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.

 

Position YOUR Purchase Offer for Success! FIVE Ways.

As previously mentioned - industrial real estate - those buildings geared for manufacturing and logistics warehouse providers, is on fire in Orange County! These are typically constructed out of concrete, located on little known city streets such as Blue Gum, Coronado, Carnegie, and Capricorn, and house companies that make and ship things. But, as the term on fire means different things to different folks not related to our industry - I believe it’s important to offer some context.

2020 - the year of the pandemic is now over 80% complete. Costco has Christmas decorations - and socially distanced Halloween isn’t yet a memory. What? You’ve not yet strung your lights? But, I digress. Since January, 15 sales have occurred - on industrial buildings greater than 50,000 square feet within the 34 Orange County, California cities. These from approximately 868 existing units in this size. Excluded from these statistics are lease transactions - another conversation. But, in 2020, suffice to say - 15 sales, 868 buildings 50,000 sf and larger - 1.7% of the base inventory sold. Wow! Now. How many 50,000+ sale availabilities are there? Care to hazard a guess? If you guessed 5 - you’d be spot on. Viewed another way - only a bit more than 1/2 of a percent (5 available, 868 exist) is ready to receive your offer to buy. To add some historical perspective, during the last pause in the action - 2008-2009 - there were 22 buildings for sale (50,000+) along La Palma Avenue in East Anaheim ALONE! My, my. Look what 10 years of robust growth has done to our stable of sale availabilities!

You may be thinking, so what? What’s caused this and how does this affect my plans to purchase in 2021? The causes are two fold. Increased demand and the lowest borrowing rates in decades - maybe ever! If your plans include testing the sale market in 2021 - please be prepared for pitiful supply, intense competition, multiple offers, and lenders that scrutinize every debit. Please don’t enter the fray unprepared for the environment that exists in today’s sale market. Sure. You can consult with your banker and get pre-qualified - a MUST. Maybe now is the time to wait - after all, can this overheated frenzy last for years? Leasing for a period of time until the fever ends might work out well. If you’re adamant about buying - have you considered these things?

Your Representative. Recently, we found ourselves in competition for a site. Our buyers were well qualified and motivated. But, akin to straight A+ students competing for limited grad school spots - ALL of the buyers were well qualified and motivated. We won the deal based upon a twenty-five year relationship we had with the seller’s broker. He knew us, trusted our word, and advocated for our buyer with his seller.

Your Story. In today’s sale arena - the back story is critical. We came in second last week. Second is first loser and doesn’t pay very well in commercial real estate brokerage. Why, you may ask? We got “out storied”! Sure, I crafted the reasoning for pursuing the building along with our track record of successful purchases with this buyer. What won the day? The neighbor. It seems he’s been trying to buy the building forever. Tough to compete.

Your Differentiator. We were honored to represent a family last month in their purchase of an income property. They didn’t need financing. Proceeds were in the bank awaiting the right deal. Short due diligence and a quick close could be accomplished. Tack on - we were prepared to offer asking price and no one could touch us.

Intangibles. In the previous examples - intangible factors existed - a twenty five year relationship, the neighbor as the buyer, and tax deferred exchange motivated capital. If you dig deeply into why one buyer was chosen over another - in many cases an intangible is the reason. Sometimes it boils down to a gut feel. Trust those!

Other Directions. What alternatives are available with a lease? Maybe a short term with an option to buy may be structured. How about adjacent states of Nevada, Arizona, or Oregon? We’ve witnessed several occupants exodus California in favor of a tax friendlier area. Buildings are cheaper in some of our inland markets such as Riverside and San Bernardino counties - although the gap is narrowing. Could you shorten a contingency period? How about paying cash today and refinancing later? Factors like these can give you an advantage.

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 commercial real estate lease terms are normally negotiated?

In any given year - as a commercial real estate professional - approximately 50 to 85% of our transnational volume is generated from lease originations and lease renewals. The balance occurs with sales. Certainly this is an industry average and the percentages vary based upon an agent’s specific expertise. Simply, if the niche is tenant representation - the deals completed each year will be all leases. Conversely, selling Single Tenant Net Leased (STNL) investments yields all sales. Today, I’d like to delve into some specific terms typically negotiated during a lease transaction. I’ll break these down into new leases and renewals - similar yet different deals.

