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.

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.

How to Approach a Lease Renewal - 6 Suggestions

One thing that differentiates commercial real estate professionsls from our residential counterparts is leasing. Sure, residential agents can lease houses but most focus upon the higher fees associated with home sales. After all, we are paid a fee on the consideration of a deal - a fancy description of the total dollar amount of the transaction. Lease fees are a percentage of the amount of rent an occupant will pay over the term of their lease. Simply, the variables are rate and number of years. Commercial leases tend to be three to ten years in length whereas a lease for house will be month-to-month or a year. Thus, the short term creates a small amount from which a fee can be earned. Now you understand why home sales are more profitable and residential agents shun leases.

In a given year - a portion of a commercial agent’s income will be derived from completing lease deals. These come in two flavors - new leases and renewals. Yes! In many cases our clients engage us to assist with renewals. Today, I’ll focus on some suggestions as you approach your decision to relocate or renew - akin to “Love it or List it” on HGTV.

Understand your owner’s position. Is the rent that you pay sufficient to cover the owners’s mortgage? Is the building owned free and clear? Is this the only building owned? Can the owner afford a vacancy? What is the nature of the ownership - sophisticated or mom and pop? What are the owner’s plans for the building - hold or sell? All of these variables will play into your ability to craft an acceptable lease renewal. As an example - if your rent barely eclipses the owner’s costs - he may be unwilling to negotiate. Conversely, a building owner with no debt can be more flexible.

Understand your position. In many cases, you know the building better than its owner. After all, your business has lived there for a period of time and weathered roof leaks, air conditioner outages, a shortage of parking, break-ins, and truck access. You reside despite the “warts”. However, if you vacate and another occupant must be found - will the new tenant discount for these deficiencies? What sort of renewal rights - if any - are contained in your lease? Do you have an option to extend? How is the option rent calculated? Finally, has your operation outstripped the capacity of the real estate or are you swimming in excess space?

Know where you are relative to market. Lease rates have increased exponentially over the past five years. If you crafted your agreement prior to 2015 - chances are your rate is dramatically below current levels. Plus, inventory percentages - number of available buildings on the market - are at historic lows. Therefore, if you’re not prepared with this knowledge - you’re in store for a shock!

Calculate your moving costs. Moving companies will gladly visit your site and give you a complimentary estimate of the cost to move your operation. However, don’t forget other relocation variables such as electrical feeds, special permits, downtime, and key employee drive-time. An owner will bank on the disruption and cost of moving your operation in his negotiations - so know your stuff.

Do some math. On your side of the aisle - you have relocation expenses, rent in the new facility, and the goodies that accompany a new lease - free rent, fresh paint, new flooring. But, you’ll pay a market rate for these amenities. On the owner’s ledger will be the expense to replace you - building refurbishment, lost rent from the vacancy, free rent for a new tenant, possibly some special stuff like a new office or two, and transaction fees. Most of these allotments will be “lost forever” - IE: an owner will never recoup them. Many times, the cost of replacing you can amount to 15-25% of the lease consideration - the total amount of rent you’ll pay for the term.

Start early. I cannot stress this enough! Your negotiating strength depends upon it. 12-18 months in advance of your expiration is advisable.

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.

5 Things to be a Commercial Real Estate Expert

I mentioned our summer intern in a previous column. Ahhh - the enthusiasm of youth! It’s a beautiful thing. Questions that emanate from the Cal State Fullerton senior are thought provoking and column worthy.

So here goes! What does it take to be an expert in commercial real estate? To respond - I’ll focus on the nuts and bolts vs things such as an agent license from the DRE, a Broker, empathy, professionalism, diligence, a wee bit of intellect, staying power, honesty, integrity, and the right mentor - sounds like a Boy Scout! Yeah all of those are critical - but can be said of most sales professions. To be an expert in commercial real estate you really need five things - which I’ll describe below.

Inventory. What is available for sale and for lease and more importantly - what exists at the baseline that is occupied. To determine buildings currently on the market - we use a combination of multiple listing services available to commercial agents (or those willing to pay a hefty monthly fee) - CoStar, Catylist, ILS. We supplement this information with Loopnet and our proprietary data. Baseline stats - standing stock or planned and under construction buildings are tracked using LandVision, Reonomy, CoStar, Catylist, or old school methods - such as saving brochures.

