Strategies to Avoid a Massive Rent Increase!

I hosted a webinar yesterday. Our team’s first ever. I’ve watched others - no commercial real estate practitioners, btw - employ these as a way to add value, stay top of mind with clients, and generate new business. Excited was I to try my hand. We were thrilled with the outcome as our room was crowded with a combination of prospects, strategic partners and clients. All who attended found pearls.
 
So what was discussed? Ways to renew a lease on YOUR terms. A synopsis follows.
 
The genesis of the Zoom centered around many of our clients receiving a note from their landlords with a whopping rent increase. We believed a counterbalance of sorts was necessary.
 
Why the BIG increases. Pandemic fueled demand coupled with skimpy supply - little to no new construction in certain size ranges - has caused a classic imbalance which results in price increases.
 
Know your owner. Owner investors fall into distinct categories - Institutional, Private national, Private regional, and Private local.
An institutional landlord such as ProLogis or Rexford will view rents differently than your neighbor who may own one or two industrial buildings. How you may ask? A building’s worth is capitalized rent. Therefore to an instructional owner, coupon rate is paramount. Many times concessions will be given to keep the rate in tact. Generally, a private owner will be more interested in cash flow and will potentially discount the rent to avoid a costly vacancy.
 
Your value as a tenant. The most a landlord can achieve is the market rent - which is a look back and a look forward at the transactions that have occurred and the new availabilities. Let’s say that amount is $20,000 per month. With 4% annual increases built in - the maximum she’ll get over a five year term is $1,323,878. But. What will she expend to achieve the market rent? Downtime while the building is shopped, abated rent once a new occupant is located, refurbishing the space, potentially tenant improvements, and brokerage fees. ALL must be subtracted from the total expected. Known as an effective rate - seldom is this equal to the coupon rent. In down markets an owner will spend 20-25% of the future take originating a new lease.
 
Extensions rights. You may have pre-negotiated your right to stay. Take a look at these clauses - options to renew, terminate, expand and rights of first refusal or first offer. Just remember. Time is of the essence - you must adhere to the periods specified.
 
Timing. In today’s robust market and scant availability - you may be able to relocate, sublease your remaining term and make money. In some cases, your owner will want a taste, however.
 
Cost to relocate. The Yang to the Yin of the cost to replace you is the dollars you’ll deliver to move. If you have large machinery, a special purpose use, ISO certifications or a spray booth you will be shocked how expensive it is to alternate quarters. Know these costs. Your landlord with use this as leverage.
 
Next steps.
Locate a copy of your lease.
Abstract the key dates and terms.
Create a system for assessing the trends.
Schedule an annual virtual or in person meeting with your landlord.
Don’t forget. You have the right to representation. Your owner certainly will have someone.

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.

An Interesting Investor Conversation

Last week, I wished you all a Merry Christmas. This was my way of adding some levity to decorations appearing in stores the last week of September. But I then got serious and discussed the chats I’ve had recently with investors, tenants, and owner-occupants. If you allow yourself to listen, interesting challenges are disclosed. If you missed the column - below is a recap of what I’m hearing from investors.
 
From last Sunday. Investors. Our industrial market crossed a pivotal point in the middle of 2020. For the first time I can remember, the occupant premium disappeared and investors started paying more for offerings than those who bought them to house businesses. Deep pools of capital, a rabid appetite for return in a stable asset class, and skimpy supply caused pricing to hit a crescendo in May of 2022. With all the world happenings - inflation, recession, global strife, and rising interest rates - investors, especially institutional investors, have hit pause. Private folks are proceeding quite cautiously. Many require debt to acquire income properties. As rates have now eclipsed 5.5% - the resulting capitalization must be north, lest negative leverage will occur (return on invested dollars less that cap rate). So with fewer buyers and higher rates - yep. Prices have started declining.
 
