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.
 

Business Values - Part Deaux

You’re reading this on Super Bowl Sunday. A celebration of a very long National Football League season that climaxes with the clash of the remaining titans - in this case our hometown Rams and rival Bengals. Enjoy the guac!
 
Two weeks ago, we discussed the circumstances under which a piece of commercial real estate housing a business becomes significantly more valuable than it’s resident. If you missed the column - you can quickly catch up here.
 
Follow the link below to view the article.
When Property Eclipses Business Inside
https://ocregister-ca-app.newsmemory.com/?publink=0e1e11bb0_1348306
 
Mentioned was - so what? It’s all paper until I’m a seller. Today, it’s time to continue the conversation.
 
Becoming a seller creates two tough challenges for owner-occupied commercial real estate - increased expense to the operation and “what do we do with the money”?
 
Increased expense. Occupants of commercial real estate generally purchase their business homes for very different reasons than investors who strictly look at the cash production. By this I mean, the business is the focus - and all efforts are made to enhance the enterprise’s value. Appreciation that occurs with the address is strictly a circumstantial benefit. Emphasis is placed upon machinery, equipment, and employees which drive revenue and in many cases provide a greater return on the company owner’s investment. Ask most proprietors and they’ll tell you - we purchased our building for our operation. Sure, collected is rent from the occupying company - an investment - but in many cases this payment is subsidized by the building owner.
 
What we’ve experienced locally is the operation clips along and produces its product or service - machine tooled parts, injection molded widgets, or storage and logistics for customers. Hopefully, sales increase and the enterprise’s worth is enhanced. Recall, this worth is a math problem that deducts expenses from revenue to form a net figure. A multiple applied and voila! Enterprise value.
 
Meanwhile, our real estate becomes more valuable simultaneously. Market conditions change, rent increases, capital becomes cheaper, investor appetites are voracious, supply contracts, demand for space increases and boom. So, if we look at the way commercial real estate appreciates (increase in comparable market value, replacement cost, or through a bump in rent and compressed cap rates) - by allowing the occupant to pay less than market rent actually devalues the premises.
 
Let’s take a look at a quick example. Assume rent paid by the enterprise is $8.40 per year. Market rent is $12.00 per year. If our return is 4%, the resulting values are $210 per square foot with the subsidy and $300 if the lease rate reflected market. On a 100,000 square foot box - that’s $9,000,000! But to reap the $9,000,000 and sell the building with our company inside suggests our resident must bear the added rent expense of $3.60 per year or $360,000. Reduced is the bottom line of our company. Unless an owner is exiting, reluctance in hopping an enterprise expense is assuaged.
 
What do we do with the money? If - and it’s a big if, an owner’s operation can swallow a big jump in rent, the next issue arises. Ok. I saddle my group with the $12.00 lease and take that unsolicited investor offer at $30,000,000 (from above, 100,000 square feet at $300 per square foot). After all, the interested party will allow the company to stay put, we avoid a costly move - and I pocket $30,000,000. Easy! Hmmm. Don’t forget. You’ll pay a bit of dowry for that gain. In some cases, up to 45%! Certainly, we can employ some tax deferral through a 1031 exchange, a Delaware Statutory Trust, or a partial exchange. But in the end - you’re trading the devil you know - your company is housed, they pay you each month, and you control the operation for the devil you don’t - another leased parcel of commercial real estate.
 
Many business owner opt to say “thanks for the free appraisal - but we’re not sellers.
 
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.
 

Shortage of Space - Now What?

Image Attribution: www.gograph.com 

Two weeks ago, I got my Star Trek on and discussed space - the final frontier. If you missed the blast off, no problem. You can quickly catch up by clicking here. Follow the link below to view the article.
 
Rent, sell or buy: How real estate values are factored
https://ocregister-ca-app.newsmemory.com/?publink=13f98ef4d_13482ff
 
Ok, now that we’re back up to warp speed, allow me to continue our exploration by discovering ways to overcome the acute shortage of manufacturing and logistics buildings in our market.
 
As previously mentioned, a high demand for industrial space - fueled by the e-commerce boom - coupled with a lack of supply has fostered a game of availability musical chairs. There is simply not enough space for the need. Therefore, we must be terribly creative to fill the void.
 
