Investors, Investors, Investors

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Your investment stake in commercial real estate varies based upon your use of said real estate. If you occupy your business address - you are an investor of sorts but generally classified as an owner occupant. Conversely, if your monthly income relies upon a rent check from your commercial real estate purchases - you are an investor owner.

Today, I thought it would be fun to dissect the sundry sorts of investors we encounter in the commercial real estate profession. So, in no particular order - here goes.

Owner occupants. Let’s start here. Important to understand is an investment is made in a location by the owner of the business - simple! Not to confuse things - but generally, owners whose businesses live in the buildings they own have an investment structure. Most typically, the proprietor of the company creates a Limited Liability Company - an LLC. Title to the real estate is then vested under the name of the LLC. Occupying the parcel is the business. Frequently, the business has a different ownership - IE a Sub Chapter S Corporation. Although the LLC and the Sub S have synonymous underlying principals - they are two separate entities. Therefore the Sub S pays rent to the LLC. The LLC is the investor and the Sub S is the tenant. 

Whew! As you can gather, a myriad of places to invest money exist for a small business. Machinery, equipment, customer acquisition, and new employees all compete for the investment dollar. Considered must be the return on investment for all of these opportunities to grow the business. Specifically - if I buy a new machine and spend X amount of money - will sales grow proportionately vs. how will a purchase of my premises affect the expansion of my enterprise?

Private capital investors. Generally defined as the use of your own money - in this case dollars generated from the investor’s hip pocket. Certainly a bank may have been used to finance the real estate purchase but the down payment came from a non-public source. In the case above - an owner occupant - consider what happens if the business that occupies the building is sold but the commercial real estate is retained. Now, that owner occupant becomes an investor owner. Before, he controlled the tenant - an operation he owned. Now, he simply owns the real estate. 

We have a client who parlayed this method into a fairly substantial commercial real estate portfolio. Acquired were the properties - in different locations - his company occupied. Amassed were a dozen or so buildings. He then sold the business, struck long term leases with the new company for all of his properties and voila! He is a private capital investor. Before, the operation he owned made money and paid him rent - a daily double. Now, the returns are only from the rental income.

Institutional capital investors. Broadly defined as the use of other people’s money - OPM - institutional capital can vary widely from friends and family to the State of California’s Public Employee Retirement System - CalPERS. An institutional investor uses these funds to buy and manage commercial real estate. Clearly, different levels of sophistication are needed. Regardless, a tenant must pay rent in order to generate a return on the invested proceeds. Occasionally, these institutional investors will package their holdings and create a publicly traded company - known as a Real Estate Investment Trust - REIT. A stock is available to buy and sell through a stock exchange - NYSE or NASDAQ. As every share of stock is valued the same, easy transition in and out can transact. Your dividends are generated from a small sliver of rent from the underlying buildings. Quite creative!

Leases, Subleases, and the Like

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Your business expansion will enjoy more space very soon. Now your employees can park at their place of employment vs down the street. Crisp new offices or tons of manufacturing space await you in the new location. You cant’t wait!

You’ve opted to lease the new spot and postpone ownership. You’ll encounter two leasing scenarios once you scour the market for suitable addresses - leases and subleases. So what are the differences? Indulge me while I describe them.

Leases are negotiated directly with the owner of a parcel of commercial real estate. Therefore - they are referred to as direct leases. Normally - your initial conversations will be through your commercial real estate professional. The deal you get depends upon the landlord’s motivation, competition in the market and the skill with which your broker volleys. She will work with the owner’s rep to craft your agreement. Outlined will be a monthly payment amount - rent, number of years - term, increases in rent throughout the term - bumps, and concessions - free or abated rent, refurbishment, and extra stuff - tenant improvements. An early termination right, extension rights through an option to renew, right of first refusal, or right of first offer to purchase may also be included. Once you reach a pact - you and the owner will sign a lease, you’ll deposit the requested amounts and secure insurance. Now your company can live in the new location for the agreed upon period - let’s assume five years.

But during the lease term - something untoward occurs - a decline in sales, someone acquires your company, you decide to move your manufacturing function to China, or California imposes a huge levy on your product - which dictates a move out-of-state. You find yourself with a glut of space - for which you’ve committed! Now what? Well, those circumstances, dear readers create subleases.

A sublease is akin to a remnant sale at your favorite carpet retailer. A full roll of flooring is not available - so you get to pick from what’s left. Because a finite amount remains - little flexibility exists. If the scrap fits your area - great! You benefit. But if you’ve a larger area to cover - you’re hosed. Also, the smaller the amount of over run- the fewer takers. Now a price discount must be employed to liquidate. Ouch.

With a sublease - the primary motivation is to stem the bleeding. Excess space wastes rent payments. The thought of providing any concessions runs contrary to a desire to move-on. Consequently - a different dynamic unfolds compared to a direct lease. Plus - another layer of decision makers will be involved. Remember. A lease is in place - with a landlord and a tenant. Now the tenant becomes a de facto sub-landlord and you are the sub-tenant. All parties - master landlord, sub-landlord, and you - sub-tenant must agree and all must approve.

So with the descriptions of leases and subleases as a backdrop - how should you proceed?

Consider all your alternatives. If you need a ton of abated rent, extensive tenant improvements, or a 10 year term, a direct lease might be your best bet. Conversely - absent these requirements - a sublease can provide you with an adequate solution.

Seek counsel. Leases are complex. Subleases are uber complex. They are not for the squeamish. If your “landlord” stiffs the owner - your sublease is in jeopardy. You’ll need two sets of approvals. Plan on extended time frames to get all resolved. We recently encountered a sublease that took ninety days to get the nod!

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.com.

Repairs During Escrow - Who Pays?

