Friday, September 24, 2021

Buying Commercial Real Estate - Closing the Deal

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Today, I focus my labor on the closing process. After all, I’m penning this post prior to the Labor Day weekend - so it proved prescient. Whether you rely upon the rent generated or for the utility gained by your business - an investor or an occupant - you execute a similar process to become a owner. Let’s dive in, shall we?
 
A search is conducted, a candidate for purchase selected and negotiation commenced. Simple. Once the terms of the buy are settled between you and the seller, a contact is drawn - known as a Purchase and Sale Agreement. Easy. But now the fun begins. The parties - buyer and seller must now complete the deal. What occurs after the paperwork is signed is the subject of this column.
 
Purchase and Sale agreements - whether standard or proprietary - provide a roadmap for how to proceed. Price, financing - if any, due diligence period, escrow holder, title company, deposits to open, deposits once contingencies are waived, and closing period are all neatly niched.
 
Price. Fairly straightforward but typically a combination of cash and debt. The seller - unless providing a loan - receives all the proceeds - less closing costs once a deed is recorded. Can this sum vary from what’s agreed? Yes. See “due diligence”.
 
Financing. Many deals we see these days are financed but not subject to lender approval. Confusing? Yes. But this seller’s market, in which we are mired, has produced this wrinkle. A seller may say - sure, Mr. buyer. Go get a loan. But, failure to qualify won’t allow you to cancel. Plus, if your lender is tardy - tough taco. In a more conventional approach, a buyer seeks loan proceeds to couple with her cash infusion to make the buy. If she can’t get a loan, she walks away and her deposit is returned.
 
Escrow. Generally, in California, an escrow holder is a clearinghouse to accept the agreement and conduct the symphony - also known as executing the deal. Deposits, documents, and closing instructions are all neatly folded into an escrow holder’s task.
 
Title. Most title companies also have an escrow department but frequently, these two functions are separate. Your title officer will produce a preliminary title report - a “prelim” early in your transaction. This uncovers things such as loans the seller has ordinated that must be paid, easements, liens, status of property tax payments, legal description, and other “exceptions”. A commitment to insure a clean title will be issued. Should a problem arise post close - you’re covered.
 
Deposits to open escrow. In commercial deals - there is no real standard. It’s whatever the buyer and seller negotiate. However, typically these run about 3% of the purchase price. Should the buyer elect not to proceed with the purchase and prior to waiver of contingencies - in most cases, the deposit is returned.
 
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.
 
Deposits once contingencies are waived. Ok. You’ve traveled the gauntlet of contingencies and are full speed ahead. You’ll now add some “skin” - in the form of an increased amount of money - to the escrow. Deposits, by the way, are generally applicable to the purchase. But, once you nod your head - deposits are non-refundable. Can you still back out? Sure. But not for free.
 
Closing. A cacophony of chords completes the transaction. Akin to a family reunion group photo - all must be looking at the camera and smiling before the image may be captured. Lender funds the loan, buyer adds the supplemental dollars, granting deeds are deposited and recorded, and monies are apportioned - seller gets hers, buyer gets title, lender gets a trust deed, and agents get their fees. Boom!
 
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.

Friday, September 17, 2021

Number One Concern

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Thanks to my neighbor Rudy - my staunchest critic and biggest advocate - for the column idea. As I pen this post from my garage office, I’m reminded of myriad conversations I’ve had lately with manufacturing and logistics companies throughout the OC and the IE. Ask any small business owner what their number one concern is these days - AKA what keeps them up at night - and universally you’ll hear…the lack of quality employees from which to choose. Doubt what I say? Just drive around and you’ll be feted with featured “now hiring”, “help wanted”, and “apply within” signs. One of our clients - who operates an adhesives manufacturing operation - has resorted to “bounties”. He pays his existing workers $500 per referral that result in a hire. His only qualifier is the new employee must stay for at least six months.
 
