FIVE Ways to Avoid Commercial Real Estate Rent Increases

Image Attribution: www.multifamilybiz.com

I have written recently about the increase in commercial real estate values in Orange County, California...specifically sale values. For months, I have predicted that lease rates would soon follow as the Econ 101 principal of supply and demand had to engage at some point.

You see, demand for commercial real estate in Southern California has far outstripped supply. Currently, ninety six to ninety seven of every one hundred buildings are occupied in Orange County.

Consequently, the rental rates had no where to go but up! This fact became painfully apparent this week for me as I sat in front of a dear client and friend whose commercial real estate lease expires in August of this year. He negotiated a killer deal in 2012 when the commercial real estate market was awakening from the ether. Now, at renewal time, he is faced with a thirty percent increase!

So, looking back, how could this have been prevented and what can you do to avoid a hefty increase in your commercial real estate rent?

Own your commercial real estate. If you have been in business five years or more, have been profitable for the past two years, can benefit from the property's depreciation, have some capital available that is not needed to grow the business, AND can predict your space needs for the next five years...YOU SHOULD OWN! Ownership of commercial real estate can eliminate the fluctuations of your rent because the purchase is financed over twenty five to thirty years. At today's super low interest rates, your rental costs are fixed at super low lease rates. My client checked every box but the space prediction. Because he couldn't forecast his space needs, I believe it would have been derelict to sell him a building three years ago.

Structure longer term leases. In my client's case, the culprit was a three year lease that commenced in 2012 and matured in 2015...awful timing. Had we entered into a five or seven year lease, who knows? We purposely opted for a three year lease because my client predicted he would outgrow the building in three years and didn't want to be saddled with remaining lease term on a building that he had outgrown. Had my client entered a longer term lease in 2012, he would still benefit from cheaper rent than the market rate today...but you know what is said about hindsight!

Negotiate extension rights. During the tough, down times owners will agree to extension options at fixed increases, or rights to extend at favorable terms. Once the market heats up, fixed rate options are a distant memory. In my client's case, we had negotiated an option to extend...but at market rates. The option was an afterthought because...once again...he believed he would not be renewing in three years and would be moving to a bigger building.

Understand the cycles. Generally speaking, commercial real estate moves in seven to ten year cycles. Our recent trough was 2009. Adding seven to ten years would place the peak at 2016-2019. However, some believe we are at the peak and we can only tumble from here. Regardless, consider where you are in the cycle and base your term of lease upon this...I guarantee you sophisticated commercial real estate owners time lease terms on where they believe we are in the cycle.

Know the owner's situation. If the ownership entity of the commercial real estate you lease is a private party (as was the case with my client), there should be a bit more flexibility in the terms he can negotiate. Although my client was hit with a thirty percent rent increase, the increase could have been much worse as the market could justify a fifty percent increase in his rental rate. The more institutional the ownership, the less flexibility.

How To Get Your Commercial Real Estate Leased or Sold Quickly

image attribution: www.geowize.com

You just received a call from your tenant. The good news is that the tenant's business is growing dramatically. The bad news is that your commercial real estate will no longer accommodate the tenant's growing operation and you soon will be faced with a vacancy. Bummer!

An empty building can be costly. Zero rent during the vacancy period as well as mortgage service, operating costs of property taxes, building insurance, landscape maintenance, etc. can become a mountain of losses very quickly.

The longer your commercial real estate lays fallow, the more apt you are to lease or sell the building for less money, just to stop the bleeding. So, what steps should you employ to get your property leased or sold quickly and avoid a lengthy vacancy.

Talk to your tenant. Make sure that your tenant has in fact leased or purchased a new location and that the tenant is not simply planning to move. With only four of every one hundred industrial buildings vacant in Orange County, your tenant does not have many alternative locations to lease or purchase. If the move is a maybe, there generally are ways to persuade the tenant to stay in your building. If the deal for a new location is done, explain to your tenant that you will be making a concerted effort to find a new tenant or a buyer before the tenant vacates and ask for their cooperation in showing the building during the marketing process and the remainder of their tenancy.

Decide on a direction. Will you seek a new tenant or is now the time to sell the building? If you would consider either, a greater universe of potential occupants exists. If your decision is to sell, make sure you are aware of the tax impact and after tax proceeds the sale will create.