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Buying a commercial building for your business to occupy is similar to acquiring a residence from which to raise your family. After all - your business will “live there” and grow for many years to come.

Most commercial deals are structured with a time frame to conduct due diligence - a fancy way of saying - figuring out if you want to complete the purchase. Generally - if something untoward is discovered during this contingency period - you can cancel the deal without penalty.

Some sellers are very organized and greet you with all manner of reports, studies, and opinions on the condition of title, roof, HVAC, office improvements, and environmental history. Others will simply allow you - as the buyer - access to snoop around on your own. By the way - the organized seller - the one with all the provided documents - has typically priced his offering in accordance with the report’s findings. Therefore - if you confirm the building needs a new roof - chances are the seller won’t pay. More on that in a bit.

A word here about purchasing a building in its “as is” condition. Normally a buyer relies upon his own investigation of the property’s condition - and commercial contracts are worded this way. So does this mean you must close a deal with a faulty wiring system? No. It just means the seller is not representing or warranting it or agreeing to mend.

So what happens if you realize the air conditioning has eclipsed its cooling life and blows about as hard as a defeated politician? Or - you discover - the roof is akin to a slice of Swiss cheese? Clearly, you have three choices - buy the building with all its faults and deal with the issues later, ask the seller to remedy, or walk away.

Let’s presume you love everything about the property and have decided you want to proceed - but feel its incumbent to ask for some repairs. Plan on the seller responding in one of the following ways.

He will tell you no. Certainly in the case of the organized seller - he preempted your request for repairs by investing in condition reports. He knew deficiencies existed and alerted you. Slim are your chances of convincing this seller otherwise. Conversely - if your seller was unaware - you may be able to extract some repair money. Make sure you fashion your ask with copies of your findings along with a reasonable dollar amount. What is unreasonable? Asking for a new roof on a forty year old building.

He will tell you yes. Bingo! However - the way in which the request is fulfilled is as important as the seller agreeing. A reduction in price is common. This makes a lender happy although he must re-work the loan percentages. Credits through escrow used to be the norm. Lenders now frown upon this as buyers supplemented their down payment - a no-no. Finally, a seller may simply offer to make the repairs. I’ve seen this approach work well when the dollar amounts are small or quick fixes are possible. Most sellers will not opt to do the refurbishments - however - as they don’t want the liability or the timing delays.

He will not respond. Similar to saying no - but akin to your parents answering “we will see.” So why would a seller not respond? Because a no is final. A non-response could be one of the following. He believes you’ll proceed anyway if he waits. Or - other parties to the transaction - IE the real estate professionals - might kick in. Maybe the seller wants to gauge the interest of bridesmaid buyers. Our AIR CRE Purchase and Sale Agreements allow for this “maybe” period with a ten day response requirement.

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.com.

Three Unintended Consequences of a Property Tax Increase

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Last week I delved into a subject best discussed in private - politics. Specifically - taxes and your tenancy. I weighed in on a proposed ballot initiative which - if passed - would split the property roll. Known as the California Schools and Local Community Funding Act - the proposal would tax commercial and industrial properties differently than those zoned for agriculture and residential uses. Local communities and schools would benefit.

UPDATE - As of August 12, 2019 - the authors of the proposition - which qualified for a spot on the November 2020 ballot - have removed the plan in favor of one with a few tweaks. From my review - it appears any commercial or industrial property with an assessed value of less than $3,000,000 and at least 50% of the property occupied by the owner will now avoid re-assessment. The previous text exempted fully Owner Occupied commercial and industrial spaces with an assessed value of less than $2,000,000. Now - petition signatures are needed for ballot qualification.

You may be thinking - so what? Large commercial property owners should pay their fair share. Why should a large corporate entity benefit from a property tax “loophole”? Maybe. But let’s consider - for a moment - the potential consequences of a revised levy. By the way - three companies paid a collective $185,481,000 in property taxes for the fiscal year 2018-2019 - close to 3% of the total secured property taxes billed in Orange County! Can you guess who they are?

Unintended consequence number one. The two largest property tax payers also employ close to 34,000 people. Next in line adds another 13,000 paychecks and is corporately based in Los Angeles County - so it’s tough to surmise how many reside in the OC. Suffice it to say - quite a few. If property taxes on these three are re-written to current market values and the “loophole” closed - thus raising the cost of doing business - will new investment and hiring be curtailed? Who cares? Certainly businesses who sell to these large corporations - contractors, food suppliers, material handling companies. And those who rely on paychecks from these companies to rent housing or service debt, buy groceries, fund college educations, pay medical bills, attend sporting events, eat in restaurants, stay in hotels, etc - all huge drivers for our local economy.

Unintended consequence number two. Over 1% of the total property tax receipts come from a large investment concern whose operations rely upon rents from its holdings. Guess where that property tax increase will fall? Yep! On the backs of the many tenants whose leases contain provisions for such a tax pass-through. So? Well - the CPA who prepared your tax return, the attorney who drafted your will, that department store where you rented your tux, and your favorite dining spot for date nights could rent from this owner. His costs will have to be recouped somehow. I wonder where? Probably with increased charges to you.

Unintended consequence number three. Companies with fewer than fifty employees - whether they lease or own the business property they occupy - will get an exemption from the unsecured property tax they pay. Machinery, fixtures, and equipment used in the operation of the company are taxed similarly to real property - 1% of their assessed value. A manufacturing company with a ton of CNC machines, injection molding equipment, or drill presses might opt to automate vs hiring new folks - especially if their head count is at or near fifty. Look at it this way. An employer could automate - thus reducing his need for workers plus get a tax break from the automation equipment he buys.

I certainly hope you invest some time to fully understand this ballot proposition and the potential consequences it can create.

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.com.