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

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

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

In my experience there are at least five "gotcha" issues that should be addressed in any commercial lease agreement. In my layman's opinion, The AIR lease addresses these issues quite thoroughly...with a few tweaks. In the case of an owner generated lease, the issues vary in their treatment.

The five issues are: Operating Expenses; Capital Expenditures; Subordination, Non-Disturbance, and Attornment (SNDA); Rent Increases, and Miscellaneous. I will define each issue, and suggest "asks" during the lease negotiation. This is a layman's review as a commercial real estate practitioner and should not alleviate the need to have all legal documents reviewed by counsel. These issues are from a California perspective and may vary by state.

Operating Expenses (Industrial): Operating expenses, also known as Op Exes are the expenses that an owner incurs in the operation of a property. These expenses include, but may not be limited to, property taxes; property insurance; maintenance of the foundation, roof, and walls; landscape maintenance; maintenance of the building's systems...plumbing, electrical, HVAC, etc.; utilities; occupant's share of the amortized capital expenditures, etc. The costs are sometimes referred to as NNN expenses or "gross-ups". These expenses vary greatly based upon an owner's management preferences but are largely skewed by the amount of property taxes. If you negotiate a NNN lease, the costs are paid in addition to your rent...either as due or monthly. If the lease is an industrial gross lease, the base year op exes are included in the base rent. Ask: I suggest postponing the base year until the first full year after the commencement of the lease. If the lease commences in February, this is a tough ask. If the lease commences in October...not so much. I suggest asking for a cap on the increases in op exes over the base year.

Capital Expenditures: Capital Expenditures are expenses that are largely non recurring such as roof replacement, parking lot replacement, drive and landscape modifications, etc. Ask: I suggest there be a mechanism in the lease to specify that any expense that exceeds 50% of the cost to replace a capital system (roof), be the responsibility of the owner and the cost be amortized over 12 years at an agreeable rate of interest.

Subordination, Non Disturbance, and Attornment: This is defined as the financing holder's means of securing their interest and the outcome of any foreclosure. Also known as an SNDA, this clause causes the lease to be subordinate to existing and future financing that is placed on the property. As a tenant, a request that the lease be non-disturbed (terms not modified), should be sought in return that the tenant agrees to attorn (recognize) an owner that becomes the owner through the foreclosure of the underlying debt. Requiring ALL of these is important in my opinion...especially during economic times that could suggest a high likelihood of foreclosure. Ask: I suggest that the lease clearly provide for ALL of the components...S, ND, and A, and that where possible the lender be persuaded to sign an SNDA recognizing the lease.

Rent Increases: These are defined as increases in the rental schedule during the term of the lease. Generally, the increases are at a fixed percentage increase annually or vary based upon the change that occurs in the Consumer Price Index or some other inflationary index. Ask: If a fixed increase cannot be negotiated, Caps and Floors are always suggested to hedge against a rampant inflationary increase.

Miscellaneous: Former and existing cabling removal, ADA requirements (and who is responsible), city permitting, subleasing and assigning, rent abatement vs FREE rent, and options to extend and purchase should all be carefully vetted and when necessary, negotiated.

3 Reasons WHY FLEX commercial real estate so HARD to Lease or Sell

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Flex commercial real estate, AKA research and development buildings, AKA industrial buildings with too much office space!

Just WHY are they so incredibly difficult to lease or to sell?

This post will provide some insight into why this product category too often finds itself on the Island of Misfit Toys.

Background: When Reagan was POTUS...some of us were brokering in those days...before the widespread use of desktop PCs, the internet, and mobile devices, etc., we lived in a mainframe world of large, bulky, power devouring computers which required tons of space. The design, manufacture, and assembly of these behemoth machines required a huge building footprint from which to operate. Commercial real estate of the day was ill equipped to house these employee heavy, image conscience operations. Industrial buildings generally lacked the parking, image, and amount of office/assembly space that the typical R and D guy needed. Traditional office space was absent the manufacturing and assembly areas..as these uses needed heavy power, truck loading doors, high bay warehouses, etc. Commercial real estate developers, during the decade of the eighties, saw an opportunity to produce space (R and D/flex buildings) that would accommodate the high tech computer uses of the era. R and D buildings...which later were named flex buildings...are a hybrid of an industrial building and an office building.

So with that brief historical snapshot, what makes these buildings so difficult to lease or sell when they lay fallow?

The office space doesn't meet today's needs. A typical flex building would have 30-50% drop ceilinged, air conditioned office space. If the total building was 100,000 sf...30,000-50,000 sf of office would be included. The proportionate employees that would occupy that space would be 90-120 folks. Engineering, clerical, sales, accounting, managerial types are not office bound anymore...they can work from their basement in their bathrobes or from a flat in Sri Lanka. Today's office environment includes fewer space hogs...computer servers, management heavy production teams, phone switches, and large desks and credenzas and is conceived in a more open collaborative setting. The days of giant private offices or of dark back office dungeons with no outside light are reserved for Madmen. Converting the old eighties styled office layouts to today's open concepts is expensive...many owners don't have the funds to invest in an upgrade...so they make the decision to see what tenant comes along  that may be less costly to re-purpose. Why not just eliminate some of the office space and convert it to warehouse, you may ask?...not so easy as much of the space was built as a second story. You can remove it but what's left is unusable as office OR warehouse.

The pool of users got smaller. Computers are MUCH smaller and require less real estate. Much of the guts of today's technology is manufactured in cheaper off-shore locations. So, fewer companies require flex space. What about the modern day tech companies, you may ask? One tour of a Google, Microsoft, or Amazon campus will quickly educate you upon how differently these tech giants work and collaborate today.

