Occupants of commercial real
estate, also referred to as users or occupiers fall into two categories - tenants
or owners. To draw a finer distinction - both are tenants - however one genre
pays rent to an unrelated third party, a landlord and the other pays rent to a
related owner of the building. Most common in the second type, is a real estate
ownership structured as a limited liability company, LLC, and the occupier a
corporation.
Today, I want to focus upon some
common mistakes I witness occupants make in their commercial real estate
decisions.
No agreements. Too frequently, I see this with occupants whose building
ownership is synonymous with that of the operation. A building is purchased,
many times with debt, and a mortgage payment is originated. Additionally,
property taxes, insurance, and maintenance are incurred. Resulting is a payment
- rent - which ownership charges the resident. Unfortunately, the payment has
no relation to a market rent for a comparable building. The owner has her costs
covered and believes everything is golden. Unfortunately, a subsidy - charging
the company less than market - devalues the operation. If a market rent was
charged, a deduction in profit results. Conversely, billing too much places
undo strain upon the occupant and ready sources of capital are consumed. This
can limit the ability to hire, buy machinery, and grow sales.
Once a satisfactory market rent
is determined, it’s critical to have a written agreement between the parties -
outlining the rent, expenses, term, increases, and options.
I once had a client forced to
move because no written agreement existed between the owner and occupant.
Unbeknownst to the occupant, the owner had deeded small portions of the
building ownership to various entities, such as ex-wives, charities, ex-girlfriends,
and the like. When the owner met his untimely demise, the occupant - who was
also a small owner of the building - found himself without an agreement and
many different factions wanting their equity. A trustee was appointed to sort
out the mess. The trustee’s only course of action was to sell the building and
force the tenant to relocate. Extreme, but it can happen.
Extension rights. Extension rights fall in to numerous categories including
options to renew a lease term, options to purchase the building, options to
terminate the lease, options to take additional space, rights of first refusal
to purchase and lease, as well as rights of first refusal and rights of first
offer to purchase the real estate. Clearly, these understandings must be in
writing in order to avoid conflict. However, one of the problems I see is the
agreements are too vague. As an example, maybe an occupant has the option to
renew the term of their lease for five years upon the expiration of the
original lease term. If the language simply says - and occupant can stay for an
additional five years at a mutually agreeable rate, disagreements can occur
- because
no mechanism exists to determine a fair rental rate. Therefore, it’s important
for options to not only be in writing, but also have clear definitions as to
how rents and purchase prices are to be calculated. I’m involved in one such
exercise currently where the language is very specific. If the landlord and
tenant cannot agree upon a rate, each appoints, an arbiter to make an
independent evaluation of the market. If those two arbiters cannot come to an
agreement, a third arbiter is appointed by the previous two and her
determination is final. This is a cumbersome process, but one which will avoid
any disagreement. Finally, make sure the market lease rate or market purchase
price is based upon comparable buildings within a comparable sub-market with
similar amenities. In other words, it’s unfair to compare a 4000 square-foot
address in the Irvine Spectrum to a 100,000 square-foot building in Santa Fe
Springs.
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.
Last week we spent some time examining those
fortuitous business owners who’ve enjoyed the good fortune of occupying - with
their business - a facility with which they hold title. Their companies have
enjoyed steady rent over the years with no need to sweat dramatic increases.
Appreciation in commercial real estate values has eclipsed the businesses worth
- in many cases. As we talked last week - subsidized rent can play a role in enterprise
valuation. After all, the cheaper the rent, the more profit an operation
generates - which is used to project a company’s multiple.
My question is - does it matter? You own both - the
real estate and the enterprise. Both have more decimals than before. Business
is worth more due to a rent of less than market. Real estate because of forces
around us such as scarcity, demand, lack of new building starts, etc. So what?
Here’s what. You now believe it’s a great time to
liquidate your equity by selling the operation. Generally, two genres of
business buyers will come knocking - a private equity group or a strategic
operator.
In the former, a goal could be to acquire a number
of companies like yours, create value, and sell the bigger unit. Typically, they’ll
utilize the existing footprint and attempt to operate without moving. A boon
for your building ownership - IF they’ll pay a market rental rate. Don’t
forget, the profit of your group is partially bolstered by the rent discount. A
huge bump in rent could crater the profit of the company. In one instance, I’ve
seen the difference in subsidy and market cause the profit margin to be zero!
An option could be to sell - rather than lease - the
real estate. Akin to selling a used car and buying a new one - this arm
wrestling match rarely results in a maximum number for both your enterprise and
your real estate. Many times the company
buyer will inflate the price of the business at
the expense of the real estate - only to then create a long lease and sell the
facilities to an investor. The proceeds are then used to “buy- down” the
business acquisition.
If favor is garnered by a strategic operator, a new
set of circumstances occurs. Operating within the same industry, this buyer
type views the acquisition as a way to expand market share, geographical reach,
or specialization. Typically, they have adequate facilities and don’t want the
real estate. Now you have a costly vacancy that must be filled.
Finally, you should consider your return on
investment. Assume your investment is the real estate from which your
enterprise operates. Therefore the return is the amount of rent you charge
divided by the price you paid. Structured as a home to your operation vs a
return driven investment - you’ll likely leave shekels on the sideboard. Plus,
now the parcels are way more valuable. The same rent divided by a new larger
value will cause the returns to diminish.
So what’s the answer? So long as you own the
operation and the buildings are needed - it rarely makes sense to sell them.
Certainly a transition - death of a principal, a move out-of-state, divorce,
loss of a key piece of business - can skew direction.
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.
