Has Anything Really Changed with Commercial Real Estate?

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As I sit here in my home office - a conversion of the third stall of our garage - crafting this column, my thoughts reflect upon 2019. So long ago, it seems, yet in reality only eight short months hence.

This time last year, I wrote about a brewing change in the way commercial real estate is assessed and taxed in California. Akin to observing the massing clouds in the local mountains - those in our industry could sense a storm. Presently, because of Proposition 13 - which became a constitutional amendment in 1978, ALL real estate state wide is taxed at 1% of its assessed value. If real estate of any genre is sold - a new property tax baseline is established and the 1% applied. No recent sale? Property taxes can only increase by 2% annually. Opponents believe an unfair advantage exists for those who’ve owned for years and pay a smaller tax bill - because values have eclipsed a 2% annual bump.

 But in August of 2019 - an initiative had secured a November 2020 ballot spot - albeit with a re-write underway. The “new and improved” version has now qualified and been given a moniker - Proposition 15. Now, voters in the state of California will be given a choice in November to enact said Proposition. If passed, Proposition 15 will “split the tax roll” in two. Assessed differently will be residentially and agriculturally zoned parcels from their commercial counterparts. Simply, a commercially zoned piece of real estate will carry a higher property tax burden than a corresponding resi or ag zoned property. Hmmm.

You may be thinking - so what? I don’t own any commercial real estate and our cities and schools partially rely upon property tax receipts to fund their activities - see police, fire, street maintenance, etc. Plus, commercial real estate is owned by huge conglomerates who will simply absorb the potential increase and finally pay their fair share. Tack on the fact that our municipalities face funding shortages from the self imposed business lockdown and voila! We have a trifecta suggesting enactment.

Please keep in mind - the majority of commercial real estate ownership is not huge corporations - but with folks like your neighbor. Owners and occupants of manufacturing companies, hair salons, consulting businesses, auto repair shops, and the like. Where do you suspect this increased property tax cost will fall? Yep! On you as a consumer of these goods and services.

Also, please consider this. If Proposition 15 passes - do you really believe your home will forever be immune from the same mechanism? Some would say, absolutely, yes! Increasing residential property taxes is the third rail. You don’t touch it lest you’re electrocuted. However, according to my research, residential owners in California pay approximately 72% of property taxes. Proposition 15, some argue, would level this percentage - causing a greater burden on commercial owners. Here is where the crossover could occur. Currently, multi-family properties of four or greater units are classified as commercial real estate - although they are residentially zoned. So, what’s to keep cities - facing an ever increasing crush on their budgets - to “re-zone” multi-family properties to commercial? This move is not unprecedented. Certain cities - facing a shortage of domiciles - have done the opposite - re-zoned commercial to residential. I’ll bet they regret that move! Remember redevelopment districts? Those vehicles intended to quell blight and grant incentives to construct new, nice buildings. Orange County’s abundance of auto malls and big box retailers were the unintended consequence - as new sales and property tax revenues would follow.

What can appear as a great idea - with all the best of intentions - can sometimes yield horrible outcomes. Remember shag haircuts and leisure suits? I thought so.

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.

Pandemic Winners and Losers - Update

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Early in the lockdown I penned a column entitled Corona Virus - Winners and Losers. The column Registered in this space on April 5, 2020. As the journey began, we knew some economic passengers were not going to survive, others would thrive, and still others would feel little - if any effects. Sound familiar? Akin to the way in which the novel Corona virus takes residence in our bodies - some die, others are asymptomatic and still others experience mild to moderate effects - this pandemic has chosen its economic winners and losers as well.

We have now been stuck in first gear for five months! A ray of economic hope glimmered in early June as businesses were allowed to rev and reopen - only to be stalled again in July. Different than previous recessions - this one was self inflicted. After all, that is government’s job, right? To keep us safe. But, even at the expense of our livelihoods? You could make a case that the recessions of 1990-1992 and 2008-2010 were also caused by an overreaching intervention. Savings and Loan implosion in the early 1990s stemmed from a deregulation. In 2006 and 2007, an easing of loan requirements led to a housing value bubble. Lancing of said bubble in 2008 caused the pain! But I digress.

So, five months into our stay at home order - with no end in sight - which industries have thrived, failed to survive, or stayed relatively constant? As every business has one thing in common - it’s home - AKA a suite of offices, a manufacturing plant, or a retail storefront - there is relevance to commercial real estate.

The thrivers. Clearly any business that caters to a “work from home” population has seen a huge uptick in revenue. ZOOM!, companies that make routers, internet service providers, Google classroom, DropBox, Dell PCs, Apple, Microsoft all have experienced a pop. Personal protective equipment - PPE - in the form of masks, gloves, gowns, face shields, and their manufacturing operations. Boom! Residential real estate has benefitted from depression era interest rates coupled with record levels of available houses. Doubt what I say? Ask our friend Leslie Eskildsen if she’s busy. Logistics providers that supply Costco, Target, Walmart, Home Depot, Petco, and Amazon are slammed. What about items such as forklifts, racking, conveyor systems, dock and door equipment? These are essential to support the business of shipping things to home bound customers. Finally, home improvement contractors and DIY stores are having record years. Folks are at home. Might as well remodel that master bath which still has checkerboard tile. Ugh! Commercial real estate housing the thrivers has largely been unaffected. Sure. There are those occupants who believe they should derive a pandemic discount but owners are reluctant. We’ve not seen a spike in vacancy of manufacturing or logistics buildings.