You may be wondering what any of this has to do with commercial real estate? Just this. Relocations are triggered by several factors. One of these is an expansion of commerce. Added business is fulfilled through the addition of employees, machinery or both. Commercial real estate houses said enterprises. If a building has capacity - ie: places for the extra folks to sit or spaces in the plant for the equipment - no issue. In the alternative - big issue. Now, the company must place a “band aid” by doubling up offices, adjusting the shop, or moving to larger quarters. As I’ve written ad nauseam - there is an acute lack of vacant industrial space in the market - so the problem compounds. But, this tete-a-tete will be tabled for another time. Today, I want to focus on the shortage of workers and my suggested fixes.
 
I read with great interest today how California’s unemployment rate is one of the highest in the nation. Hmmm. Then why is hiring such an issue? Some may opine. In the early days of the pandemic - our government paid people to not work. Good decision? Initially, yes. But, from what I hear from employers - the prolonged subsidy has created lethargy in our workforce. After all - why rise early, schlep the freeways, and encounter a cranky supervisor if you can make just as much by NOT working?
 
But in my view, the drought is more systemic. I believe we’ve done a substandard job - sorry for the pun - of preparing tomorrow’s workforce for the jobs that will exist when they graduate high school or college. Specifically, in our trades - carpenters, painters, electricians, plumbers, welders, contractors who repair air conditioning and heating, appliance and flooring installers, etc. there’s a huge imbalance. If you’ve a stopped up drain - good luck getting someone out to repair it anytime soon.
 
Most of these trades are learned through an apprentice program. Unions understand and train accordingly. But many times, a more seasoned non-union individual passes along her craft to the next gen. But what about vocational training in high schools? Remember the days of wood shop, auto shop and home economics? But how about building stuff?
 
The next gen should be willing to learn because the income potential is unbridled! Maybe these jobs lack a “coolness factor”. It’s not that appealing to work in a hot attic versus an air conditioned suite. Plus, we as a society are partially to blame. But, I won’t go there.
 
As to skilled labor such a CNC machine operators, plastic injection molders, die cut operators, truck and fork lift drivers - I believe the solution might lie within our community colleges. Wonderfully positioned - and state funded - to serve the local employer needs - these centers for learning are perfect! How about a partnership with the largest local job creators and academia to understand the needs and accommodating them?
 
With a little planning and leadership - we got this!
 
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.

Friday, September 10, 2021

Why Make it So Hard?

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My neighbor constantly reminds me my voice echoes with commercial real estate owners well above his pay grade. Certainly not my intention but I take any comments to my missives seriously and attempt to morph into a more meaningful messenger. Regardless of the size of a commercial real estate portfolio - one multi-family property or global holdings of distribution boxes populated with Amazon-eque tenants - investments are simple! Why do we make them so hard? You see, any investment of money seeks a return. Period. Sure. You’d like the return to be commensurate with the risk. But after all the fancy terms of capitalization rates, internal rates of return, replacement cost, source of capital, exit strategy, expense leakage, cash on cash, leverage, etc. it’s really about this. I shell out this much money and get this much back. Mic drop.
 
Commercial real estate brokerage is simple. Why do we make it so hard? A real estate transaction - a sale or lease of commercial property - has two sides - an owner and an occupant. Now. The occupant may seek to lease or own and the owner may want to sell or lease - but you get the idea. Inject our representation and you now understand what we do. We are matchmakers of sorts. An owner engages us to locate a tenant or buyer to fill her vacant building and/or an occupant awards us the opportunity to source a location for their use. The former assignment is known as a listing and the latter an occupant representation. If you ask me what I do and I respond - “I sell commercial real estate” - you’ll probably wonder - “what the heck is commercial real estate?” But if I explain - “many of our clients are family owned and operated manufacturing companies experiencing a transition - such as a move” - my guess is you’ll have a better idea what fills our days.
 
Networking is simple. Why do we make it so hard? I’ve often opined - “the true value of a commercial real estate professional is the depth of her network.” Need a roofer? Got you covered. How about a legal professional to draw a new LLC? Hold on - I have several. Someone to install new warehouse racking? Yep. Got just the gal. But all of these examples are “downstream” of the deal. By that I mean the need is after - or “downstream” of the sale or lease. But, what about “upstream”? What classes of professionals see a transaction before it takes flight? The answer harkens back to what we do. Remember - “many of our clients are family owned and operated manufacturing companies experiencing a transition - such as a move”? If we focus on those professional service providers who complement not compete with our efforts - a treasure trove emerges. As an example - let’s say a manufacturing concern experiences a record year but leases their building. During a periodic meeting with her CPA these facts are discussed - revenue and leasing. If the CPA advises his client to buy a building - you get the idea.
 