New deals. As defined - a transaction which involves a relocation from point A to point B. These deals are about half of the lease transactions that occur in a market during a given year. Covered during most negotiations are the following points:

Term of lease. For leased premises fewer than 5000 square feet, we will see 2-3 year terms. As the square footages increase, so do the number of years. For a 100,000+ square foot building, we generally ask for a much longer term - maybe a five year minimum up to ten. The rationale for this is pretty straightforward. Bigger spaces can lay fallow for longer periods of time which is costly. Therefore, owners of large buildings want a secured term for a longer period of time.

Form of lease. Many are unaware that you can ask an owner for a specific form of lease. Standard forms include those produced by the AIR-CRE or the California Association of Realtors. As deal sizes increase we see a preponderance of owner generated leases.

Commencement of lease. The start date of the lease is an important part of any lease negotiations. We try to marry this with the expiration of the existing location. If successful, any sort of double rent payment is avoided.

Possession of the premises. In some cases tenants are given occupancy prior to the commencement of the lease. This is known as “Early Possession”. It’s not uncommon to see early possessions of 30 to 45 days prior to the commencement of the lease.

Lease rate. A critical component of any lease negotiation is the lease rate and monthly rent that will be paid throughout the term. Rent amounts may include the operating expenses - such as property taxes, property insurance, and common area maintenance - also known as an industrial gross lease or an office full service gross lease. An agreement net of these operating expenses which is known as a triple net lease.

Increases in rent. Standard in any multi year lease would be an increase in rent throughout the term. 2 to 3% annually would be found in today’s market place. Rarely do we see changes in lease rates as they occur in the consumer price index - the reason for this is the increases are too difficult to compute.

Tenant improvements. Any sort of office additions, power distribution, changes in the parking, or general cleanup and painting should be clearly outlined in the tenant improvement ask. Most leases provide a warranty for the systems within the building such as air-conditioning, roof, plumbing and other mechanical systems. However, it’s very important to specifically outline the condition with which the building should be left prior to occupancy.

Free or abated rent. In robust times like we’re seeing industrially - free or abated rent would encompass many fewer months than in more difficult economic times. As a landlord’s motivation increases so does the amount of free or abated rent he is willing to consider. Half to one month per year of the term is pretty standard.

Extension rights. What happens at the end of your lease? That question is answered via extension rights. Whether they are a Right of First Refusal to Extend, a Right of First Refusal to take additional space, a Right of First Offer for additional space or some sort of an Option to Extend or Purchase or an option to purchase arrangement - all can be found in the request for an extension right.

Miscellaneous. Many large corporate leases will have opt-out or termination clause within their leases. Some also might include an allowance for moving expenses, a must take provision whereby a tenant agrees to lease a smaller square footage today in return for an absolute agreement to expand into additional square footage in the future.

Lease renewals. The biggest difference between a lease renewal and the origination of a new lease is the tenant is currently in residence and desires to stay. Therefore many of the terms and conditions above or non-applicable. Things such as the miscellaneous category which includes termination rights are probably not included in a lease renewal. Many times free or abated rent are excluded. But the length of term, the lease rate, and in certain cases clean- up or a small allowance for carpet are included within at lease renewal. One word of caution with respect to your renewal - please don’t try this at home! Even if you have a wonderful relationship with your landlord, it’s always best to have representation by a commercial real estate professional who is familiar with market conditions and can advise you 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.

 

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.

How to AVOID the Re-Trade in Deals

Last week week we covered four things that can occur once a commercial real estate deal reaches the end of its contingency period - that time frame whereby a buyer can determine - in its sole discretion - whether the proceed to close. As you recall - the four outcomes are - move forward, cancel, seek additional contingency time or ask for a price reduction - AKA re-trade.

 Promised last week was a discussion of how to avoid a re-trade. But first, let’s spend a moment and dissect this request a bit more. Once a buyer spends time and money understanding a commercial real estate purchase - in many cases they know the building better than the owner. After all, they’ve poked, prodded, reviewed, surveyed, and analyzed every aspect of the structure, title, roof, HVAC, mechanical systems, zoning, tenancy if any, and operating history. Therefore, it should come as no surprise if something untoward is discovered. Hopefully, what’s uncovered is a minor fix and the deal can proceed smoothly. However, if the issue requires a price reduction, your options as a seller are:

 Agreement. If the request is well reasoned and thoughtful you might simply agree.

