When is Commercial Real Estate a BAD Investment?

When risk outweighs return. Our neighbor has a tidy portfolio of single and multi tenant properties. The good news? Single tenant buildings are easy to manage - one tenant, one rent check. Multi-tenant - such as an apartment building or strip center don’t crush your cash flow if someone bolts - but you have several rent checks to chase. For our neighbor to eliminate her management and convert to single tenant - a risk greater than her tolerance, ensues. Thus her balanced portfolio. Think of single tenant assets as a share of stock and multi-tenant as a share of a mutual fund.
 
Good for business. We recently represented a family owned construction company. The company found its origins in the 1950s in a part of town that was booming. Owning the location from whence the business resided was a solid plan. Flash forward. A decision was made, by the next generation, to shutter the enterprise. Boom in the 1950’s was replaced by blight in this decade. Consequently, with no occupant to pay rent to the family - the construction company was closed - and little upside - selling and redeploying sale proceeds became the direction. Therefore, an investment good for the business evolved into one less favorable years later.
 
Metrics are skewed. Replacement costs, rent, capitalization rate and return, sustainability of the income stream, and exit plan are ALL considered by most investors of commercial real estate. Should one of these measures of an income property’s value need alignment a future problem may arise. As examples. If you buy a Starbuck’s location and pay $1000 per square foot for a building go that can be replaced for half that amount - your basis is artificially inflated. So long as Starbuck’s stays current, no harm. But if folks start brewing coffee at home and store sales wane - you see where I’m going. Finally, investors focus on a return on their money. If a check is written to acquire the asset then the return is the cap rate. Easy. Layer in some debt and the answer is a bit more complex. Simply. If the capitalization rate exceeds the interest rate on your mortgage - positive leverage occurs. This is magical - as the return on your invested down payment now is greater than the overall cap. Clearly the opposite occurs when a borrowing rate eclipses said capitalization.
 
Tax laws change. When Ronald Reagan was President. Yes. I was around the industry then. But I digress. At the end of 1986 - a tectonic shift happened with our Federal tax laws. Lower marginal rates of taxation were swapped by eliminating certain write-offs. I believe our present depreciation rules - 39 years - were examples. Real estate bought with certain tax shelters in mind were no longer great investments.
 
Improvements are specialized. We toured a building last week with a client. Our occupant processes food but does so in an ambient environment - no specialized freezers or coolers are required. The vacancy we walked was complete with tons of cooler space. Our premise was some of the cooler infrastructure would translate to our use. For those who need these special purpose goodies - rent is not an object. As the cost to create them is astronomical. But for those who don’t - which is a much greater universe of tenants - they won’t pay for the extras.
 
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.

Things to Consider When Buying a Building

Commercial real estate ownership - especially when it houses a business operation in which you have a stake - stabilizes your costs, provides some tax breaks, and appreciates over time. The trifecta!

 
Cost stabilization. If you rely upon a series of 3 to 5 year leases for your location strategy, over time your rental rate will increase based upon the change in the consumer price index or by a fixed annual amount. Sure, you might time a dip in the market with an expiration - but don’t count on these ends meeting very often. So, using fixed rate debt over a 20 to 25 year amortization period can provide a level amount.
 
Tax breaks. Infinite are the incentives Uncle Sam provides for those who own income property. Mortgage interest, operating expenses, and depreciation can all be deducted. In some cases - capital outlays, such as a new roof or parking lot can be expensed.
 
Appreciation. Depreciating an appreciating asset is one of the marvels of commercial real estate investment. As an example - say you buy a structure for $5,000,000. The improved portion (not the land) can be depreciated over 39 years. But at the same time - over a ten year span - your $5,000,000 could be worth double!
 
With these benefits, you may be wondering. Why don’t all companies own their buildings? Why would anyone lease? And what should be considered before buying?
 
Fluctuating space needs. Many fast growing operations opt to lease vs own. You see, the amount of square footage required can vary. If you own and outgrow the footprint - money is tied up in a facility that is obsolete. Conversely, a series of short term leases and options to extend can handle the fluctuations without consuming precious capital.
 
