt. Unfortunately, as supply was increasing - demand was falling as more of this genre’s output was shipped overseas. Thus we found ourselves with a whole class of industrial construction with limited flexibility - special purpose. Many lay fallow for years. Those that secured residents prayed for their longevity lest they’d be stuck with a costly void.
 
Another one we see is a facility improved with food grade infrastructure as they are rarely morphed into anything else. Sure, the next guy might be able to use some cold or frozen space - but generally the floor drains, washable walls and the like end up in the scrap heap.
 
Buying a parcel with special purpose improvements becomes challenging for myriad reasons. Chances are the occupant uses the intricacies and so long as he’s in residence - you’re golden. If he bolts, you’re scrambling to replace his tenancy. You see, a substantial investment went in to the goodies - now you must pay to remove them. This assumes of course that what underpins is marketable. Frequently, it’s cheaper to scrape the whole thing and start new. We saw this on the countless aerospace campuses occupied by the lines of Boeing, McDonnel Douglas and Beckman. Built specifically for the use they housed - no one foresaw a time when a retool would be necessary. Why would they?
 
Rarely are sellers prepared to hear the downside and how this impacts the price a buyer may be willing to pay. In the case of the aforementioned campuses - owners had to realize the buildings had no value and all would be based upon the land underneath. A bitter pill indeed!
 
Now for the good news. If you’re fortunate to find one of these with a mammoth credit tenant and a long term lease - great upside is to be found. The bad news is if there’s a vacancy. However, because the location is so unique - there are no places to move. We refer to this as a “sticky” tenancy. The improvements cause the occupant to “stick” in place and not relocate.
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.

A Conversation with a Private Investor

Investors in commercial real estate come in different shapes and sizes. Recall, I define an investor as one who relies upon the rent an occupant pays for her livelihood. All investors - institutional, public, or private have in common this requirement - a paying tenant. You may be wondering. Do investors ever buy a vacant building? Sure. But trust me. They understand the time and expense necessary to originate a tenancy. If they miscalculate - there goes the return on their invested dollars. And this loss can never be recouped.
 
Recently, we were engaged to assist a private investor redeploy proceeds from the sale of another piece of commercial real estate. He’s deferring the gain through use of a 1031 exchange. If you’re unfamiliar with an exchange - here’s a brief description. A seller transacts. The proceeds are placed with a qualified intermediary. Time starts. Replacement(s) must be identified within 45 days and purchased the earlier of 180 days from close or the filing date of next years tax return. An equal amount of dollars and debt must be spent on a like kind income property(s). If orchestrated correctly, the income taxes on the gain are deferred. Simple. But, please consult your tax, accounting and real estate professionals before undertaking.
 
Last week, we toured a couple of alternatives and I believed our conversation was column worthy.
 
While his sale property was in escrow, we spent a couple of meetings discussing his qualifications for the buy. What emerged was a desire to acquire a single or dual tenant industrial building with a triple net lease. The return should be north of 4.5%, and should provide a reasonable remaining lease term. Credit of the tenant is important and the rent being paid should be at or below market.
 
First on our list was a single tenant property that could be divided once the tenant vacates. Currently, the building is occupied by the owner who is moving out of state. Because his new business home is not yet completed, he is looking for a short term lease back of a year to 18 months.
 
After the first property visit we looked at option number two. The occupant of the building was once owned by the owner of the building. We frequently see this when a business owner decides it’s time to cash in the chips but sees merit in retaining ownership of the real estate. In this case - it’s now time for the owner of the real estate to move her money into a more tax friendly state - therefore her motivation to sell. Encountered was an operation that has a significant amount of money invested in the infrastructure of the building and 4 1/2 years remaining on their term of lease. Located in an emerging area - but not quite mature - one could sense we were pioneering a bit.
 
So here’s what our client had to say about both alternatives.
 
He really likes the first building we looked at although he understands an amount of money for re-tenanting the building must be considered. After all, this will be addressed in early 2024. Our client was concerned that the owner of the building has time until his new building is completed and therefore might not be terribly motivated. Additionally, the owner had unrealistic expectations of the property’s worth especially based upon the economic storm clouds we see massing on the horizon of inflation, rate increases and the threat of inflation. He’ll offer, but at well less than the ask.
 
On to the wild, wild west. We discovered the owner of this building would like to carry a loan. If favorable terms can be negotiated, this could actually be a win. Because the property is located in a developing area, the term of lease becomes critically important. Insufficient are the 4 1/2 years that remain. Consequently, we will ask to have a longer-term deliver to us upon the close of escrow.
 