 Cancellation. I’ve seen sellers get very defensive and cancel. Certainly, this is your right. You entered a contract to sell for a certain price. Your buyer agreed to buy the property in its “as-is” condition. Now they’ll proceed - but at a lesser amount. Sure. Something is cheesy about a buyer that operates this way. A deal’s a deal. But, if you walk away, the next buyer may ask for more. You’ll certainly have to disclose what you encountered. Plus, you’ll now start over with another buyer and reset the shot clock with another contingency period.

 Compromise. We just completed a lengthy due diligence. The buyer discovered three things that gave them heartburn. We successfully whittled the three down to one and the seller agreed to a slight price reduction to remedy the remaining problem. Had the buyer sought recompense for all three - the conversation would have been short. Fortunately, the seller was prepared and the buyer’s ask was reasonable. Game on!

 But, in my experience the best way to avoid a re-trade is to anticipate them and prepare. You know your buyer will require a water-tight roof. How about conducting a preemptive inspection? You’ll then know if there is a problem. Take it a step further and get bids from contractors to repair the leaks. I’ve found some buyers will inflate the cost to remedy what they find. Imagine that! It’s your option whether you bear the expense pre-marketing or wait. You’ll then be armed to address any request for a price reduction - because you know the extent of the issue and what it costs to fix it. I also enjoy putting a seller into a great offensive position - with back-up buyers who’ll step in and perform in case buyer number one hiccups.

 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.

The DREADED Re-Trade in Commercial Real Estate Deals!

Ahhh, the dreaded re-trade! Simply. A buyer asking for a price reduction well into the purchase process, prior to close, but before they are contingency free. 

Buying a parcel of commercial real estate is really three negotiations. I even wrote about it here. http://allencbuchanan.blogspot.com/search?q=Three+negotiations. A quick review of the three is in order. First - price and terms. This conversation could take place through a binding Purchase and Sale Agreement but typically is negotiated via a non-binding Letter of Intent. Next - Purchase and Sale Agreement talks - if not handled in the first dialogue. And the final discussion - which occurs once a buyer has completed their due diligence - and where the re-trade can happen. 

Generally, commercial real estate transactions allow the buyer a certain amount of time to inspect what he’s purchasing. Reviewing a title report, conducting environmental surveys, insuring the AC blows cold air, and confirming the roof doesn’t leak usually are done. Also in this no obligation contingency period - the buyer arranges financing, interviews the tenants if any, and pours over leases, utility bills, aged receivables, operating statements, and anything else they can dredge up. A quick trip to the city may be important to work out any zoning concerns. We see 30-45 days as a typical contingency time frame. Once ALL this is completed - the buyer decides to move forward, cancel, request additional time, or ask for a price reduction to offset anything untoward discovered. Since a monetary remedy is sought - in effect the purchase price is re-traded or re-negotiated. Bummer!

Let’s discuss in detail the four ways a deal can proceed once due diligence is completed - shall we?

Move forward. The BEST result for buyer and seller! Everything came out great. Lender approved the loan, city welcomed the new business with flowers, all systems are AOK and pilot you are cleared for landing! I can tell you from experience, this happens about 10% of the time. As a seller - if you get this outcome - awesome! Count yourself among the very fortunate. 

Cancel. Extreme! But it happens. Generally cancellation is trumpeted far before the end of a buyer’s contingency. Sure. We’ve all had deals stall in the “red zone”. However, in my dealings, you know when a transaction is doomed. Entrenched within all real estate professionals is a sixth sense of sorts that shouts “danger Will Rogers!” Cancellation occurs in around 5% of all deals. What causes a buyer to walk away will be discussed another day. 

Request additional time. Executing deals during our shelter-in-home period found many buyers asking for additional days to complete their study. Inspectors - hampered by rules and regs, lenders swamped by PPP loan processing, sellers squeamish about tours - all contributed to slow the process. Typical 30-45 day contingency periods became 45-60 days. Frankly, the delays were out of the buyer’s control. 50% of deals reach this crossroad. 

