Advising a #CRE Client in an OVER-HEATED Market

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World events have business owners a bit spooked these days.

China's economy is imploding, our stock market is crashing, commodity prices (especially oil) are at historic lows, wages have remained flat since 1977, sluggish labor participation for American workers, and the threat of Islamic terrorism - oh, and a new presidential administration is on the horizon.

Curiously, vacancy rates for industrial buildings in Orange County, California have never been lower, sales prices have eclipsed the Mount Everest 2007 levels, lease rates are increasing, and interest rates continue their Eisenhower era bump across the bottom.

Truly, two extremes exist. Advising commercial real estate owners and occupants becomes challenging. So what am I telling my clients?

If you own and occupy your commercial real estate. Take a hard look at your business that occupies the commercial real estate. What is your succession plan? How old are you? Would you benefit from selling the commercial real estate today and leasing the building from the buyer for three to five years? The answers to these questions can illuminate a direction. Said simply, there has never been a better time to sell commercial real estate - if - the need for the building has passed - or will within the next three to five years, you have a place to deploy the sale proceeds, and you can't fathom yourself as a landlord. If the building meets your needs, you have a deep family membership that will run the business for years to come and you have a loan, now is a great time to refinance.

If you lease your commercial real estate. One of several scenarios may exist. The advice that I give depends on the scenario.

• You have two of more years remaining on your lease - not much to do here, unless, your needs for the building have changed. In that case, there are a number of ways that we can assist in making the building more suitable so that you can live out the term of your lease. I discuss these things in this post.
• Your lease will expire in fewer than two years. Time to get busy! You will make a decision to move and buy, move and lease, or stay. Now is the time to plan for your move if that direction looks appealing. Remember, with 98 of every 100 buildings occupied, your choices are limited and prices are overheated. If you want to stay, try to negotiate a renewal today with a term fewer than two years. I'm concerned with committing to a long term lease today that could find you paying much more than the market in a couple of years.
• Your lease has expired, you are occupying the building on a month-to-month basis. Oh boy! Phone your owner today and get yourself a lease for at least one year with some options to renew. You are vulnerable! Imagine your owner calling you next week to inform you that he has decided to sell your building and you must move out - it happens!

If you rely upon commercial real estate as an investment. Lock your tenant in for as long as possible, today, or consider selling the building today to the occupant, paying the taxes, putting the money in a CD, and waiting patiently. I believe some buying opportunities will present themselves in the next two years.

You will notice I give conflicting advice to investment owners vs occupants. Good get! And, you're exactly correct. Differing objectives means different advice.

My Commercial Real Estate Didn't Appraise...Now What?

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Appraisals of commercial real estate are required if you are financing your purchase through a lender - conventional or otherwise.

The possible exception might be an owner financed purchase. In that case, the owner becomes the bank and may not require an appraisal.

An appraisal is a lender's way of "hedging their bet" to insure the agreed upon value - the negotiated purchase price -  is consistent with the market.

An appraiser is generally engaged by your lender and looks at three measures of value: market approach - recent sales of comparable buildings, the income approach - capitalized market rents, and cost replacement approach - the price of land plus depreciated construction costs . These three value measures are compiled, reviewed by the lender and a value is determined. The appraised value is then compared to the negotiated purchase price. If the appraisal supports the negotiated purchase price, great! If the appraisal is less than the negotiated purchase price, there is an issue.

So what can be done if the appraised value is less than the price that you and the seller have negotiated? In my experience, one of several solutions exist.

The seller can reduce the purchase price. The solution is simple but not easy to accomplish - especially in a robust market where buyers are plentiful. The seller chose you as the buyer because you had the best offer, the greatest motivation, or for another reason. Remind the seller of this fact. Also, if the building didn't appraise with your lender, there is a high likelihood that the building will not appraise with another lender. The low appraisal is now a material fact that will need to be disclosed to the next buyer - hmmm. Maybe a price reduction isn't so bad after all.

You can invest a larger down payment. If the seller is adamantly against reducing the purchase price, you can bridge the gap by making a larger down payment. Just understand your lender believes you are paying too much for the building so examine your reasons for buying the building.

A combination of the two solutions above can be used. Frequently, the seller and buyer will compromise and the seller will reduce the price slightly and the buyer will invest additional dollars to close the transaction. I would say this is the most common way in which a low appraisal is remedied -  both parties participate to solve the issue.

An appeal can be made to the appraiser. Prior to the economic collapse of 2008, this was a viable option. We could "massage" the appraised value by talking to the appraiser, looking at the value measures and suggesting other comps, capitalization rates, or construction costs. These days, we have very little latitude because brokers are divorced from the appraisal review and the final determination of value. If all else fails, however, this is worth a shot.