How to Unwind a Commercial Real Estate Deal

Today, I will delve into the topic of cancel culture. No, not stifling free speech, but the cancellation of a commercial real estate deal - AKA, how to unwind a transaction.
 
As mentioned in this space over the years - commercial real estate agreements come in two forms - leases and sales. Unlike our residential colleagues, commercial leases can make up a substantial portion of our practices - in some cases 100%. Because many businesses opt to lease the premises from which they ply their professions and the sale market these days has an acute shortage - more and more leases are originated. Clearly, cancelling either - sale or lease - have their nuances - so I’ll spend time on both.
 
What precedes each direction is an identification of needs, a survey of the market, tours of potentials, negotiation and contracts. Departure occurs at the documentation stage. When a lease is signed, the deal is done - notwithstanding fit out and move-in. When a Purchase and Sale Agreement is executed - the deal begins. As you can gather, unwinding depends upon where you are in the process. Allow me to dissect.
 
Leases. Until you scratch your John Hancock on that 17 page tome - you can walk away - even if you’ve signed a Letter of Intent. In some cases, after you’ve signed a lease and you don’t timely deliver the deposits called for - the owner can hit eject. But generally, once you and the owner sign, deposits and insurance are swapped, a lease agreement is affected. Now. Should circumstances cause a “delay in possession” - meaning you can’t move in - beyond what’s outlined - a cancellation may occur.
 
Ok. You’re in and things change. Now what? Typically, you’ve three alternatives - buy-out, sublease, or default.
 
A buy-out works like this. With the lease, you have committed to a certain dollar obligation which is calculated by multiplying your monthly rent by the years remaining on your term. Let’s say this figure is a million dollars. In order to achieve a buyout, you would approach the owner of the building and offer her a fraction of the remaining obligation. She then will analyze whether taking a buyout is in her best interest. Specifically - with the money offered - can the costs of sourcing an new occupant be absorbed.
 
Next, a sublease. You attract a surrogate to live out your lease and do all of the things you committed to do - like pay the rent, reimburse the property taxes, mow the lawn, etc. Beware. Subleases must be ok’d by the landlord - but she can’t be unreasonable.
 
Finally, you walk away and stiff the owner. Never recommended as all manner of legal recourse will be unleashed. But. It’s an option.
 
Sales. Recall. When a Purchase and Sale Agreement is signed, the stopwatch begins ticking. Until a deed is recorded - signaling the race is over - there are escapes.
 
The easiest occurs during a due diligence period. Accomplished within 15-60 days from execution of a contract is a commitment for financing; a review of title; inspection; forensics of the leases(if any), expenses and income; and an investigation of environmental conditions. If any don’t pass muster and a solution compromise can’t be reached - over and out.
 
Once all of the conditions outlined in a contingency period are waived - some money is at risk. Meaning, the buyer may bolt - but the deposit is forfeited.
 
Some may wonder - hmmm. It appears the buyer holds the key. When can a seller cancel? Simply, if the buyer performs - the seller can’t. My lawyer buddies are collective saying - uh huh! True. Suffice to say, however, a costly “specific performance” battle may ensue. Probably, the wackiest example of this occurred a couple of years ago with a seller we represented. It seemed the seller - after committing to sell his property - and the buyer waiving contingencies, discovered a costly pre-payment penalty. I received a call one day from the seller asking me to cancel the deal. Astonished, I asked - “on what basis”? ‘Because I can’t afford the pre-pay, he replied”. Hmmm. Fortunately, we persuaded the buyer to walk away. But not without a reimbursement of their costs and paying their agent.
 
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.
 

When Commercial Real Estate Values Eclipse the Business Value

As mentioned previously in this space - many business owners in SoCal have opted to own the premises from which they ply their trade. We refer to this as owner-occupied. Benefits of this structure are plentiful - tax advantages, appreciation, and facility cost stability - to name a few. The other alternative for an operation is to lease their business home. They become a tenant and the monthly rent they pay is sent to an unrelated landlord. Today, I’ll focus on owner occupied real estate.
 
In both circumstances, if properly nurtured and managed, the enterprise value grows. It’s quite common for that plastic injection molding operation or your neighbor who’s company tools aerospace parts to be worth several million dollars. I should mention here - the business valuation appreciates independently of the real estate’s worth. Sales generated by the company - top line revenue - is apportioned to account for expenses such as employees, raw materials, plant and equipment, etc. Resulting is a measurement called EBITDA - earnings before interest, taxes, depreciation, and amortization. Multiplied by the industry norm is this net figure. Generated is an estimate of valuation. There you go. I’ve just simplified the role of an investment banker into one paragraph. In practice, the process is much more complicated - but you get the idea.
 
Now, let’s dissect the ways in which commercial real estate becomes pricier. When considering a parcel of commercial real estate, we look at three metrics - income approach, comparable sales, and replacement cost.
 
Let’s start with the easy one first - replacement cost. You’ll need some land. Curbs, gutters, storm drains, maybe some demolition, and loss due to street widening are called off-sites. An architect will charge you to design, engineer, and process your new build through the city. A contractor will quote construction. Money may be borrowed which adds a layer of expense. Finally, to compare with an existing structure - depreciation is deducted. Now you properly have estimated replacement cost.
 
Comparable sales are a great gauge of commercial real estate value - normally. These simply view the market in the rear view mirror. In our over-heated industrial playground - if only the reverse is considered and not where the puck is going - you’ll miss a big chunk of equity. Therefore, in addition to COMPS, please contemplate what’s available and what those alternatives portend.
 
Finally, the most complex - Income approach. Regardless of the commercial real estate genre - apartments, industrial, office, retail, raw agricultural land - ALL can generate a dollar amount per month - rent. The amount and associated risk of said rent form a valuation labyrinth. Let’s say that manufacturing facility which bears your company’s name pays your LLC $12.00 per year in rent. Coupled with a risk defined return of 4.5% would suggest a value of $266 per square foot. Easy.
 
As you’ve gathered, two buckets of wealth are created - company plus brick and mortar. What’s uncanny today? How far the values of business homes have exceeded the company’s worth. This week I witnessed an example - six fold! Both figures were accurate as the owner recently paid a consultant to value the operation and we received an unsolicited offer to purchase his real estate.
 
Ok, so what? You may be wondering. It’s all paper until I’m a seller. That, dear readers is the topic for next week. So, stay tuned.
 
So, there they are - my 2022 predictions. Stay tuned this time next year to see how I did.
 
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.