The industrial space lacks amenities. Too often the industrial portion of these R and D buildings was designed with a single purpose in mind...manufacture and assembly of electronic components. Consequently, warehouse clearance is skinny...no need to stack very high, loading is compromised...the raw materials and finished products were small so most arrived and departed in small trucks that didn't need dock high loading doors. Rarely is any outside yard storage or staging available...as outside area was reserved for employee parking...plus, the components were too valuable to store outdoors, anyway.

HOW to Successfully Negotiate a Commercial Real Estate Price Reduction

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Recently, I have encountered two situations where buyers have attempted to reduce the contract purchase price while in escrow with the seller.

In one case, I represented the buyer and in the other, I represent the seller...as the conversation is ongoing.

This post will be aimed toward buyers.

If you are considering buying a piece of commercial real estate, there is a chance that you will encounter issues with the building...the roof has eclipsed its useful life, an inoperable HVAC unit (s), an environmental spill, an alligatored parking lot, etc.  Unless the seller has spent money conducting property condition assessments, and discloses the property's condition, chances are you will have to perform your own inspections to understand what you are buying.

Be prepared to encounter SOMETHING!...and have a plan in place. To prepare for discovering issues that need to be addressed, there is a strategy that you should employ. I have used this strategy many times to successfully negotiate a price reduction when something untoward is discovered during the buyer's due diligence.

Below is the strategy:

Don't attempt to extract the VERY last dollar in the initial negotiation. I have witnessed countless buyers that negotiate like Donald Trump on steroids...they are going to get the VERY last ounce of blood out of that seller...no matter what. If the seller agrees to the price that the buyer demands, there is an artificial line drawn in the sand...I'll agree to this price...but not a penny more! I advise buyers to aggressively negotiate, BUT, leave a little room in case something is encountered...which is ALWAYS the case...during the inspection of the property, the environmental survey, the title review, or in case the property doesn't appraise. In many instances, you as the buyer, can receive a larger price reduction...to correct issues...than if you had hammered the seller in the initial negotiations. The reason is...you have a tangible reason to request a price reduction.

Use reputable inspectors. You MUST engage reputable environmental consultants, building inspectors or contractors to provide a thorough survey of the building. Avoid using a contractor that provides the survey AND accomplishes the corrective work as this can create a conflict of interests...I'll provide the report inexpensively in return for accomplishing the recommended repairs. DEMAND that the contractors provide written reports. If the reports recommend repairs, take the time to get bids on ALL of the recommendations. You now have a concrete basis from which to request a price reduction.

Understand the seller's situation. Does the seller have a back up offer that he has accepted subject to you not performing per the terms of the contract? If so, he will be less likely to reduce the price or worse...he will cancel your deal and move to buyer number two. Does the seller have sufficient equity in the building to provide a price reduction? If not, you can clamor all you want...but the money just isn't there. Is the seller a bank or is the seller a private individual that can listen to reason?

Be realistic. You may have a written report (s) that suggests repairs are needed in the amount of x dollars. Are you asking for the seller to provide brand new HVAC units on a twenty five year old building? Can the roof be repaired to milk several years of life or must it be replaced? What if the seller says no to ANY price reduction...are you prepared to walk away? Consider all of these factors before you simply request a dollar for dollar offset.

A price reduction is generally preferable over a credit. There are three ways to handle repair requests...a reduction in the purchase price, a credit in escrow, or allowing the seller to make the necessary repairs. When I represent buyers, I suggest a price reduction for three reasons. The tax basis in the building is lowered which means the buyer has a smaller property tax liability over time. Lenders these days avoid credits as the loan ratios are affected negatively. I recommend the buyer accomplish the repairs with the reduced price vs. relying upon the seller to fix things to the buyer's satisfaction.

How do you KNOW if your Commercial Real Estate is OVER-Priced?

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Pricing. Ahhh, the P word. As commercial real estate practitioners we become keenly aware of pricing and whether a building is over priced, under valued or just right!

In the seller's market in which we are immersed, determining pricing for a vacant industrial building becomes a big challenge. I believe more challenging than a buyer's market.

Why, you may ask? Because as a market escalates and demand from industrial occupants sky rockets, you don't want to under value a building and consequently you must guess at where the next pricing plateau will be achieved and how is the new price justified. This requires a bit of pixie dust.

From experience, I employ the following system to determine pricing recommendations:

First, I take a look at the commercial real estate and note the building's features...size, percent of office within the building, location, freeway access, power, loading, warehouse clearance, fenced parking, fire sprinklers, column spacing within the warehouse, truck turning radius, etc.

Next, I analyze recent sales that closely mirror the features of the building I am evaluating. A certain lack of features will devalue a piece of commercial real estate - such as a warehouse with limited ceiling height or a building with more office than the parking can support. A recent set of comps will let me know where deals have transacted for similar properties.

Then, I pull a list of currently available  buildings that would compete with the building I am pricing. How many are there? Where are they priced?

Lastly, comes a bit of broker magic. I determine if the market is up or down trending and add a bit of up or down wiggle room to my pricing recommendation.

So assuming I get the assignment to sell or lease the building, How do I know if the building has been overpriced? Generally, one or more of the following will happen:

The phone will ring non-stop: Oops. Either I underestimated the demand and priced too low or there is a supreme shortage of available buildings and I'm the only alternative.

I will receive no inquiries: Functionality. There are not enough occupants in the market that need the features that the building contains...or lacks.

Many tours will be generated but no offers will be received: Pretty much a pricing issue. Many tours, no offers generally means you have scared the market of available occupants with your pricing.

Regardless, you should have some really good data points within the first thirty days of the marketing process.