Transactions. You really must know what has leased or sold - also known as COMPS. Sale deals - because they are generally a matter of record - can be easily catalogued. Lease deals rely upon broker to broker sharing. But, the true experts understand the story behind each transaction - what caused the occupant to choose that building and the underlying motivation of the owner.

Trends. Most look in the rear view mirror of deals. But you must couple this with a look forward. Sure. Past performance can be an indicator of future success. But what if storm clouds are massing? Many of us missed the warning signs of impending doom in 2008. Using these predictions - of market direction - assist in advising our clients.

Ownership. Tricky - but crucial! Commercial real estate owners are one of two genres - owner occupants or owner investors. The former owns the premises and occupies the parcel with his business. If an owner relies upon the rent generated by the building - with no ties to the occupant - he’s an owner investor. Here’s where the expertise is needed - piercing the ownership entity. If High Dollar, LLC owns the real estate and ABC Manufacturing, Inc. is housed there - is the owner an occupant or investor? The only way to know is to research the common members of the LLC and corporation. See what I mean?

Occupancy. Easier! A simple canvass, phone call or door knock will yield this information - but its time consuming. Whether the resident leases or owns the site is another matter and relates to the ownership section.

So there you have it! Easy business. Hmmm. Not so much.

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.com.

Operating Expenses - A Primer

Generally, January is the time of year when your landlord will present you with an invoice for expenses - in addition to your base rent. This assumes - of course - that you lease your business home. However, if you own your business home - take heed - as you may be able to take a few more dollars from your left pocket and move them into your right pocket - by asking your occupant to pay for some stuff. This column is designed as a primer for these expenses.

Let’s define a couple of key terms - shall we?

Operating Expenses. Typically defined as the costs of maintaining the commercial real estate in which you reside.

Lease form. Forms of leases vary as widely as days of the week but commonly are either net or gross. Meaning - your base rent is net of the operating expenses - or in the case of a gross lease - your base rent includes operating expenses.

Now let’s dive in!

What expenses are included as operating expenses. Biggest in this category are property taxes. Currently, property taxes are based upon roughly 1% of the building’s assessed value. I say roughly because certain cities may add fractions to this percentage. You can easily check on the amount through your county assessor’s website. Next, insurance on the property - which is different from the liability policy you carry for your business and contents.

Finally, common area maintenance which is a broad category of expenses which can encompass mowing the grass, trimming the trees, sweeping the parking lot, disposing of the trash, exterior lights, property management, changing the air conditioner filters, and reserves for capital expenditures such as roof replacement. Treatment of these CAMs - as they are called - varies widely among owners. Simply, some may not bill for these until due whereas others may budget for them monthly. Still others may not ask for any reimbursement.

What expenses are not included in operating expenses. A major system replacement - such as a new roof or air conditioner - or, changes made to the exterior of the building - like new pavement or parking lot lighting - falls into a class known as capital expenditures. As noted above - some landlords budget for these through reserves while others bill their tenants when the changes occur. Please check your lease. Treatment of these costs should be outlined. Commonly - language allows your owner to bill you for portion of these expenses spread over time - but not a lump sum. Expenses related to accounting, mortgage interest, entity fees, and business licenses should not appear on your invoice.

Gotchas. If an ownership change occurred recently - property taxes will increase based upon the sales price. As a tenant - you generally shoulder this bump. Watch out for generalized expenses. Most leases allow for you to reasonably audit any expenses you’re asked to reimburse. If you don’t understand a line item or if your owner simply sends you a flat amount to pay - ask for back-up. Check to see if your lessor can require you to paint the exterior. This clause killed a deal for me recently. 

Finally, anticipate these costs when you negotiate your next lease or renewal. Simple things like asking for operating expense increases to be limited or moving a base year forward can save you loads.

Allen C. Buchanan, SIOR, is a pricipal 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.com.

Five "MUST Address" Issues in a Commercial Real Estate Lease

Approximately 75% of my commercial real estate brokerage activity is in leasing and lease renegotiation...either on behalf of a landlord (owner) or tenant (occupant).

Congratulations! If you are reading this post you have secured a new home for your business and are now about to sign a commercial real estate lease and move in. But, before you reduce that pen to paper, you might want to consider a few of the issues below.

In my experience there are at least five "gotcha" issues that should be addressed in any commercial 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 commercial real estate 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; occupant's 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. Ask: 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. Ask: 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. Ask: 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 at a fixed percentage increase annually or vary based upon the change that occurs in the Consumer Price Index or some other inflationary index. Ask: If a fixed increase cannot be negotiated, 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.