Many times, the solution is found in the problem. By that, I mean a dissection of the “why” reveals a new direction. Did your company secure a piece of business that cannot be fulfilled in your current location? Has the growth come organically through an increase in the industry? Did you add employees? Has the way in which you conduct your business changed? Have you acquired a competitor or another product line that must be folded into your operation? Have you purchased new machinery or processes that require additional space? Has one of your suppliers asked that you warehouse some of their product where before the product was dropped shipped directly to your customers? Have you brought a formerly outsourced function back into the operation?
 
Specific answers to these questions may determine how we solve your space issue (and what type of space you need - production, warehouse, or office). Let’s spend the rest of our voyage assuming you’ve added a sales staff and the shortfall is caused by a need for additional office employees.
 
Generally, industrial space has a portion of its area devoted to a traditional office environment complete with reception, privates, and possibly a shared cube domain. This “office” is bolted on to the plant or warehouse and may be single or multiple stories. Typically 5-25% of the square footage houses office staff. Therefore, adding additional office space to your location could do it! On the surface this appears to be an easy fix. However, please consider the cost of construction ($100-$125 per square foot depending upon walls, plumbing, upgraded finishes, etc.). If you own, you may be over improving your building for the market and this could affect future resale timing and pricing. If you lease, you will need the owner's approval AND you will be leaving the improvements in the building if you move at the end of your lease. Some occupants have found great utility in modular furniture - flexible layouts and you take the furniture with you if you move. Other considerations are the city in which you operate (the improvements will have to be permitted) and the parking ratio. Generally, office space will require 4 parking spaces for every 1000 square feet of space. Most industrial buildings are parked 2 spaces per 1000 square feet (including office, production and warehouse). You may be limited as to the amount of office space you can add to an existing configuration.
 
Add an office mezzanine:  All of the considerations outlined in the previous paragraph apply here as well. The differentiation is that in addition to adding office space you are also adding square footage to the overall structure by creating a second story. Parking, city permitting, clearance in the warehouse (because you don't want the second floor to be sufficient for Klingons only), cost (structural footings are required to brace and support the mezz and are consequently 40% more expensive than first floor office space). If you create an office mezzanine, are leasing the location, and renew your lease - be prepared for the landlord to base your new lease rate on the "increased square footage" including the new mezz space you added.
 
Lease additional space close by: Whether you own or lease your location, a temporary fix to your space needs may be accomplished by leasing space close by. Please realize you’ll be less efficient with a function close by vs within your confines. The upside to this strategy is that the excess space (if the lease is flexible) can be discarded at the lease expiration (if the space is no longer needed) or renewed until a more permanent solution can be achieved.
 
Allow the function to operate virtually. Not an option a mere two years ago - now quite prevalent in industries across the US. Certainly cultural, management, productivity will be considered but it’s a great alternative for some.
 
You may be wondering how we discover plant and warehouse boons. That, dear readers is a planet for another trek.
 
Columnist note: Today marks my seventh year anniversary as a SCNG columnist! Thank you to all who’ve made the sojourn so enjoyable. Here’s to seven more!
 
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.
  

The Importance of Dates

Image Attribution: www.clipartmax.com 

Today, dear readers, I’d like to talk about dates. No, not those that emerge from swiping right - where’s the challenge there, btw? Or, for those frothy products of palm fronds that find their way into a shake. But, those calendar creatures that presage the passage of time. You see, dates are quite important in a commercial real estate transaction. Indulge me, as I share a few examples.
 
Time is of the essence. A fancy legal way to let you know - hey, pay attention! I learned this the hard way early in my career. We negotiated a five year lease. My guy ultimately wanted to buy the building. Thus, we convinced the landlord to grant us an option. Well, the date for exercising said right - by notifying the owner in writing - came and went as did our opportunity. Ooops! Fortunately, the title holder was forgiving and allowed us a bit of grace - but not before a finger wagging letter was sent our way. Contained within most commercial real estate agreements are these words - “time is of the essence.” Governed are all the dates - commencement, expiration, notices, and extensions. Wise agents calendar the important ones lest they blink past. I’m penning this post three days late. Hopefully, my editor will allow some latitude.
 