Use of the down payment. Most finance an owner occupied commercial real estate purchase through the Small Business Administration - SBA. Originated is a loan(s) for 90% of the buy with the balance coming from the borrower. But 10% of a $5,000,000 deal is still $500,000. In some instances, this capital can be better deployed in new employees, machinery, or equipment.
 
Financeability. A lender considering making a loan will look at the credit worthiness of the borrower as well as the occupying entity. Is the business cash flow - after all the expenses are paid - sufficient to service the debt?
 
Company structure. As mentioned above, depreciation - for those who can benefit - is awesome. Publicly traded companies frequently avoid ownership of their buildings so that depreciation doesn’t ding their earnings.
 
Age of the principals. Years - an important consideration as commercial real estate ownership is a long play. Meaning. If the principals are in their eighties - chances are great - they won’t live to see the appreciation. Certainly, their heirs will thank them.
 
Exit strategy. Owning for an operation should also be considered in light of your horizon for the enterprise. Simply, if you plan to dispose of the business within the next five years - what remains is the facility. I’ve witnessed this work quite well as the acquiring group needs a place to live and signs a lease. I’ve also watched the value of the operation be diminished because a duplication of addresses occurs.
 
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.

Two Things that Derail Most Sale-Leasebacks

You’ve opted to own the location from which your company operates. A great move by the way! A Limited Liability Company was formed and owns the building. Presumably, the LLC’s members are similar to that of the occupying group.
 
You struck an agreement with the resident - your enterprise - to pay you (the LLC) an amount of money each month for the use of the address. In effect, you’re paying yourself. It’s a beautiful thing! Tax benefits are afforded the ownership LLC - depreciation of the asset, write-offs for any mortgage interest, property taxes, and operating expenses. Over time, the LLC’s investment appreciates.
 
Your occupying business pays rent just as it would to a landlord who has no stake in the company. Plus, because the owner of the real estate and operation are synonymous - if business ebbs and flows - so can the rent you pay yourself monthly. We are fortunate to have such a situation. We own the building from which we ply our brokerage. Each month Lee & Associates Orange - occupant - pays Taft Lee, LLC - owner - a dollar amount that provides a nice return on our investment. However, during the term of our ownership - we have deferred rent increases, banked reserves for a new roof, and kept the rent commensurate with market conditions. We can do this because we are the landlord AND the tenant.
 
Generally, a business or ownership transition will create a commercial real estate decision. As an example, if you acquire a competitor - will the real estate you own and occupy adequately house the marriage? Conversely, if you sell the business - your “tenant” - does the buyer of the business have their own location? Thus making yours excess? An election to move your enterprise out of state requires some time to facilitate and the equity in the real estate to buy your new location. In all cases - as you can surmise - you’ll make a decision. Keep the building or sell it.
 
When selling is chosen, one of the strategies employed is a sale-leaseback. By definition - a sale-leaseback inserts an investor - the sale - to replace the LLC ownership. The group - your company - stays in the building - the leaseback - and pays rent to the investor.
 
With that as a backdrop, let’s discuss what the title previews - two things that derail most sale-leasebacks.
 
The operating company cannot afford a market rent. Remember. One of the reasons you own your business location is to provide flexibility during tough times. Maybe the amount you allow your operation to pay is well below what comparable rents are. This is done because your two interests - business and building - are satisfied. In order to maximize the value of your investment, however - you’ll need to shore that delta. Someone buying your real estate - and relying on rent - is only concerned with a return on their money. Therefore, the price an investor will pay you is based upon a formula - known as a capitalization rate or cap rate. A cap rate is determined by net income (rent less expenses) divided by purchase price. The relationship is inverse - lower cap rate, higher price. But, the higher the rent - the higher the price…within reason. If the group housed cannot afford a market rent - the sum an investor will pay will result in a lower value. As a seller, you’d like to max your sale proceeds - but don’t want to saddle the business with an unsustainable monthly rent. Dilemma!
 
What to do with the proceeds? Your ownership LLC with a related company paying you is a tidy investment. If you sell the real estate, where can you reproduce the return? Recall, you’ll need to accomplish a tax-deferred exchange into another income property or be faced with a whopping tax bill. In the three transitions above - acquire a competitor, sell the business, or move out of state - a sale-leaseback could ensue. However, each presents complexity. Buying a competitor is easy - especially if you need more space. No lease-back needed. You simply sell the smaller and exchange into a larger. Boom. A business sale - especially if the business buyer doesn’t need your real estate - is challenging. You’ll have to fill a vacancy by selling or leasing. The timing of an out of state move works great for a sale-leaseback. Simply, point A is sold. Lease is created for two years. Point B is bought and rented short term while you prepare to move your enterprise. Lease expires on Point A and the relocation to Point B completed.
 