Re-trade. Maybe my least favorite outcome! Why? Because you are so close - yet so far away. Sellers have agreed to the purchase price. Buyers now want some blood. If not properly managed - this can quickly spiral out of control. Plus, as the intermediary, you’re often sought to “bridge the gap”. Candidly, sometimes a cancellation is easier. At least contention is avoided and energy can be expended to locate another buyer. However, close to 75% of agreements include some sort of “ask”. Roof and heating, ventilation, and cooling head the buyer’s list. These are major capital expenditures that must be addressed. Buyers gladly ask for a seller to pay. 

Next week I’ll discuss the ways you can minimize or avoid a re-trade. So, stay tuned!

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.

How to Exercise an Option in a Down Market

Business shutdowns in Southern California have wreaked havoc in some sectors of commercial real estate - most notably retail. Others - such as manufacturing and warehouse buildings have barely skipped a beat! Certainly, where our economy is headed with respect to the “new normal” is worth considering. Masks, gloves, sanitizing, distancing, and limited capacity will all have a seat at the company table as we reopen. Add in some down days on Wall Street, civil unrest, and a pending election and the crystal ball is a bit murky. I was encouraged this week to read Disney’s plans for rebirth. Those guys are pros! Watch and learn. Their organization is inspiring.

Occasionally, a long-term decision must be made in the midst of a short term disruption - our present circumstances. If you lease commercial real estate and currently have an option to renew your term or purchase your building - you understand what I mean. You must predict where business will be in the future. An option is a right you have as an occupant. Certain characteristics apply. For one thing - an option is personal. Simply, you cannot transfer it. Dates are critical - also known as “time is of the essence”. A fancy way of saying - if you don’t by then you can’t. Finally, most options contain a mechanism for the exercise of the right plus some means of determining price and terms.

Typical language in an option to extend the term of your lease might be - five years at the prevailing market rents for comparable buildings within your market - but in no event less that your current rent. Ok. Easy enough. Generally, you’ll have to notify your landlord in writing within a window of time prior to the expiration of your lease. Common is, no sooner than nine months or later than six months is common. Got it!

However, here is where things get tricky. What if your window - to extend your term - opened on April 1 of this year and closes June 30? Hmmm. A bit tough to imagine where we are headed - especially if now you must commit for an additional five years.

So what should you do? I’d break it down like this.

Understand your specific option. You could have something of real value here! Or, you might simply have an agreement to agree. In the former, options forged during the last downturn could be at preset rates. Those presets could be substantially below the prevailing lease terms found in today’s environment. Value indeed! You can stay, avoid a costly move, and enjoy a favorable rent. Conversely, your “market rate option” creates a negotiation with the owner. Tenancy continues but at a higher amount. Regardless, spend some time and know how your option reads.

Take a look at the worst-case scenario. What happens if you don’t exercise your option? Will the landlord give you the boot? Certainly, that is a possibility. But how realistic? Here is where you might be vulnerable. Let’s say you moved into your space in 2010. Times were a bit different then. You clipped along for five years and extended for another in 2015. Mid-decade found rents on the rise - but the exponential increase occurred in 2017-2019. So now, a wide gap might exist between the rent you pay and the market. As we explained above - if your extension is tied to current rates vs presets - you’re facing a monthly bump. On your side? The cost to replace you. Don’t forget. Vacancy down time, concessions, abated rent, and brokerage fees - all must be paid by the landlord if you bolt.

Examine where you are - now. Congratulations! We’ve just weathered one of the largest business downturns - if not the largest - EVER! If you’re still standing - albeit a bit wobbly - chances are your operation is built for the long pull. My prediction is we climb from here. Send that letter! Stay and pay. On the flip side - serious concerns about the future don’t bode well for long term commitments.

