Subleases - What Causes Them?

Penning this in the final month of 2020 - my thoughts consider 2021 and what might be coming. I suspect, a tremendous amount of “shadow space” better known as subleases will fill the landscape of office and retail availabilities next year as occupants adjust to the realities of the pandemic economy. Sure. We could also see industrial overruns - but for very different reasons. 

A bit of context to begin. Commercial real estate is occupied by the building’s owner, also known as an owner occupant or by an entity unrelated to the title holder - a tenant. In the case of the latter, a contract exists. Leases, rental agreements, or the like state the terms of the relationship - monthly amount paid, number of years, responsibility for maintenance, and who pays the property taxes and building insurance. When a change occurs during the term of the lease - causing a shift in the real estate requirement - one result is sublease space. 

So, with that general background, allow me to explain excess square footage and specifically what causes it with office spaces, retail storefronts, and industrial boxes. 

In our first example, let’s take your local attorney’s office. Generally, these counselors lease their spaces. Ok. Some take advantage of the benefits of owning their locations...but play along with me. Assume at the beginning of 2021; three years remained on a five year lease the firm signed in 2019. Once “stay at home” orders took effect in mid-March - the group found itself with most of its practitioners working from home - and loving it! Now, that marble floored and mahogany paneled boardroom is rarely used. The plethora of private offices - which are typical - now lay fallow. However, rent payments are still owed. Decision time. Is the under utilization permanent - meaning a need for a smaller footprint? Or, will full staffing exist soon? In the former - you have the classic need to find an occupant willing to morph into the vacant seats and fulfill the law firm’s remaining obligation - a sublease. 

Another situation - which floods the sublease market - is observed at virtually - sorry - every regional mall, power center, strip, and freestanding big box retailer in SoCal. Pier One, Steinmart, Bed Bath and Beyond, JC Penney, Brooks Brothers, Forever 21 and other name brand outlets all took their lumps this year. Many shut their doors for good. Others are surviving - but just barely. In every business failure, leases must be considered. Some are abandoned through bankruptcy courts. Select ones leave vast, vacant, dark holes where vitality previously existed. Low cost providers such as Tuesday Morning take over. Although, for how long? Creative solutions emerge such as the Union Marketplace in Tustin’s District - a former Border’s Book Store. There, the larger space was chopped into smaller experiential retailers. But suffice to say - leases must be consumed. 

Finally, industrial buildings. You know, those concrete behemoths which house a variety of manufacturing, warehousing, and service concerns. A very different dynamic will create vacancy in 2021 - companies outgrowing their spaces. With the spate of on-line shopping - ECom providers cannot keep enough stock on hand. Food producers are slammed. Any company manufacturing repair and replacement parts is thriving. Try getting a plumber out to fix a leaky toilet at your home or business - good luck! One of our clients distributes mufflers. With the number of folks staying home and extra $$ piling up because they can’t go to Disneyland or the movies - yep. They’re fixing their cars. A building conversation faces them next year. They’ve eclipsed their capacity. Another is also an automotive distributor. Recently, their demand was so great they opted to double their square footage and find someone to sublease the building they vacated. 

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.

Location Advice for Transitioning Companies

Recently, I described several changes that occur during the life of a family operated business - specifically, manufacturing and logistics interests. These outfits are owned by your neighbors next door and employ millions around the United States. To review - a transition could be; acquiring a competitor, the death of a matriarch, exponential growth, loss of a key customer, sale of the operating unit via stock or asset purchase, or a move out-of-state. Sadly, it could also be the end of the road because of a changing market.

 This week alone - I met with three such companies. Yep! All experiencing a change. Below is the commercial real estate advice I gave them. You see - whenever a transition occurs - a commercial real estate requirement soon follows.

 Better returns out-of-state. In 2014 a family owned aerospace tooling entity was sold and the real estate that housed the company retained. A couple of years later, it was time to sell the buildings. Concern was - the new owner of the business ran the day-to-day differently. Could the rent be replaced if the group bolted? Sale of the real estate and the purchase of three investments through a tax deferred exchange quickly followed. Then, as 2020 dawned, a decision to sell was made on one of three 2016 buys. After all, activity was robust, pricing was at an all time high, and belief was - higher returns and reduced taxes could be garnered out of California. Meanwhile, all of the partners had vacated the Golden State. In addition, there was uncertainty with near term roll over of half the tenancy. And if that wasn’t enough - after launching in February and just in time to receive a great offer - the Novel Coronavirus ravaged the national economy! The buyer paused and then cancelled. After the buyer exited - due to the uncertainty - guidance was sought on which direction was best. We were able to provide clarity, create best in class collateral, and re-launch the offering. Closing happened on time! The net proceeds of the sale allowed a 1031 tax deferred exchange into properties in tax friendly states and with a greater overall return and reduction of risk. The last of the four upleg purchases closed this week.