Leases. Leases memorialize the terms and conditions of landlord and tenant understandings. Generally, a commencement date signals the start. Early possession may indicate an earlier date under in which the occupant is granted access. Expiration occurs at the end. Easy! Not so fast. Don’t forget rent increases that bump throughout the term - typically on the anniversary and by a preset or calculated amount. Then there are expense reconciliation dates. Expect these in February. As mentioned above - extension rights such as options to renew, extend, expand, contract, and ownership options such as rights of first offer, refusal, to buy come with dates. Fortunately, in the case of options to extend - you’re afforded a window - like no earlier than nine or later than six months from expiration. Approaching expiration - you’ll make a decision to stay or move. Staying might be for an additional term or month-to-month. Yes. Dates are involved.
 
Escrows. Purchasing commercial real estate is a rather involved dance defined by days on the docket. A signed purchase and sale agreement is delivered to a clearinghouse of documents and dollars - AKA an escrow holder. Date of the agreement, yep. Date of full execution, sure. Dates for deposits to be received, uh huh. Date for additional deposits, boom. Ok, got it. But, lurking within the boiler plate are dates under which contingencies are outlined. How much time will a buyer have to arrange financing, inspect the condition of the roof, visit the city and check on uses, review title for any exceptions - etc. And. When will these time stamps commence? Upon buyer and seller signing the contract, seller delivery of an important document, preliminary title commitment or the opening of escrow? Yes, yavol, oui, and si! As you may have gathered - a cacophony of calendar credits consists. And ALL of the dates are as important as your first one with your significant or as memorable as waiting in line on PCH. You may be wondering - how does an agent keep track? Many employ a critical date calendar produced by the escrow holder. Or, we group certain waivers together. Or, we simply write into the contract language that reads - “the later of 30 days from opening of escrow or five days from receipt.”
 
So, don’t date yourself by using a paper calendar or singing “Eye of the Tiger”. Simply, use a modern tool that can provide calendar alerts - like when it’s time to head to Laguna and wait in line for a shake.
 
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. 

True Down Payment Amount

As you’ve read here a number of times - purchasing commercial real estate is a great way to build generational wealth. It’s like a jelly of the month club. By that, I mean the gift that keeps on giving! Many who read this column founded an enterprise housed in a parcel of commercial real estate which they also own. So. The occupying company earns income through its business operation and pays rent for use of the building. Company value increases over time and the address appreciates. A double whammy! Southern California has countless entrepreneurial stories whereby a generation took a risk, formed a company, bought a location and succeeding family members benefited. I have the privilege of counseling these family owned and operated manufacturing and logistics businesses. 

Recently, a conversation occurred which I believed column worthy. Specifically, how much should be allocated for a down payment when considering a buy? The easy answer is 10% of the purchase price if leveraged through the Small Business Administration and 20-30% when financed conventionally. Boom. Done. See y’all next week. But, there is substantially more to the story of originating a loan. So please stay tuned for a minute more. 

In addition to the 10-30%, suggested would be to budget for the following: 

Appraisal. Regardless of your lender choice - SBA, bank, insurance company, or hard money - an appraisal will be completed. Contained within the bank’s underwriting - this confirms the price paid is in line with the market. Plan on $2500-$5000 for this review. 

Environmental. Lurking beneath the surface of your purchase could be a problem. These unseen issues are caused by something toxic deposited in the soil. A review of the previous occupants in the building, messy neighbors, and the smokestack down the street combined with a look at old aerial photos - forms what is known as a phase I environmental report. Generally, this does the trick and provides a clean bill of health. If recognized environment concerns - such as stained concrete or containers of waste - abound, a phase II will be employed. Soil borings are sampled and tested. Recommendations range from no further action to remediation. Have you ever witnessed a pile of dirt inside yellow tape next to a gas pump at your local station? No. It’s not an episode of CSI. Aeration is one way to get the bad stuff out of the soil. Plan on $2500 for a Phase I to ?? If remediation is required.

Legal. You’re going to want an attorney to review the purchase agreement, title commitment, and draw your LLC formation documents. Budget around $10,000. 

Escrow and title. Sure. Seller pays for a standard policy but any lender policies or extended coverage are yours to bear. Plus, you’ll pay 1/2 of the escrow fees. Another $10,000 but dependent upon deal size. 

Survey. Not always necessary unless you’re after an extended policy of title insurance. Unrecorded easements, abandoned driveways, and recorded leases are typically not covered with a standard policy. Utility locations, property lines, and underground pipes are clearly mapped as well. $5000 is reasonable. 