R.I.P. Unfortunately, bar and restaurant enterprises face a dismal future - especially those eateries that rely upon an upscale, sit-down, white table cloth experience. Do you really want to spend $80 on a steak and sit under a tent in the parking lot? Hmmm. Maybe just pitch one in your newly remodeled back yard and fire up the BBQ. Movie theaters. This one baffles me. Seems as though with the advent of seat reservation apps - distancing could be afforded. Theaters could be sanitized between features, and concessions monitored. Oh well. Stream away! Regional Malls? Toast. Companies relying upon conventions, sporting events, concerts, county fairs, amusement parks, or gambling? Crickets! What about travel? Not just airlines but cruise ships, hotels, and rental cars? Finally, business apparel. I’ve not donned a dress shirt in several weeks. Our dry cleaner senses that. Brooks Bothers, Jos A. Bank, Ann Taylor, and Neiman Marcus are in various stages of atrophy. We’ve already witnessed carnage with retail sites - especially those mentioned. Office space is a bit slower to respond. Suffice it to say - the way in which companies operate and consume office space will change. Medical offices will occupy more. Those who can benefit from a virtual workforce - fewer square feet.

Business as usual. Drive through food outlets and restaurants that responded early to take-out are maintaining - albeit maybe not at pre-virus heights. Most contractors - HVAC, plumbing, roofing, flooring have experienced a steady flow of biz. See above. Manufacturers have generally not seen a huge dip - especially those who manufacture a consumable - paper, plastic, packaging, auto parts, tires, food. I wonder how long this will last?

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 Price per Square Foot Overrated?

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Presently, we are sourcing properties for a client of ours to buy. Wanted is unencumbered cash flow with no landlord responsibilities. Ideally, our client would enjoy a hassle free check each month - without the need to fix the roof, mow the grass, or pay the property taxes. This type of agreement is know as an absolute net lease. Please don’t confuse an absolute net lease with a triple net lease. Sure, there are similarities but they are different - fodder for another foray. Fortunately, our client is not geo-sensitive. They will consider properties throughout the U.S. Preferably, the new holdings will be located in a minimal or zero income taxed southwestern state. Our alternatives are limitless! But in pouring through scores of offerings - we’ve considered several metrics. Indulge me while I review a few.

Price per Square Foot. Single Tenant Net Leased investments also known as STNLs abound. Dollar Generals, Caliber Collision, DaVita, Harbor Freight, Tractor Supply, Starbucks, Taco Bells are available throughout the country. Most provide returns in the 4.5% to 6.5% range. However the resulting price per square foot of the improvements is staggering. We looked at a mini hospital in an Austin suburb priced at over $1000 psf! Wow! And no beach in sight. So what’s the big deal? Only this. Assessed is your property tax basis on the price you pay. So long as there is a viable tenant springing for them - no problem. But if your tenant bolts - big problem. You must now re-lease the building with a rent that replaces your return.

Capitalization Rate. Simply. The net rent the tenant pays divided by your purchase price. Easy? Sure. Here’s where it can get tricky. What if the rents exceed the market? Once again. If your occupant lives out the term and pays you as agreed - awesome! But if faced with the task of originating another tenant - hmmm. Best make sure you understand market rents.

Term of Lease. For our client, the longer the better. 10-15 years of sustainable income is desired However, key to consider are the increases in rent throughout the term. Many drug stores - Walgreens and CVS - sign multi year leases with multiple options to renew. Great! But, in some cases the rent throughout the term remains flat. Therefore, no income growth occurs. If you’re comfortable with the net amount each month, ok. But just remember, the future value of your investment is a formula of net rent and the return an investor will pay.

Cash Flow. Our folks are paying cash. No need to originate debt for the buys. Thus, cash flow is simply the amount of net rent received by the tenant each month. However, if your purchase includes debt plus equity - cash flow is more complicated. Borrowing money to purchase real estate is known as leverage. But the interest rate in which you borrow must be considered. Negative leverage occurs when your borrowing rate exceeds the capitalization rate. Deteriorated is the percentage return on your equity.

Strength of the Income. In my opinion - the MOST important consideration. We looked at a manufacturing operation in the Midwest. Price per square foot - check. Well below all the sales in the area. Cap rate - another check. North of 7%. 15 year lease - three checks in a row. Plus rent increased throughout the term by 3% per year. Cash flow was amazing because our capitalization rate was great. But...the tenant was in the exhibit business and provided large displays for conventions. Hmmm. I’m guessing sales aren’t so hot in the year of the pandemic. Generally, a premium is paid for strength. The market prices the strength by a lower return. Sound strange? Just think in terms of United States treasuries. With the full faith and credit of the U.S. government - you can expect a whopping .563%. Now you understand why people invest in commercial real estate.

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?

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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.