Don't fly solo. Engage a competent commercial real estate professional to place your property on the market and expose the building to potential tenants, buyers and brokers who represent tenants or buyers. Rarely, do we see FSBO (For Sale or Lease by Owner) commercial properties on the market. I can only speculate that the complexity of commercial transactions dissuades an owner from pursuing this approach.

The occupied building. A real quandary exists here. Should you wait until the tenant vacates to market the property? Or, should you use the remainder of the tenancy (when you still have rental income) to find a new tenant? Unfortunately, there is no easy answer. You must weigh the benefit of a "move-in ready" building with the downside of no income while the building is vacant. In my experience, empty buildings lease or sell quicker than occupied buildings especially if you have the resources to refurbish the building prior to placing the building on the market. Occupied buildings are difficult to show and challenging for the future occupant to envision their operation squeezing into the building.

Create a digital footprint for the building. I have found that a virtual video tour is the best way to make sure that your building can be found in on-line searches. Additionally, some commercial multiple listing services, such as LoopNet, spend tons of money with search engine optimization. Make sure that your broker publishes the availability on LoopNet.

Be realistic in your expectations. Your goal is to lease or sell your building for the most money you can within the shortest period of time. Got it! If you ask too much for the building you will dissuade prospective occupants from leasing or buying your building. You will fall into the unrealistic owner category. The market may catch up to your inflated idea of your property's worth, but when? A better approach would be to price your building in accordance with the most recent comps in the market plus a small percentage for negotiating room.

How to Sell Leased Commercial Real Estate to an Owner Occupant

Image Attribution:www.cremodels.com

Your commercial real estate is leased, you have decided that NOW is the time to sell the building and you have been advised that there is a "user premium" to selling the building to a company that will occupy vs selling the building to an investor that will collect the rents as a return on the price that she pays you for the building.

So just how do you navigate these waters and sell the building to an owner occupant...all while keeping your current tenant happy...and not spooking the current tenant into vacating the building prior to their lease expiration.

In no particular order, here is what I recommend that you consider:

Your existing tenant is your BEST buyer. I always recommend that you approach your tenant with your desire to sell. Because your existing tenant avoids the cost of a move, a costly fixturization of a new space, a disruption of his employees, and is comfortable with the layout, amenities and location of the building...he is the BEST buyer in many cases. However, your tenant may not want to buy the building. Publicly traded companies typically would prefer to lease commercial real estate to keep depreciation off balance sheet. Your tenant may not be financeable. Or, your tenant may foresee outgrowing the building before the next lease renewal, thus forcing a move. Regardless, thoroughly investigate your tenant's desire to own your building.

Lease term matters. Generally, if your tenant has eighteen months or more on an existing lease, too much time remains for the building to be attractive to an owner occupant. The primary reason is financing. Most owner occupants finance commercial real estate purchases with SBA loans. SBA covenants require that the owner occupant occupy at least fifty one percent of the building within one year. So with eighteen months remaining on a lease, there is adequate time to find a buyer and conduct a sale escrow with an eye toward an ownership transfer within a year or less of the lease expiration.

Consider the marketing process. In order to obtain the highest value for your commercial real estate, you will want to list the property with a commercial real estate broker and run a marketing process. A portion of the marketing process is signage in front of the building and tours through the building with potential buyers. How will your tenant react to these things? If the operation currently housed in the building is sensitive to outside visitors, this can be challenging.

Make sure your tenant understands what you are doing. If your tenant elects not to buy the building, you must be VERY specific with your tenant as to the potential outcome of your marketing process...you will sell the building to a company that will occupy the building when the tenant's lease expires...which means the tenant will have to move.

User premium, real or imagined. Historically, in Orange County, owner occupants (users) have been willing and able to pay more for a building than an investor who buys the building for the rental returns. With so much investor money in the market chasing returns, investors will accept a smaller return. Smaller returns coupled with rising lease rates have resulted in investor pricing quite comparable to owner occupant pricing. If your tenant is adamant about renewing OR if your tenant has at least three years remaining on his lease, you may be surprised at the price the real estate will fetch if you sell to an investor who will not occupy the building.