Business is hard enough. Your commercial real advisor should make it easier for you.
 
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.

Friday, September 3, 2021

When Will the Music Stop?

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One of the benefits of a five decade tenure in an industry is hindsight. Yes. It’s always crystal clear! Unfortunately, looking into the future is a bit murkier. Sure. Folks try. Every January, we are festooned with economic forecasts from scholars. Doubt what I say? Simply tune in for the Chapman, Cal-State Fullerton, UCLA, Charles Schwab reviews and others. All will give their opinion on what the blossoming year will have in store for our economy. Predicted will be growth in commerce, changes in consumer confidence, outlook for interest rates, stock market trends, inflationary pressures and the impact of all of the above on real estate pricing. But it’s August, you may be thinking. Why look forward to January? Well. When you see Christmas decorations next month - you’ll understand. These next four months will fly by!
 
I’ve consumed several of these Nostradamus events over the years. One of the most meaningful was in February of 2020. Featured was a panel of experts assembled by Northwest Mutual. One of the gentlemen in particular gave a brilliant narrative on the forces that cause a downturn. From my notes - “mentioned during the preamble was a check of five factors which cause bear markets - inflation, recessions, commodity shortages, crazy market valuations, and uncertainty.” Hmmm. Sound familiar? For those scoring at home - we have seen all five since March of 2020. So where is the downturn?
 
In particular inflation. Commercial real estate rents have increased 134% since 2011. A whopping 13.4% per year. If we dissect this further, the last eight months have produced a rise of 12.6%. Annualized - that is 18.9%! Investors, therefore are ravenously absorbing buildings with crazy high rents at - yep. Crazy high valuations. Take a look at the pump. We paid $4.89 for a gallon yesterday on the way home from Arizona. Silly me forgot to fill up before we crossed the border. Lumber? The price of a 2 x 4 has gone from $2.00 to $8.00. Container loads from China have quadrupled as well. So where is the downturn?
 
Let’s talk about uncertainty. One thing that can kill a rally quicker than anything is uncertainty. You see, when businesses or investors are unsure of the future, they postpone buying decisions. This “pause” trickles through our world. During the financial meltdown of 2008-2011 - our real estate market was mired for close to a year. Prices tumbled. Buyers and tenants enjoyed amazing deals once they saw a clear path of improvement. We certainly experienced such a stall in industrial activity between March and June of 2020. But then, something quite unforeseen occurred. Industrial demand went on turbo-charge for the balance of 2020 and the first seven month of 2021. As buying habits morphed from trips to the mall to clicks on the keyboard - commerce adjusted, space was consumed, and record profits resulted. So where is the downturn?
 
Ok. Commodity shortages. Those raw materials used to make stuff - copper, lumber, oil, steel, etc. Since we rely upon our neighbors in the Far East for much of this production, and with the noted container load disruption - you got it. Short supply. Certainly, this adds upward pressure on pricing. Plus, you just can’t get things. If your fridge goes on the blink - good luck getting a replacement. Roofing for industrial buildings - the steel trusses? 13 month lead time! But where is the downturn?
 
Hopefully, you’re getting the idea. We’ve survived a “black swan” event - a once every 100 years pandemic and the resulting five factors - inflation, recession, commodity shortages, crazy market valuations, which should have cratered real estate. And the opposite has occurred.
 
So, where is the downturn? It’s coming, dear readers. It must. Will it be a spike in interest rates, another round of lockdowns, a power surge wiping out the grid, a burst of the pricing bubble, an attack on our soil, a Japanese-esque decade of zero interest and growth, something else, a combination? I only wish my crystal ball wasn’t so murky.
 
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.

Friday, August 27, 2021

When is Commercial Real Estate a BAD Investment?

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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.

Friday, August 20, 2021

Things to Consider When Buying a Building

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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.

Friday, August 13, 2021

Two Things that Derail Most Sale-Leasebacks

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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.