More on these later.
 
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 Additional Ways to Avoid Rent Increases

If you attended last week’s column - you learned the two main ways to avoid a rental rate increase - know your owner and understand the value of your tenancy. If the bottom of your birdcage housed the Real Estate section prior to consumption - here is a brief recap.
 
Industrial lease rates have increased a whopping 134% over the past ten years. Recall, our market for manufacturing and logistics space was awakening from the ether of the 2008-2010 financial reset - errr meltdown and they’re were bargains galore. Now with the classic increase in demand from pandemic fueled buying and a pinched supply of available buildings - rates have skyrocketed! But, you may be fortunate to rent from an owner that appreciates your worth as a tenant and wants to avoid a costly vacancy if you bolt. If this is your situation and you’re approaching a renewal - count yourself among the lucky. Conversely, if maximizing the monthly income is your landlord’s objective - you could face an increase of double what you’re currently paying.
 
But, there is hope. Please keep in mind these three strategies to stem that spike in your monthly payments.
 
Buy a building. Historically, purchasing has been costlier than renting on a pure monthly outlay basis. Meaning - if we stack a mortgage, allotment for property taxes, insurance and upkeep together - the total will be higher than most leases. Plus, you must come up with a sum to bridge the gap of what a bank will loan and your purchase price - 10-25%. However, this is many times shortsighted when looking at a projection over the life of a company’s occupancy. You see, lease rates escalate over time - generally fixed at 3-3.5% annually. And, when a term expires, your landlord will bump the number even higher to compensate for the market variance. Currently, we’re seeing a huge boost in rental rates which eclipses that 3-3.5% annual escalator. Some find it better to own, finance the buy with fixed debt - thus stabilizing “rent”, enjoying appreciation and the tax benefits that accrue. A word of caution. If you enter the buying fray - be prepared. Structure your A-game with proof of your down payment, lender pre-qualification letter, and a well reasoned story of your desire to purchase.
 
Move to a cheaper geography. Once, the Inland parts of SoCal were cheaper, newer, and alternatives were plentiful. If you’re a logistics provider and you look East - this affordability gap is quickly narrowing. However, there are still “deals” to be found. Don’t forget areas just outside the state borders - such as Arizona and Nevada. You might even find a business climate that welcomes enterprise with goodies - tax breaks, employment incentives, and fewer regulations.
 
Do more with less. We toured an operation recently. Occupied was a big chunk of a larger address. Since they leased the space five years ago, several distribution centers had been added to their supply chain thus lessening their need for the square footage they leased locally. By trimming their premises by 40% - a great building popped up which fit their requirement. Another client of ours took advantage of the relative softness in the office space market and peeled away that portion of the company. Eliminating the people component from their warehouse created several new buildings to consider. Don’t forget. Your additional capacity might be found if you look up and maximize your stacking. Frequently, a group will believe they are out of space because their floor is consumed. Ignored is the two or three feet in height not used. With the advances of material handling equipment - you can literally use every inch if you narrow your aisles and pile your product high.
 
More on these later.

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.

Dramatic Rent Increases - Ways to Avoid Them

Lease rates for industrial properties in Southern California continue to rise! To place this in some context, if your direction - as a business owner - was to rent a location in 2011 and your operation consumed 100,000 square feet - you could expect to pay around $45,000 per month in rent. Of course, charges for things like property taxes, insurance and maintenance would have been in addition to the $45K. But, the additional charges would have added around $12,500 per month - bringing the total to $57,500 - $.575 per square foot. Flash forward to our pandemic fueled shortage of space these days and a comparable building leases for $135,000 per month! For those scoring at home - that’s a 134% increase in ten years. Or, a 13.4% annual increase. Simply nuts! Am I saying if you rented an address in 2011 and signed a ten year lease - when your lease expires this year - you can expect your rent to more than double? Yes! You got it. Wow! How are businesses able to afford such a whopping spike? Better still, are there strategies you can employ to stem the bumps? The answers are - I don’t know and yes. Indulge me as I outline a few ways to lessen the blows of gigantic rent inflation.
 