Loan points. In addition to the interest payments due over the term of your debt - you’ll pay a percentage of your loan amount to the bank. 1-2% is pretty typical. 

Cost segregation. One of the really cool things about owning commercial real estate is the depreciation which lowers your income tax burden. The improved portion of your parcel - the buildings - can be depreciated over 39 years on a straight line. 1/39th each year. But, other components of the improvements such as walls, doors, glass, and air conditioning have a shorter useful life and if properly segregated - can be written off sooner. Usually your CPA can help with this. She’ll want to be paid, though. $15,000 seems fair.

Once you become the owner, gather and total your receipts. Add all you spent to the 10-30% down payment. What results is the “true” investment into your buy. 

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 Issue? Now What?

Last week I reviewed the the steps in purchasing commercial real estate. Whether you’re buying to house your company’s operation or simply to enjoy the rent a parcel of commercial real estate produces, the steps are essentially the same. The possible exception could be the financing portion - which some investors abandon in favor of deploying large sums of cash into the buy. 

Today, I will complete the orbit and describe some challenges that can occur and some suggestions on how to overcome them. 

From last week:
 
“Due diligence. Also referred to as a “contingency period”. Ranging from as few as 15 days to as long as 90 - a ton must occur during this time frame. Financing must be secured, title exceptions approved, inspection of the building - roof, electrical, HVAC, etc. accomplished, vesting documents drawn, financial aspects of the tenancy - if any - analyzed, and environmental health diagnosed. Whew! Within each of the main categories of approval - there are checkpoints which guide toward the end. Financing, for example, involves - credit of the buyer, the tenant, an appraisal, an enviro report, and lender concurrence. There’s a lot to be done in a short time. What if something isn’t approved? That, dear readers, is a subject for another column.”
So, here goes.
 
Generally, purchase and sale agreements include a mechanism for solving issues that arise in a deal. Specifically, the most widely used contract is published by the Association of Commercial Real Estate - AIR. Clearly defined within paragraph 9 are the various categories of approval items - inspection, title, tenancy, other agreements, environmental, material change, governmental approvals, and financing. Within the boiler plate language are roadmaps for resolution. If your contract is not the standard AIR form - results may differ. As always, it’s wise to seek legal counsel before engaging. But within the document - typically, offered are three choices - cancel, accept, or fix. A fourth creeps in which is a buyer and seller compromise.
 
Indulge me as we walk through some quick examples.
 
Let’s say a building inspector discovers the HVAC units are past their useful life. From experience - this is quite common. So, here’s what happens. The buyer objects to the condition of the cooling systems by disapproving a portion of the physical inspection contingency. You may be wondering. Wait, I thought the buyer was buying the building “as-is, where-is, with no seller warranties”. She is. But that refers to relying upon her inspection to alert her to any fixes necessary. Confusing? Yes, it is. Sure. A seller may simply refuse to repair or replace the units and cancel the escrow but cannot do so immediately. You see, here’s where the “mechanism” takes place. Buyer objects. Seller has 10 days to respond - yes, no, or maybe. A no vote on the recall - ooops, sorry. Wrong issue. If seller refuses, buyer can cancel the deal within another ten days, opt to continue and purchase with the faulty units, or accept a compromise - the “maybe” offered by the seller.
 
Financing is trickier. You see, if the buyer is unsuccessful in their pursuit of a loan by the date specified - generally, the seller can walk away. Therefore, it’s imperative to be quite transparent with the seller during the loan approval process. Because prior to the financing condition date - there may be some leverage. If an appraisal comes back less than the contract price - which causes a lender to renege on the amount - it’s recommended to level with the seller. Sure. You or the seller can cancel, additional dollars can be added to adjust for the delta - accept, an appeal can be made to the lender - buyer fix, purchase price can be reduced - seller fix, or a compromise between buyer and seller can be struck whereby buyer adds some dough, seller reduces the price - and voila!
 
I’ve witnessed these go every way you can imagine over my decades in the business. One certainty - there must be issues. It’s a thing. The next deal I close without one will be the first. But, fair warning. In today’s overheated industrial market, I’d not plan on a seller being terribly receptive to what’s referred to as a “re-trade.” Chances are there is a line of suitors waiting for the chosen buyer to blink.
 
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