 Structuring for the future. Maybe one of my favorite stories of owner occupied commercial real estate enjoyed a new chapter this week. Two of my dear manufacturing clients purchased their business home in 1995. In the ensuing twenty-five years exponential appreciation has occurred. By their admission - the address is worth three times the value of the business it houses. Finally, a suitor for the company has gained favor. A sale of the assets may occur soon. The terms and conditions of the leaseback are critical. Potential investors for their real estate holdings will look at the lease rate in comparison to market, the length of the lease, and the maintenance expected of the owner. Even if there is no interest in spinning the parcel today - these issues need discussion.

 Everyone is agreeable - until they aren’t. One of my clients was approached by his neighbor. They struck a handshake deal. Unfortunately - the agreed upon rate, term of lease, and extension rights don’t provide my client with a lot of latitude. He’s bound to dealing with the expanding neighbor if he wants or has to sell - at a pre-determined price and time.

 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.

 

Are 1031 Exchanges at RISK?

As we have now surpassed Labor Day in the election year of the pandemic 2020 - expect political rhetoric to reach a fever pitch. Sorry. Pun intended. As our nation slowly recovers from business lockdowns, distance learning, storms along the gulf coast, wildfires in California, and upheaval in our streets - and governments respond monetarily to stem the bleeding - expect the next question to be - “how on earth can we possibly pay for all of this?”

 California has proposed a 16.8% marginal tax through AB-1253. Targeted are those who earn more than $5,000,000 annually. Who cares, you may ask. They should pay their fair share. What’s another 3.5% of their income to help the greater good? Consider this, please. Many small business owners could tip this scale and face the extra burden. How long will they remain in California when Nevada, Texas, and Washington have ZERO state income tax? If we export a significant amount of our tax base - who’ll be left to foot the tab?

 Proposition 15 - on the California ballot in November - proposes to split the property tax roll and tax commercial properties differently than residential parcels. I’ve written ad nauseam about where the ultimate bill will be paid. Yep! By you as the consumer of goods and services. You see - if the cost of commercial real estate rents rise through an increase in property taxes - businesses who occupy the industrial buildings, office space, and retail storefronts will be forced to pass that expense along to their customers - you.

 A target for a significant tax grab could also be the way in which capital gains taxes are deferred through 1031 exchanges. I’ve not seen any storms massing on the eastern horizon - but it’s always calmest - so the saying goes.

 Congress could propose an elimination of this “loophole” and generate billions in tax revenue. It currently works like thus. If you sell a piece of income property - you are allowed to defer your long term capital gains taxes. Simply, you enter a contract to sell, create a qualified intermediary before you close, close, net sale proceeds go into an accommodator account, you identify upleg purchases within 45 days from close, and buy the upleg(s) at the earlier of 180 days from close or the filing date of next year’s tax returns. Easy! Literally thousands of these are done each year. Deferred are Federal long term capital gains of 15-20%, depreciation recapture of 25%, California state taxes on Capital Gains of $13.3%, and 3.8% for the Affordable Care Act. A whopping amount! Assumed is - if we tax those sales today vs allowing a deferral - think of the revenue we’d generate!

 Good in theory - but here’s the rub.

 When I visit with owners of commercial real estate about the likelihood of selling their property - I’m asked this question. If I sell, what will I do with the proceeds? After all - I don’t want to pay close to half my gain in taxes! We then have an in-depth conversation about tax deferred exchanges. So if Congress were to change the rules or disallow 1031 exchanges altogether - sellers would be left with very little motivation to sell. 

Some might say - this argument is quite self serving. After all, this guy is paid to sell commercial real estate. True enough. However, please don’t forget the multitude of industries who benefit from the sale and purchase of commercial real estate. Title companies, escrow holders, transactional lawyers, CPAs, qualified intermediaries, lenders, property inspectors, environmental engineers, contractors all drink from the trough of a commercial real estate transaction. Behind the scenes are real people - with families - whose livelihoods depend on property sales.

 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.

I’ve SOLD My Commercial Real Estate - Now What?

Motivation to sell can vary from desperation to windfall. Some sellers don’t have a choice - they must sell. While others take advantage of a large run up in pricing to reap some profit. In the former - a loan that must be repaid, a business failure, or a pending foreclose are all catalysts. The latter? Taking advantage of market swings, an offer “too good to reject”, or an uptick in business. Ideally, sale proceeds are rolled into another buy - which defers capital gains taxes. Such a mechanism is referred to as a tax deferred exchange under chapter 1031 of the Internal Revenue tax code. Allow me to spend a moment and discuss some nuances of the 1031 Exchange.

 The way an exchange works. Simply. A 1031 Exchange defers capital gains taxes - both state and federal. Any income property generally qualifies - including an owner occupied building if properly structured. Relinquished or downleg is the term typically used for the property sold. Replacement or upleg describes the property(s) purchased. 45 days is allowed - from the close date of your relinquished property - to identify a replacement property(s). You must complete the upleg purchase(s) the earlier of 180 days or April 15 of the following year from the sale date. “Like kind” must be bought. A fancy way of saying - another income property. Finally, if your relinquished price was $1,000,000 - you must spend $1,000,000 or more to qualify. Don’t forget any loans as those must be replaced also - either with new borrowing or additional cash. Whew! Complex? Yes! Please don’t attempt this at home. Consult tax, legal, and commercial real estate professionals.