Ok, nets cast. Time to harvest the bounty of investor interest.

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

How will we Know When the Market Changes?

Much has been written lately about economic storm clouds massing on the horizon. If you doubt what I say, pick up any periodical, listen to talk radio or a network news broadcast and mentions of inflation, interest rate hikes, and the Fed’s remedies will abound. Akin to a desert monsoon that starts with a puff of clouds and morphs into something larger - everyone senses the deluge is coming but are uncertain how extreme the soaking will be. Full disclosure. Neither do I. 

 
Certainly, my years of experience and witness of several downturns can add credence. But, the reality is all are different in their causes. Take 1990-1994 as an example. Loose lending by savings and loans and their ultimate demise, over building, and Iraq’s invasion of Kuwait catalyzed the boom years of the late eighties to a screeching halt. 
 
How about 2008-2011? Easy money to unqualified home buyers coupled with another spate of massive construction starts was ill prepared for a pause in the music. Many were left without a chair as the financial markets froze and lending ceased. 
 
Today, the culprits are the pandemic which left us home bound and computer key happy, stimulus checks, and supply chain clogs. The classic case of too many dollars and too few goods took effect causing consumer prices to spike. Not since the Carter years have we seen inflation this high. 
 
Caught in the crossfire is real estate - commercial and housing. Housing has started to slow as buying power is directly impacted by pricier loans. Even though inventory of homes for sale is low - offerings are sitting around longer and the frenzied pace of January 2022 is a distant memory. 
 
So when will we know the commercial market is slowing? The following will provide some guidance. 
 
As I’ve mentioned, commercial real estate trends follow residential by 12 to 18 months. But we’ll sense a slowdown soon - if it’s coming. 
 
First, listings will languish. What flew off the shelves earlier in the year will take longer to lease or sell. Recall, our vacancy is at historic lows. So, this won’t happen next week. But, maybe an offering that generated multiple offers will settle for one or two. 
 
Next, owner motivation will shift. The longer a vacant building lays fallow, the more desire an owner will have to fill it. 
 
Pricing will stabilize and then decline. With occupants on the sideline, owners will be forced to deal. One way to do so is through a reduction in asking prices. 
 
As rents adjust, so will values. Recall, the price an investor will pay is a return on the lease check a tenant writes each month. A decline in this amount coupled with an upward move in capitalization rates causes the price per square foot to decrease.  

Believe me, I’m watching all of the above quite carefully. Just today - while guiding a tour - the conversation centered around “where are we going” as it pertained to our owner’s situation. Yep. An entirely different rhetoric was rampant a mere three months ago. 

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

Random CRE Thoughts

Occasionally, it’s cathartic to empty the cache of our consciousness. Today is that day. As someone famous once opined - they’re only thoughts but they’re random and all mine. So with no further adieu, here goes!
 
Lee and Associates Summit. Last week we found ourselves at the Encore in Las Vegas for our annual soirée - AKA the Summit. Participants from all over North America and the UK attended. 2020 was scrapped entirely. 2021 was virtual. So this was the first time we’d been together since 2019. MUCH has changed - including a supercharged industrial market, an uncertain office environment, and a morphing retail experience. I should mention, our technology tools have also improved. Months of lockdown will do that to an industry.
 
Highlights from the industrial panel featuring professionals from the Rockefeller Group, Dermody, and Prologis follow. Institutional property owners are wary of inflation, a pending recession, and what impact both will have on cap rates. All agreed - industrial has been the darling and even if all of the new projects under construction laid fallow - our vacancy would still be skimpy - around 5.5%. Fuel conservation, automation, and taller and more efficient inventory is in our future. With the advent of self driving trucks - truck courts may be shorter.
 
Technology use in commercial real estate has lagged our residential counterparts. Since a house purchase is largely a consumer transaction vs a business deal - target rich social media sites are not as plentiful. Plus, we don’t share our available inventory and lease comps through a realty board clearinghouse. Therefore, we’ve been slower to adapt. We’ve witnessed a large consolidation of tech providers as evidenced by Lightboxes acquisition of ClientLook, Real Capital Markets, and Digital Map Products. Also, Buildout recently added Apto, Rethink CRM, and Prospect Now. No one dares to take on the big Gorilla - CoStar however. Some in the audience wondered if the broker would ultimately be ousted? Consensus was more money CSM be made selling to brokers vs replacing their role.
 
