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.

Deal Cancellations Abound!

The commercial real estate market has an entirely new feel these days. Gone are the buyer fueled bidding wars brought about by too few buildings chased by too many occupants - the classic supply demand imbalance. We were clipping along at warp speed for the first five months of 2022 when bam! We hit a massive speed bump named the Federal Reserve. You see, to tamp down rampant inflation - the Fed raised interest rates - some would opine too aggressively. Buyers felt emboldened to behave - well, like buyers. Personally, our team has felt the impact as we’ve had three deals cancelled at the alter. Jilted indeed.
 
Our latest divorce - terminated transaction - was the representation of a private investor in his search for a suitable upleg purchase. He sold a property in June and now must redeploy the proceeds to defer capital gains taxes. As we scoured the universe of available leased buildings - we settled on single tenant net leased industrial buildings - ideally in Southern California. Flooded in our search area were sale/leasebacks. After all, net leased real estate is created by: one, an investor believing now is the time to sell or two, an occupant who needs the equity contained in her owner occupied facility. The latter was the genesis of our deal implosion.
 
Therefore, I thought it column worthy to review sale/leasebacks and some things to consider when pursuing them. So here goes.
 
I've advised a number of my clients recently to consider selling their commercial real estate and striking a three to ten year lease with the investor that buys it. A few have listened.
 
This structure, in our parlance, is known as a sale leaseback. Different than a straight lease and not a short term lease that accommodates a purchase, a sale leaseback allows an owner occupant the chance to sell at today's high prices and remain in the building - albeit as a tenant - and avoid a move.
 
It's a slick arrangement when the correct motivations are involved.
 
Today, I want to spend a moment and discuss the downside of a sale leaseback.
 
The message it sends to the market. When a sale leaseback is listed and marketed for sale, the buyer’s questions range from - "why is she selling?" to "is her company leaking at the gills and needs cash to survive? Generally, there is a story. Its critical to understand the story, why a seller is selling, and how the current financials present. Our challenge recently was the creditworthiness of the occupant and the seas of red ink we were asked to navigate. In the end, we said - next.
 
Rent. Value is determined by taking the rent a company is willing to pay and packaging the rent as a return on investment. Simply, if the business can afford to pay $10,000 per month or $120,000 per year and the return is 5% - resulting value is $2,400,000. Easy, yes? Now the fun begins. Where is $10,000 per month in relation to what other comparable buildings achieve in rent? It's either above, below, or at par. Par or below - you're golden. Above and you're scrambling. You see, an investor looks at the worse case scenario - if the occupant spits the hook after a year, can't pay the rent - or worse files bankruptcy - then you’re stuck with a building you can't rent for the same amount she was paying. Thus was our conclusion in the failed deal.
 
Operating company is strapped. One of the befits of owner occupied real estate is the flexibility when times get tough. As an example, we own the office building we occupy. We’re the owner and the tenant. When our revenues dipped in 2009 and 2010, we simply reduced our monthly payment - to ourselves. Once an arms length investor enters the fray - you’re simply a tenant and the flexibility evaporates. In our cancelled scenario, rent was inflated in order to get the most dollars out of the sale. The problem was the rent was unsustainable.
 
There are tax consequences. As we've discussed, selling appreciated commercial real estate comes with a heavy tax consequence - unless a tax deferred exchange is employed. Yes, equity is feed, but at a significant cost - in some cases up to 35%. You may be wondering why this matters. Unless the seller has carefully thought through these consequences - the deal can screech to a halt.
 
Fortunately, we still have the engagement and are proceeding to the second possibility. This time the seller is arms-length from the company. So we’ll see.
 
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.

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.