 May I do it myself? No. Prior to the close of your downleg, you’ll need to designate a qualified intermediary to affect the exchange for you. IPX1031 Exchange is a good one.

 Can I change my mind? Yes. If you decide to forego an exchange prior to the sale of your downleg - you receive the sale proceeds - albeit now with potentially a large tax bill looming. If you designate a qualified intermediary, close, and then pivot - you, once again, receive the boot - but it’s most likely taxable.

 May I take some of the sale proceeds? Simple answer, yes. In reality, the answer is more complicated. This is where legal and tax counsel can help.

 When must the upleg purchase be completed? Some sellers overlook this nuance and have their exchange disallowed. The rule is the earlier of 180 days from your sale’s close date or the filing date of your taxes the following year - presumably April 15th. Let’s say you close your relinquished property on July 17th. 180 days later - your replacement(s) must be completed. However, if your close date falls after October 15th of this year and you file your returns April 15th of next year - your 180 days decreases.

 Can I buy more than one property? Yes you may. Within your 45 day identification period you’re allowed to designate as follows:

1.        Up to three with unlimited value - you can then buy one, two, or three

2.        An unlimited number at 200% of the relinquished value - you’re allowed to buy several , or

3.        An unlimited number with an unlimited value - but you must buy 95% of the ones identified.

 Multiple exchanges? If you sold and did a tax deferred exchange and subsequently sold again - you’re allowed to affect another exchange. Currently, there is no limit on the number of these you may complete. Just remember - at some future sale point the taxes will be due. So plan accordingly.

 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.

What Can Loss Teach us about Commercial Real Estate?

Loss. Simply, “the state or feeling of grief when deprived of someone or something of value.” 2020 so far has been a year of loss. Businesses bankrupted, careers cratered, freedoms foregone, routines re-routed, celebrations cancelled - all losses - in some cases forever. Required are we to change - like it or not.

 Last week, our family experienced loss in its most poignant form. Our father, Samuel A. Buchanan Jr. left us to be with the Lord. I’m certain this is true. Dad was a faithful follower of Jesus and loved his church. Suffering from a terrible bout with cancer - fortunately, Dad’s final days were peaceful. He left a legacy of five children, ten grandchildren, nine great grands, and countless friends. I’m sad that Dad is gone but relieved he is no longer in pain. Thank you for allowing me to share that!

 So, what - you may be wondering - does loss have to do with commercial real estate? Only this. From loss comes gain. Here are a few examples.

 2008 ended with many commercial real estate professionals scrambling. Our world abruptly halted. Buyers weren’t buying, sellers refused to sell at such depressed values, and lenders were more frozen than Queen Elsa. Tenants suddenly were seeking great deals. Landlords were stubborn. A mist of uncertainty shrouded our industry akin to that over the Enchanted Forest in Frozen II. Yeah. Recently, I got my Papa cred by watching The Disney Channel with our grandkids. But I digress.

 In 2009, we were forced to adapt. With vacancy in commercial properties rapidly rising, I focused on tenants and buyers. “Blends and extends” became a thing - a reduction in a rental rate today in exchange for a longer lease term. ‘Working out loud” - a phrase coined by my wife, Carla - was the start of a blog in 2010. Authored is digital content for owners and occupants of industrial buildings in Southern California. The Location Advice blog is now published by the Southern California News Group on Sundays. Yep. You’re reading a post now. A return to fundamentals caused the decade of the 2010’s to be my best yet.

 Gains from the losses we’ve experienced in 2020 are starting to sprout. E-commerce has exploded. More folks are shopping from their iPad vs visiting a brick and mortar store. Logistics companies that feed the supply chain are hustling to fulfill demand.

 Material handling outfits - forklifts, racking, dock and door equipment - are recording a record year. Owners of warehouses have enjoyed steady rent checks.

Rumored is a re-shoring of manufacturing. Our economy’s dependence on cheap stuff may shift. Less reliance on low cost production will cause prices to rise but quality and reliability will as well.

 Regional malls could spell the end of our housing crises. How, you might ask? Brookfield Properties made an enormous bet on mall ownership in 2018. Currently, Brookfield is the nation’s second largest owner of regional malls. As we see major mall tenants such as Sears, JC Penney, Neiman Marcus, Macy’s, Pier One, J-Crew, Forever 21, Brooks Brothers and others struggle and fail - watch a gradual re-tooling of these massive spaces into multi-family mixed use re-developments. Closer to home, Integral Communities just bought the land beneath the JC Penney store at the Village in Orange. A similar proposed development is slated for a portion of Main Place Mall. So, it’s happening!

 I’ll always be grateful to my Dad for not hiring me to run the family business. The rejection motivated me to seek an alternate career path - commercial real estate brokerage. What I viewed as an horrendous loss at the time resulted in a huge gain.

 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.