Who knows where we’ll be next year. Most agreed Las Vegas is tough to beat for its travel ease, entertainment, and massive convention know how. It is a tough schlep from the East however.
 
My foray into the Orange County office world. As readers know, my expertise centers upon manufacturing and logistics buildings and the family owned and operated companies that occupy them. I don’t seek office assignments, but occasionally they find me. Our current task is an offshoot of an industrial deal. You see, we were engaged to sublease a building’s warehouse. Planned was for the tenant to remain in the office portion. As our campaign unfolded - two groups emerged who wanted both - the warehouse and office portion of our offering. Now the operating group is considering a move into a suite of offices. Therefore, we toured eight suites in five buildings over the past week. The office world is changing to meet an evolving workforce. Open collaborative spaces are vanishing and returning to banks of private areas. After all, virtual meetings require privacy. Outdoor space is sought for respites, meetings, and functions. On-site amenities such as conference areas, fitness centers, and game rooms are cropping up. Corporate America is considering amenities in office buildings as a way to attract new workers and convince existing ones to return. Quite interesting turn of events, indeed.

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

Mechanics of a Build-to-Suit

Negotiations are underway - actually we have a signed Letter of Intent - on a large logistics building outside the Southern California basin. Our client plans an expansion of their operation into this location. The lure of less expensive land and fewer city restrictions hooked us. The lack of supply nearly capsized us until we decided to buy land and build - AKA a build-to-suit.
 
Recently, we sold a building located out of the state of California. Our client is an investor who purchased the Texas building to affect a tax deferred exchange.
 
Cash flow, ease of management, and the multi year lease had appeal to the buyer. For the next 10+ years, our client will enjoy clipping the coupons of rent payments. 
 
The building is leased long term to a Fortune 500 company. A build-to-suit was accomplished for the tenant four years ago.
 
So, what is a build-to-suit and when should one be considered? I believe one or more of the following circumstances would dictate building new versus buying or leasing an existing building.
 
Lack of availability. Industrial vacancy in Orange County, California is the lowest in history. 99.5 of every 100 manufacturing and warehouse buildings are occupied. And if your desire is Class A - in many cases there is no supply. If your company needs to grow into a larger building, chances are you'll be hard pressed to find one. The lack of available buildings should suggest a good climate for a build-to-suit. The trouble is - there is very little undeveloped land in the county. Even if you wanted to build a building, no vacant land exists to accommodate the build. In the case of the Texas building above, there were NO vacant buildings within the desired city - but a surplus of affordable, available, buildable land sites. Thus, the choices were - build or consider another city.
 
Special purpose building. This is similar to the circumstance of "lack of availability" yet very different. If you are patient, and occupied buildings are present in your market, eventually one will lay fallow, create a vacancy, and need a new occupant. A special purpose building contains features that don't exist in the market - a warehouse with 40' ceilings, or a building with acres of excess land for outside storage, maybe one constructed to store highly combustible or explosive contents. Our Texas building required two of these - VERY high ceilings and acres of excess land for expansion and trailer storage.
 
A unique deal structure. Recently, a grocery distributor required a class A constructed warehouse building in a size that didn't exist in the city they desired. Additionally, the occupant wanted to own but couldn't afford to purchase land, build the building and carry the debt on a building under construction they couldn't occupy until completion. The solution was to interject a developer who purchased the land, built the building, leased the building to the grocery distributor and granted the occupant an option to buy the building once completed.
 
But, be wary of the following issues.
 
Lotsa lead time. Few if any occupants can predict their space needs two to two and one half years in advance of a move. However, you must allow this much time to complete a build-to-suit.
 
Complete understanding of the mechanics. The basic structure is - land is owned or purchased, new construction is planned and permitted, building is built, new construction is occupied. Easy, right? Yes, if you own the land, already have the plans drawn and permitted, have a bucket of cash to spend on the construction, and don't need the building for several months. Complexity is added with each un-checked box.
 
Financeability. You need to understand how the financing of a build-to-suit works. I could write an entire column on this subject, however, some of the highlights are - vacant land will generally need to be purchased for cash, a construction loan will precede the permanent loan, a couple of appraisals may be needed, land owners won't allow their loan (if seller carried) to be junior to a construction loan - are you yet confused? Exactly - not a simple transaction!
 
Understanding you will pay more. I would encourage you to take a look at the reasons you will pay more to occupy a new build vs. an existing building. In short the reasons are - land prices, soft costs, entitlements, time value of money, financing, economies of scale, and market forces.
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.