How to Exercise an Option in a Down Market

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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.

Is SB 939 Good for Commercial Real Estate Owners?

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In this columnist’s opinion - NO! Ok. See y’all next week. But since I’ve a bit more space - allow me to expand. First a bit of background.

SB 939 - if passed - would provide rent relief for tenants impacted by the Covid-19 shutdown. In some instances - tenants would be allowed to terminate their lease if they cannot reach agreement with their landlords. SB 939 is presently making its way through Senate sub-committees. Recently confirmed in the judiciary by a vote of 5-1 with three abstentions - next up is the Senate appropriations. In its amended form - the lease termination provision has been narrowed and only applies to restaurants, bars, and places of entertainment but the rent relief would be available to ALL commercial tenants meeting certain criteria. You can read more about the bill here California Senate Bill 939 Includes Significant Protections for Commercial Tenants Impacted by the COVID-19 Pandemic: Eviction Moratorium, Rental Deferment, and Right to Modify Rental Obligations or Terminate Lease | Seyfarth Shaw LLP and here SB 939’s New Controversial Provision: Eviction Protections For Covid-Impacted Tenants In ALL Industries (Not Limited To Restaurants, Etc.) – A.I.R. Forms Practitioner

To be sure - certain segments of our economy have been devastated by the self imposed interruption. Restaurants, bars, entertainment venues, amusement parks, movie theaters, and the like may never fully recover. We have witnessed several high profile bankruptcy filings such as JC Penney, Hertz, and Pier One Imports with others threatened like 24 Hour Fitness and AMC. Some may say - we were clipping along quite nicely. Actually, we were on pace to have our best year yet and wham! Our revenue - and thus our ability to pay rent - was crippled by a microscopic culprit and government’s response ordered us to stay at home. I get it! And since the business impact was completely out of our control - someone should step in and provide a cure. Enter SB 939. Easy enough in theory. A bit more difficult in reality.

Disrupted is the contractual relationship with two consenting parties - a tenant and his landlord. Here is how. A lease is an extension of credit from a landlord to a tenant. In return for a schedule of timely rent payments - a landlord delivers possession of his building to the occupant for a period of years. The occupant may lawfully use the premises. Simple. Most commercial leases provide for remedies in the event of default - a tenant decides not to pay or a landlord fails to fix something. At the extreme - an owner may evict a defaulting tenant - give him the boot. SB 939 changes this relationship in favor of the tenant - with no regard to the owner. Here’s why that one sided approach is a problem.

Some owners leverage rent checks as debt repayment. If a tenant fails to pay - an owner must then subsidize his mortgage. If deep pocketed - great! If not - then what? With no income from his occupant and no ability to find another tenant -because of the bill’s provisions - an owner must appeal to his bank for help. SB 939 places the rule of law behind the occupant for rent relief but not behind the owner who must fend for himself and suffer the consequences imposed by his lender. Quite slippery is the slope when government attempts to intervene between agreements made by its citizenry.

Look. I’m all for saving tenants as they are the lifeblood of commercial real estate. I even wrote about it here. Plus, I’ll admit - some commercial real estate owners have enjoyed a very good ride since the doldrums of the Great Recession - sometimes by increasing rents on tenants with few options but to remain in residence and swallow the bump. But, because the issue was created by government’s reaction to the virus - the solution is not by creating government overreach with bills such as SB 939. My fear is a spate of bank foreclosures. 

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.

6 Elements of a BEST and FINAL Offer - in a Pandemic!

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Our economic engine in Southern California is starting to rev in anticipation of another race. Witnessed has been renewed activity by occupants seeking locations and investors with dry powder to deploy. There is rumor of distress in some commercial real estate sectors - especially retail and office space. In my world of industrial buildings - not a lot has changed. Certainly - buyers are proceeding cautiously, lenders are squirrelly, and sellers wonder what the post virus values will be. Until recently, no one really new what impact an eleven week business shutdown would impose. I’m pleased to say - at least with my narrow perspective - we’ve not experienced a dramatic tumble of prices. Quite the contrary. On one offering in particular - we had a bidding war! So if asked to dress in your Sunday best - here are the six points to consider.

Price. Maybe your initial offer was your best. Or maybe you’ve a little gas left in your tank. Most sellers these days are focused upon certainty of close. They may be on the heels of a deal cancellation - their buyer didn’t perform - and now they are back on the market. Or they’ve been available for some weeks and have recently reduced their asking price. Regardless - give great thought to the highest you can pay - and close!

Terms. Generally, commercial real estate transactions include a period of time to study the property, accomplish inspections, confirm zoning and use, and potentially secure financing - all as contingencies to moving forward. Unlike residential purchases that carry pre-set time frames - our number of days can vary. Post Covid - times frames to engage consultants and conduct property tours have stretched. Before you commit - talk to your vendors and get an understanding of how quickly they can react. Deposit structure is big. Offer the greatest initial and post contingency amounts you can muster. This will give sellers confidence in your ability.