Talk to the owner of your building. With the understanding of your specific option, a hard look at the worst case, and a view of present and future - schedule some time to talk to your owner. It should be in person. This can be challenging but manageable with ZOOM or other video conferencing tools. Covered during your chat will be your view of the world, your desire to renew or move, and an exchange regarding his situation. We just attended such a meeting. It was enlightening! Resulting was a comfort level. Both sides aired their positions. We will now move forward. However, some tenants use the following strategy. The building works for our business. We’re girded and armed for what’s next. Rent as outlined in the option is too high. What can we do? Your landlord’s answer might surprise you.

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.

Options in a Commercial Real Estate Lease

By definition - an option is a right contained within a commercial lease which allows you to do something as the occupant. Generally, an option enables you to extend the term of your lease, cancel your lease, or purchase the building. Simple! Oh, I wish that were the case. In practice - option language and exercise can be much more complex. Let’s explore a few of the tastier ones - shall we?

Options are personal. If your company has successfully negotiated an option with the owner of your business address - the option is “personal” to only you as the occupant. It cannot be assigned. Consequently, if you’ve a right to buy the building at a number dramatically below market today - prohibited is passing this along to someone else. We’ve seen cases whereby an occupant exercises their purchase right only to quickly flip the property to another. However, there are tax consequences and logistical challenges to this approach. I should also mention - options completely benefit an occupant. An owner derives little if any benefit from their grant.

Strike prices. On the scale of most valuable to least valuable - an option right with a set price is the most attractive. Conversely, an extension with a price at “market” would be a bit better than worthless. A “market” option - an extension which computes the lease rate or sales price at the time of option exercise - is fraught with peril. Unless a specific mechanism is outlined to calculate market rates - left to opinion is the price. Here’s the rub. Let’s say you have a right to to extend your lease for five years at the prevailing market rates. Cool. You signed your lease in 2015. It’s time. But there is a problem. You and your landlord have a different view of the market and reach an impasse. Now what?

Time frames. Typically - an option - whether to extend, purchase or cancel will have clearly defined time frames from which your right may be exercised. IE: no sooner than twelve months or longer than six months before the expiration of your lease term. These periods are sacrosanct! Strict adherence must be observed or your right may be extinguished. So, what happens if you blink and miss the window? Should you start looking for a place to move? Not necessarily. You’ve simply limited your leverage as now you have no “right” to extend. Your owner still may want to keep you in residence - but at terms more favorable to him.

Method of exercise. Options must be exercised in writing by you. Remember that “options are personal” description? Yes. YOU must send a letter to your owner - unless another method - electronic exercise - is specified in your lease agreement. I discussed this issue with a prospect the other day who shared with me a horror story. Let’s call him Al. At Al’s prior location - Al wanted to renew his lease, avoid a costly move, and had an option to do so. Al’s owner paid Al a visit to discuss Al’s intentions. Clearly stated was Al’s desire to stay. Al assumed all was groovy. After all, Al made his pitch directly to the owner. In person! Imagine Al’s surprise when his notice to vacate arrived in the mail a few weeks later. You see, the option was not exercised in writing. Extreme? Maybe. But don’t fall victim.

  

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.

How to Approach a Lease Renewal - 6 Suggestions

One thing that differentiates commercial real estate professionsls from our residential counterparts is leasing. Sure, residential agents can lease houses but most focus upon the higher fees associated with home sales. After all, we are paid a fee on the consideration of a deal - a fancy description of the total dollar amount of the transaction. Lease fees are a percentage of the amount of rent an occupant will pay over the term of their lease. Simply, the variables are rate and number of years. Commercial leases tend to be three to ten years in length whereas a lease for house will be month-to-month or a year. Thus, the short term creates a small amount from which a fee can be earned. Now you understand why home sales are more profitable and residential agents shun leases.

In a given year - a portion of a commercial agent’s income will be derived from completing lease deals. These come in two flavors - new leases and renewals. Yes! In many cases our clients engage us to assist with renewals. Today, I’ll focus on some suggestions as you approach your decision to relocate or renew - akin to “Love it or List it” on HGTV.

Understand your owner’s position. Is the rent that you pay sufficient to cover the owners’s mortgage? Is the building owned free and clear? Is this the only building owned? Can the owner afford a vacancy? What is the nature of the ownership - sophisticated or mom and pop? What are the owner’s plans for the building - hold or sell? All of these variables will play into your ability to craft an acceptable lease renewal. As an example - if your rent barely eclipses the owner’s costs - he may be unwilling to negotiate. Conversely, a building owner with no debt can be more flexible.

