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

Recession, Retrades, and Fundamentals

As I pen this, we are half way through July 2022 and Christmas decorations should replace patio furniture next month. Anymore, it seems we have two times of year - before Christmas and after. Before starts August 1st and after on December 26th. Everything else is just a footnote.
 
So much has happened in the world - after Christmas. We’ve seen commercial real estate values eclipse sanity, two quarters of declining GDP - read, recession - inflation the highest it’s been since 1982, a global war in Ukraine, gasoline above $6.00 per gallon, food shortages, folks losing their minds and opening fire on innocents, brick and mortar retail foot traffic slowing to a crawl, interest rate hikes, residential activity coming to a screeching halt, and rumors of slowing in our market. My how things have changed! And in a heartbeat.
 
However, one thing that stays constant is commercial real estate fundamentals. You know, those pillars from which we base our direction. In a changing market - it’s helpful to keep these in mind. One fundamental is a lease agreement. Whether renewing an existing arrangement or originating a new deal, the following should help you bend with the changing times.
 
In my experience there at least five "gotcha" issues that should be addressed in any lease agreement. In my opinion, The AIR - Association of Industrial Real Estate lease addresses these issues quite thoroughly - with a few tweaks. In the case of an owner generated lease, the issues vary in their treatment. The five issues are: Operating Expenses; Capital Expenditures; Subordination, Non-Disturbance, and Attornment (SNDA); Rent Increases, and Miscellaneous. I will define each issue, and suggest "asks" during the lease negotiation. This is a layman's review as a practitioner and should not alleviate the need to have all legal documents reviewed by counsel. These issues are from a California perspective and may vary by state.
 
Operating Expenses (Industrial):
Operating expenses, also known as Op Exes are the expenses an owner incurs in the operation of a property. These expenses include, but may not be limited to, property taxes; property insurance; maintenance of the foundation, roof, and walls; landscape maintenance; maintenance of the building's systems - plumbing, electrical, HVAC, etc.; utilities; occupants share of the amortized capital expenditures, etc. The costs are sometimes referred to as NNN expenses or "gross-ups". These expenses vary greatly based upon an owner's management preferences but are largely skewed by the amount of property taxes. If you negotiate a NNN lease, the costs are paid in addition to your rent - either as due or monthly. If the lease is an industrial gross lease, the base year op exes are included in the base rent. I suggest postponing the base year until the first full year after the commencement of the lease. If the lease commences in February, this is a tough ask. If the lease commences in October - not so much. I suggest asking for a cap on the increases in op exes over the base year.
 
Capital Expenditures:
Capital Expenditures are expenses that are largely non recurring such as roof replacement, parking lot replacement, drive and landscape modifications, etc. I suggest there be a mechanism in the lease to specify any expense exceeding 50% of the cost to replace a capital system (roof), be the responsibility of the owner and the cost be amortized over 12 years at an agreeable rate of interest.
 
Subordination, Non Disturbance, and Attornment:
This is defined as the financing holder's means of securing their interest and the outcome of any foreclosure. Also known as an SNDA, this clause causes the lease to be subordinate to existing and future financing that is placed on the property. As a tenant, a request that the lease be non-disturbed (terms not modified), should be sought in return that the tenant agrees to attorn (recognize) an owner that becomes the owner through the foreclosure of the underlying debt. Requiring ALL of these is important in my opinion - especially during economic times that could suggest a high likelihood of foreclosure. I suggest the lease clearly provide for ALL of the components - S, ND, and A, and that where possible the lender be persuaded to sign an SNDA recognizing the lease.
 
Rent Increases:
These are defined as increases in the rental schedule during the term of the lease. Generally, the increases are throughout the term of the lease and could vary based upon the change that occurs in the CPI or a fixed annual amount. Throughout 2021 we saw these fixed amounts escalate. Recently, a lease was written with 5% annual bumps! Wow. Almost double the amount we saw in 2019. Caps and Floors are always suggested to hedge against a rampant inflationary increase.
 
Miscellaneous:
Former and existing cabling removal, Americans with Disabilities Act - ADA requirements (and who is responsible), city permitting, subleasing and assigning, rent abatement vs FREE rent, and options to extend and purchase should all be carefully vetted and when necessary, negotiated.
  
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.

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!

Five "Gotcha" Issues that All Occupants Should Negotiate

I provide Location Advice to owners and occupants of industrial buildings in Southern California. Approximately 3/4 of my activity is in leasing and lease renegotiation...either on behalf of a landlord (owner) or tenant (occupant). In my experience there at least five "gotcha" issues that should be addressed in any lease agreement. In my layman's opinion, The AIR lease addresses these issues quite thoroughly...with a few tweaks. In the case of an owner generated lease, the issues vary in their treatment. The five issues are: Operating Expenses; Capital Expenditures; Subordination, Non-Disturbance, and Attornment (SNDA); Rent Increases, and Miscellaneous. I will define each issue, and suggest "asks" during the lease negotiation. This is a layman's review as a CRE practitioner and should not alleviate the need to have all legal documents reviewed by counsel. These issues are from a California perspective and may vary by state.

Operating Expenses (Industrial):

Operating expenses, also known as Op Exes are the expenses that an owner incurs in the operation of a property. These expenses include, but may not be limited to, property taxes; property insurance; maintenance of the foundation, roof, and walls; landscape maintenance; maintenance of the building's systems...plumbing, electrical, HVAC, etc.; utilities; occupants share of the amortized capital expenditures, etc. The costs are sometimes referred to as NNN expenses or "gross-ups". These expenses vary greatly based upon an owner's management preferences but are largely skewed by the amount of property taxes. If you negotiate a NNN lease, the costs are paid in addition to your rent...either as due or monthly. If the lease is an industrial gross lease, the base year op exes are included in the base rent. I suggest postponing the base year until the first full year after the commencement of the lease. If the lease commences in February, this is a tough ask. If the lease commences in October...not so much. I suggest asking for a cap on the increases in op exes over the base year.

Capital Expenditures:

Capital Expenditures are expenses that are largely non recurring such as roof replacement, parking lot replacement, drive and landscape modifications, etc. I suggest there be a mechanism in the lease to specify that any expense that exceeds 50% of the cost to replace a capital system (roof), be the responsibility of the owner and the cost be amortized over 12 years at an agreeable rate of interest.

Subordination, Non Disturbance, and Attornment:

This is defined as the financing holder's means of securing their interest and the outcome of any foreclosure. Also known as an SNDA, this clause causes the lease to be subordinate to existing and future financing that is placed on the property. As a tenant, a request that the lease be non-disturbed (terms not modified), should be sought in return that the tenant agrees to attorn (recognize) an owner that becomes the owner through the foreclosure of the underlying debt. Requiring ALL of these is important in my opinion...especially during economic times that could suggest a high likelihood of foreclosure. I suggest that the lease clearly provide for ALL of the components...S, ND, and A, and that where possible the lender be persuaded to sign an SNDA recognizing the lease.

Rent Increases:

These are defined as increases in the rental schedule during the term of the lease. Generally the increases are throughout the term of the lease and could vary based upon the change that occurs in the CPI or some other index. Caps and Floors are always suggested to hedge against a rampant inflationary increase.

Miscellaneous:

Former and existing cabling removal, ADA requirements (and who is responsible), city permitting, subleasing and assigning, rent abatement vs FREE rent, and options to extend and purchase should all be carefully vetted and when necessary, negotiated.