Source of funds. We saw several deals - that had loan approval pre-virus - sputter at the finish line. In some cases, the culprit was the drain on cash flow caused by Payroll Protection Plan loans. Touted as forgivable - but with a catch - lenders approving building loans must take into account the worst case - that the amounts must be serviced. Buyers relying upon capital partners also received a shock when institutional sources of funding hit the pause button in late March. Anticipate a seller’s concern and confidently “show him the money”!

Qualifications. You want to demonstrate this is not your first rodeo! If you’re an investor - how many other deals have you bought? How familiar are you with the market - therefore rents and selling prices? How competent is your organization? Do you have property mangement or will you rely upon a third party? Generally a buyer that has a need for his operation will nudge out an investor who must rely upon the income.

Challenges foreseen. Will your use be approved by zoning rights or will a lengthy dance ensue? This is the moment to be quite transparent with your seller. Are you concerned the roof may leak? Wondering about access and therefore an easement? What else will preclude you from closing? Is your funding committed?

A surprise at the end. We recently conducted a Best and Final process for a seller. Received were seven offers! We asked for their best shot. Three upped their numbers and one dropped out of the running. Six remained. Akin to an episode of Survivor and based upon certainty, net proceeds, and qualifications - we narrowed the field to three and conducted buyer interviews. ZOOM is good for that. What surprised us was the final kick for one of the buyers. They offered a portion of their deposit to be non-refundable day one! Talk about confidence! But it was a bit too late and the seller opted for another buyer. Frankly, the decision was made on an intangible - gut feel of the seller. I certainly hope they chose wisely!

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.

An Illness Much Worse than Covid-19 - Distress!

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Akin to the infection we are dodging by staying home, wearing masks, and distancing socially - another disease is lurking - commercial real estate distress!

First. A bit of a primer on what causes distress - meaning widespread pressure on commercial real estate owners to sell their holdings. Commercial real estate is a complex web of owners, occupants, lenders and locations. Owners either reside in their business homes or rely upon rent paid by a tenant to fund their livelihood. Occupants are synonymous with the operation housed or are independent of their landlord. Lenders run the gamut from community banks to public pension funds. Locations are varied into several broad categories - Industrial, Office, Retail, Land, Specialty, and Multifamily. Dissecting further - Industrial buildings could be used for manufacturing, warehouse logistics, or service and maintenance - or a combination of all of these. Regardless of ownership or the class of commercial real estate - one thing is consistent. All rely upon a business occupant to write a rent check. Therefore economic interruption which affects the ability to pay can lead to distress.

Ok. With that backdrop you can start to understand why the pandemic has been devastating to certain types of commercial real estate. Your stylist? Crushed. The location from which they operate? Who’s paying? You got it. No one. That huge apartment complex you depart each day - well used to - now you’re working there. Wow! A landlord can’t collect and can’t evict. What does that owner tell his bank? How about the landlord with an empty office building? Chances are he’s getting rent. But for how long? Will all of his residents start to downsize as they realize less is more?

You might be wondering - hmmm. I don’t get it. A monthly payment is missed. So what? These are wealthy property owners with deep financial resources. In some cases, yes. But in many circumstances - owners of commercial real estate are your neighbors - they own their business and it’s address or they’ve made an investment into a small retail strip center or quad-plex for passive income. Additionally, some may have borrowed to acquire the asset and therefore owe money each month to a bank. Even if there is no debt - ongoing expenses occur - property taxes, insurance, maintenance, gardening, etc. So. If no one is paying monthly - the property owner must fund the shortfall. Inability to do so can cause distress.

Sure. There are some major players in commercial real estate who own thousands of square feet across all classes - industrial, office, retail and multi-family. Are they immune from distress? Nope. Massive portfolios operate under the same premise - someone must pay rent. Kudos to those who were preemptive with their retail or apartment tenants and provided rent relief. But there is a risk they may never be repaid and must suffer the loss. Some large commercial real estate groups have lumped the rents they receive into securities and formed a real estate investment trust. You witnessed a dramatic devaluation of REIT stocks early in the lockdown. Now you understand why - there was fear collections would slow. Pension fund dollars are regularly poured into commercial real estate as is the case with with Cal-STRS and Cal-PERS. That’s right. Your friend who fought fires now relies on a commercial real estate tenant for a portion of his retirement. Institutional property owners with Office, Retail, and Multifamily - because their receipts are challenged - face potential distress.

Will we see volumes of distressed real estate flooding the market as was the case in 1991-1992 or during the Great Recession? In this columnist’s opinion. It depends on how quickly we get back to work, start generating revenue and ramp up that rent machine!

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.