Understand your position. In many cases, you know the building better than its owner. After all, your business has lived there for a period of time and weathered roof leaks, air conditioner outages, a shortage of parking, break-ins, and truck access. You reside despite the “warts”. However, if you vacate and another occupant must be found - will the new tenant discount for these deficiencies? What sort of renewal rights - if any - are contained in your lease? Do you have an option to extend? How is the option rent calculated? Finally, has your operation outstripped the capacity of the real estate or are you swimming in excess space?

Know where you are relative to market. Lease rates have increased exponentially over the past five years. If you crafted your agreement prior to 2015 - chances are your rate is dramatically below current levels. Plus, inventory percentages - number of available buildings on the market - are at historic lows. Therefore, if you’re not prepared with this knowledge - you’re in store for a shock!

Calculate your moving costs. Moving companies will gladly visit your site and give you a complimentary estimate of the cost to move your operation. However, don’t forget other relocation variables such as electrical feeds, special permits, downtime, and key employee drive-time. An owner will bank on the disruption and cost of moving your operation in his negotiations - so know your stuff.

Do some math. On your side of the aisle - you have relocation expenses, rent in the new facility, and the goodies that accompany a new lease - free rent, fresh paint, new flooring. But, you’ll pay a market rate for these amenities. On the owner’s ledger will be the expense to replace you - building refurbishment, lost rent from the vacancy, free rent for a new tenant, possibly some special stuff like a new office or two, and transaction fees. Most of these allotments will be “lost forever” - IE: an owner will never recoup them. Many times, the cost of replacing you can amount to 15-25% of the lease consideration - the total amount of rent you’ll pay for the term.

Start early. I cannot stress this enough! Your negotiating strength depends upon it. 12-18 months in advance of your expiration is advisable.

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.

Your Business is in Transition - Now What?

Some commercial real estate transactions - especially involving an occupant buying, selling or leasing - stem from a trigger event. In other words, a change. Simply, the ebbs and flows of economic activity cause a company to re-evaluate its business address.

As I reflect upon the deals I have transacted and what caused them to occur - several situations come to mind:

Last year, three of our import/export clients decided to scrap their expensive warehouse in favor of a third party logistics provider. By doing so, brick and mortar expense and labor costs were saved. Gained was flexibility to meet changing inventory requirements in a “pay as you go” arrangement. However, two of the companies leased their previous spots and one owned. We dealt with the excess with two subleases of the remaining obligations and one move-out and vacant building lease.

Recently, we were engaged for just the opposite. Before, our client shipped his customer’s products directly to the job site - thus eliminating the necessity of storage. Now his customer demanded he stock the items locally for will call. His current operation was maxed. Gotta put ‘em someplace! So, we are in the market for an auxiliary location.

Buying a competitor or selling a business always morphs into space adjustments. Locally, we’ve seen merger and acquisition activity akin to the days of Gordon Gecko. “Greed is good indeed”! 100% of the time - when businesses marry or divorce - redundant real estate results. Now, the Brady Bunch of facilities must be absorbed into one hybrid family. One extreme example - with which we are navigating - involves a manufacturing interest which finds itself with four different parcels - but only needs one.

Occasionally, there is a change in the business owner’s motivation. Retirement, the death of a key employee, a move out of state, or just calling it quits - voluntarily or involuntarily - can portend a different use of commercial real estate or a re-deployment of the building’s equity. Upon the decision to shutter a fifty year old construction company we assisted the owner in selling the old site and re-investing the proceeds into a shiny, fully leased asset that will provide cash flow for years to come.

Let’s not forget a dramatic increase or decrease in sales volume. All manner of accommodation must follow if the current physical plant can’t handle the bump. If on the rise - new equipment and machinery, additional employees, and raw materials must have a place to reside. The counter causes a look at ways to jettison expenses. Yep. One of the biggest liabilities can be rent on a commercial location. A distribution client of ours chose to deal with his increase in business by buying a facility twice the size of his current endeavor. He accomplished two things - space issue solved and no longer does he fund his landlord’s retirement.

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.