Another week and several more conversations. One in particular I believed was column worthy. We are marketing an investment opportunity in Chatsworth. Included is the owner’s desire to sell the building and remain - after the close - as a tenant. Known as a sale-leaseback, this deal structure has curried favor recently as our values have eclipsed sanity. This particular offering has a bit of hair, however - configuration, company ownership, and re-use once the occupant vacates in ten years. Yes! Investors are concerned with the next round. Akin to a game of billiards where the current shot pales compared to the “leave” - investors look past the return today vs their risk once the tenant bales in the future.
 
As the market changes - an investor’s propensity for risk is padded by a need for more return. Generally, institutional investors - those which are publicly traded or invest pension funds as correspondents - seek one of two types of deals - a core or value add. The former falls right in the mayor’s office the latter involves some work to get the engine revving. Our listing is neither. Plus, with the market and global gyrations, many institutional types are playing wait and see and not transacting.
 
What buyers are left? Private capital. Your neighbor that owns a strip shopping mall or office building. Many private investors have considered our listing. Most have passed. Too risky if the tenant leaves, we don’t like the layout, how do we retrofit the building in the future, and what insurance do we have the occupant will remain in residence - are common refrains. But another interesting dynamic is occurring. Unless motivated by the need to place money via a tax deferred exchange, private capital can earn 3-4% investing in government treasuries. These afford a return of 10x versus a year ago and come with the full faith and credit of the United States government - very little risk. So, if faced with investing in a risky real estate deal with a return of 6% compared to the alternative of the bonds…yeah. Me either. Also, if I’m buying at a 6% return and I choose to finance the purchase - I must be keenly aware of my borrowing costs as loan constants are now north of 7%.
 
Allow me a simple example. Let’s assume you buy an income property for $2,000,000. If $1,000,000 is borrowed at 5.5% interest - the simple interest payment is $55,000. Easy. But, how is the $1,000,000 principal repaid? That’s where amortization comes in. A fancy way of repaying the principal over the loan term. So. If the $1,000,000 principal is repaid over 25 years at 5.5% interest - now the annual payment is $73,690. Your return on the $1,000,000 (rent from your tenant) is $120,000 but your loan payback is $73,690 - for a net of $120,000-$73,690 = $46,310. See the problem? Your $1,000,000 invested brings in $46,310 per year. Take the same $1,000,000 and throw it into treasuries and you make $40,000. Hmmm.
 
So what does all that mean? Continued downward pressure on pricing. If you want to sell to a private investor, be realistic. Times they are a changin! 
 
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.

Three Things I’m Hearing

As I’ve written before - we as commercial real estate brokers generally serve three types of clients - investors, tenants, and owner-occupants. Unlike our residential colleagues who represent buyers and investors - and the occasional tenant - many in our industry do quite well only servicing folks with leases.
 
We can be on either side - the owner side or occupant side. So our days are filled in one of six pursuits - three types of clients but working on either side. Clear as mud? Allow me to provide details. Number one and two. Investor hires us to find them something to buy or to fill a vacant building. Number three and four. Tenant engages us find them a location to lease or to sublease excess space. Number five and six. We work to locate a parcel for an occupant to buy or they ask us to sell their company’s address.
 
With that as a backdrop - you can appreciate we have our “ear to the ground” and are a great source for what’s happening. I’ve distilled this down to one thing for each genre - investor, tenant, and owner-occupant.
 
Investors. Our industrial market crossed a pivotal point in the middle of 2020. For the first time I can remember, the occupant premium disappeared and investors started paying more for offerings than those who bought them to house businesses. Deep pools of capital, a rabid appetite for return in a stable asset class, and skimpy supply caused pricing to hit a crescendo in May of 2022. With all the world happenings - inflation, recession, global strife, and rising interest rates - investors, especially institutional investors, have hit pause. Private folks are proceeding quite cautiously. Many require debt to acquire income properties. As rates have now eclipsed 5.5% - the resulting capitalization must be north, lest negative leverage will occur (return on invested dollars less that cap rate). So with fewer buyers and higher rates - yep. Prices have started declining.
 