Know your owner. The gentleman to whom you send your rent each month, falls into a category of investors. Your tenancy is singular or multiple. Unfortunately, if you’re one of many and his buildings are full - your leverage is limited. You see, he may opt to push rents even if a move-out ensues. He’ll simply replace you. Conversely, if your rent is the biggest part of his retirement income - a bit more realism happens. If you relocate - and his music stops - so does his lifestyle. He’ll be more flexible with you to keep you in residence and avoid a costly vacancy.
 
Know your value. As a tenant, your worth is two-fold. First, the capitalized income you pay each year determines the dollar amount of the investment. Simply, $100,000 in annual rent - at today’s cap rates of 4.75% suggests $2,105,263 ($100,000/4.75%) - if a sale or refinance was considered. Why is this important? A bank would lend a percent of this amount if your owner needed cash. Plus, the market would gladly pay him this figure if a decision was made to cash-in or redeploy the money into another income property. Second, your tenancy is costly to replace. By this I mean - free rent, downtime, refurbishment, and professional fees - are forked over to secure a paying customer. So, let’s say the title holder of your location believes he can get $100,000 a year if you bolt. You currently pay him $80,000. If he’s correct in his assumption - he can achieve approximately $538,406 if he’s finds a five year tenant ($100,000 with a 3% annual rent escalator). However, if he lays fallow for two months, incentivizes the new group with one month of free time, paints and carpets the offices, and pays a commercial real estate professional 6% - count on an up front expenditure of $72,303 - ($16,666 for downtime, $8333 in free rent, $15,000 for fix up, and $32,304 in fees). If we subtract $72,303 from our expected new income stream of $538,406 our net take is $466,103 - $93,220 per year. You’re willing to pay him $90,000. So, he could be slightly better off replacing you. But, if any of his assumptions are wrong - he sits four months vs two as an example, he is better off renewing you at $90,000 per year. Plus, presumably you’ve paid on time, taken care of the premises and sent him a Christmas card. Those intangibles have credibility. He may have to chase the new guy to get his rent.
 
Know your alternatives. Don’t forget. You could buy a building, consider a cheaper area or opt for a shorter lease term.
 
More on these later.
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.

Sublease or Buyout?

We have previously discussed the ways in which you can extract yourself or your company from a lease obligation. As a quick recap. Leases are contracts which allow occupancy for a certain period of time (term) and for consideration (rent). As an inducement for your tenancy, an owner (landlord) may offer some goodies - free or abated rent, an allowance to fix up the place, or a right to extend your lease or buy the premises (options). In return, you agree to pay on time, stay the full period of the lease, and take care of the building. Easy, right? Not so fast.
 
Sometimes circumstances arise whereby the agreement must be tweaked. In the extreme - a dramatic decrease in revenue - leading to bankruptcy. Conversely, an uptick in sales could cause the need for more space. If a competitor is acquired or if the operation is sold - another shift occurs. Now, you have redundancy - too many facilities serving the same purpose. What to do with your lease(s)?
 
Remedies abound. You can sublease the building, buy-out, allow the term to expire, reject the lease through a bankruptcy, or default. Clearly the last two are not recommended as there are legal consequences - but they are a way clear.
 
Most opt for one or a combination of the first three - sublease, buyout or term out. But what are the differences and when should they be used. Please allow me to dive a bit deeper.
 
Sublease. Simply, you locate a surrogate. A group to replace you. But, don’t forget, there may not be another you readily available. Did your operation lease the first building you toured? Probably not. You considered multiple locations until you found the perfect fit of lease rate, landlord motivation, amenities, concessions, and term. Now, you are the landlord and must meet the nuances of tenants in the market. All, while having little flexibility. Your goal is to get out - with as little downtime and expense as possible. Remember, your rent and term are known. Where is that rate compared to comparable availabilities - above, below or right at market. If you’re below - count yourself fortunate! You’ve something to offer. But, how do you deal with an enterprise seeking a three year lease when you’ve committed to ten. Plus, you’ve consumed the inducements. By that, I mean your free rent burned off or the new carpet is old now. To compete, you may have to consider offering some giveaways. Subleases are messy! I’ve found the the most success when the rent is below market, a lengthy term remains - 5 years+, and the building is in pristine condition.
 
Buy-out. An owner of commercial real estate spends significant dollars to originate your occupancy. First, he sat vacant while his agent marketed the availability and searched for a tenant - all while continuing to pay the bank and operating expenses. Secondly, that free or abated rent is another cost. Third, painting the offices and adding new flooring isn’t cheap. Finally, he paid professionals to negotiate the lease. All told, an owner will outlay 15-25% of the lease term’s rent in origination costs! He then recoups the expense over the term. Therefore, if you approach your landlord with the question - “what’s it going to take to let me walk?” - he will account for all of the above. Generally, tenants find the price too steep and opt for another avenue. But, I’ve encountered situations where buyouts make sense. Typically, a spread exists between the stated rent and current market. A mid term remains - 2-3 years. And little cleanup is necessary.
 
Term. Clearly, the easiest. But seldom used. Why you might ask? Because the ends rarely meet. Sure, if you could time your company’s demise with the expiration of your tenancy - boom! Problem solved. Unfortunately, the dangling participle of term generally must be severed.
 
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 Tax Deferred Exchanges Worthwhile?

One of the perks of our profession is we get insights into future legislation at the state and federal level that can affect our livelihood. You see, the commercial real estate lobby is quite influential. Recall, the enormous push that occurred last year in California to defeat Proposition 15 which would have altered the way property taxes are calculated for commercial properties. 

Presently, there is talk in Congress to gut tax deferred exchanges that are accomplished through section 1031 of the Internal Revenue code. Payback for the enormous infrastructure plan must come from somewhere and wealthy commercial real estate owners are a likely target. 

Yesterday, I consumed a webinar hosted by David E. Franasiak, a Principal and Attorney at Williams and Jensen, PLLC and Julie Baird, President of First American Exchange Company. Discussed was the Biden Administration’s American Families Plan. Underpinning the direction - “The President would also end the special real estate tax break which allows real estate investors to defer taxation when they exchange property - for gains greater than $500,000”. Dissected were the three main components of the plan - a limit of $1,000,000 for couples filing jointly, Section 1031 would effectively be killed, and the proposal - if passed - could take effect for deal closed after December 2021. 

As a quick review, tax deferred exchanges allow title holders of commercial real estate to defer capital gains taxes upon the sale of an income producing property. Certain criteria and time frames must be met. Otherwise, if a sale occurs - approximately 50% of the appreciation is consumed by Uncle Sam and Cousin Gavin. Therefore, motivation to sell would be stripped except in extreme cases. 
Today, I’d like to look at exchanges from a different view - do they really matter to those without commercial real estate ownership? As I’m admittedly biased - I’ll simply offer three thoughts to consider. 

Commercial real estate transactions employee a significant number of people. My premise? Elimination of transactions lured by tax deferral would also crater all the jobs associated with those deals. I once calculated 32 different folks were involved in a purchase. Specifically, escrow agents, title officers, environmental surveyors, roof inspectors, general contractors, sub-general contractors - air conditioning, electricians, plumbers, flooring. Not to mention professionals such as CPAs, attorneys, and wealth advisors. Loop in a few brokers and the ensemble is complete. Dollars earned - by those involved - are circulated back through the economy and groceries are purchased, rent is paid, and college funds established. And, state and federal income taxes are paid from their earnings. 

Small business owners who reside in commercial real estate through ownership use the tax deferred exchange mechanism to expand their operations. Keep in mind, business owners use the IRS section 1031 to purchase larger facilities and grow their businesses. Operational growth means equipment is purchased, workers are hired, and taxable revenue is created. 

Elimination of the tax deferred exchange mechanism would reportedly generate $19.5 billion over 10 years on a $2.4 trillion stimulus package. Unfortunately, the increment is so small - it’s akin to a rounding error. Too often, we lose sight of the unintended consequences of actions we take. As an example, when access to home loans was expanded in 2006 - the sub-prime meltdown resulted. Granted, there was more to that story - but you get the idea. 

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.