Tenants. The period between 2016 and 2019 found record numbers of leases originated or renewed. These are typically 3-10 years in length. Baked into the agreements are annual increases. Up until 2021 - these hovered between 2.5% and 3% per year. Around July of 2021 - we saw a big push for increases to proximate 4%. We even saw a couple of deals with 5% yearly kickers. But even with the hefty adjustments, lease coupons didn’t keep pace with inflation. Consequently, come renewal time - many tenants are greeted with rate increases of 50% -100%. Folks who lease industrial buildings are concerned with how their bottom lines will be affected and how to counteract a whopping bump in rent.
 
Owner-Occupants. Distinction is drawn between two commercial real estate owners - occupants and investors. The difference? Occupants also own the operation residing in the facility. Before June of this year, many owner-occupants received unsolicited offers from investors seeking to deploy capital. In general - these offers were at eye popping numbers and included a provision to avoid a costly move. Many carpeyed the diem and sold. But others got tangled in the two issues that arose - Uncle Sam and sky high rent.
 
The balance of 2022 should prove interesting as we navigate this changing market. As an aside, I did see a Santa display in a Lowes yesterday. Earliest I can recall. Merry Christmas!
 
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 Commercial Real Estate Thoughts

Currently, my inbox is cluttered. Seeking catharsis - this column will cause a clearing - which creates calm. Only one week left in the third quarter of 2022. 2023 is an Auld Lang Syne away. Blink and it’ll be here. 

Harvested from two calls today, here are a couple of situations that caused angst. 

What is a gross-up provision and why should you care? For context, this came up today in a marathon round with counsel, landlord and tenant. We are negotiating a lease with a public ally traded company and a local owner. These conversations are steeped in minutia but typically educational. According to Donald R. Oder, an attorney in San Diego, “Depending on the type of lease, the tenant may bear all or only a portion of the landlord’s expenses.  In a “triple net lease,” all of the landlord’s operating expenses are passed on to the tenant.  A lease may, however, contain an “expense stop” which establishes a point at which expenses begin to be passed on to the tenant.  In this type of lease, expenses for a “base year” are determined – the expense stop.  Thereafter, the landlord pays expenses equal to the base year and the tenant pays its pro rata share of the rest.  For example, if a lease contained an expense stop at $10,000 (“base year” expenses), and the landlord’s operating expenses were actually $11,000, the tenant would pay the $1,000 over the expense stop. It has become more common in recent years for office leases to contain what’s referred to as a “gross up” provision. Gross up provisions permit landlords to “gross-up”, or overstate, operating expenses to simulate the building being at full capacity.
 
Here’s how a gross up provision would work in the real world:

Assume the gross up provision states that common area maintenance expenses will be calculated for each tenant as if the building was fully occupied, or at 100% capacity.  Further assume the building is currently only at 50% occupancy.

Under this set of facts, a $1,000 expense to the landlord would be multiplied by a gross up factor of 2 (100% (the markup rate) / 50% (the level of occupancy)).  $1,000 x 2 = $2,000 (the grossed up operating expense).  The tenant is required to pay a pro rata share based on the percentage of space it occupies – let’s assume 20%.  In this scenario, the tenant’s total grossed up obligation would be $400.” 

Vacancy in office buildings has crept up in the past two years. In a healthy environment, the amount of dark space in a building would be a thing. But now it is. So, pay careful attention when leasing office space.

 Contingency periods. By definition, a contingency or due diligence period allows a buyer to study a purchase - upon their terms - with no obligation to complete the sale if something untoward is discovered and not remedied. Sometimes a seller passes along a vault of information which makes review and approval a snap. Other times, this becomes the buyer’s responsibility - third party reports such as environmental, building inspection, seismic, ALTA survey, zoning report, etc. must be ordered, completed, reviewed and approved. Presumably, enough time is built into the purchase agreement allowing the buyer to either approve existing reports or procure and approve. But what happens if the seller is tardy in delivering the reports to the buyer. Does the approval period automatically extend? This devil in the details caused havoc recently in a deal. We found common ground by saying the contingency period is the later of thirty days from opening of escrow or ten days from receipt of the reports. Bingo. 

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