Friday, October 22, 2021

Crazy Deal!

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When you’ve plied your trade as long as I, you see some nutty stuff. Today, I thought it would be fun to share one of those transactions with you.
 
First, a bit of background.
 
Once there were lending institutions known as Savings and Loans. These thrifts were an awesome source of home loans prior to 1990. However, in the early eighties interest rates spiked to double digits and trouble ensued because they were ill-prepared to handle the surge. A number became insolvent. As a solution, deregulation allowed the S & Ls to invest in riskier real estate assets to bolster returns. Good in theory, bad in practice. Groups such as Far West Savings, American Savings and Loan, and Cal-Fed became capital sources for commercial real estate investors and developers. Sure. Many amazing projects resulted but there were also a number of train wrecks. We had the task of marketing one such train wreck.
 
A group from Tennessee acquired a portfolio of non-performing assets in California from American Savings & Loan. Most were foreclosed houses but one was a multi tenant industrial complex. Understand. Most bulk buys included dozens of buildings across numerous cities. It’s akin to the line from Forrest Gump - “like a box of chocolates - you never know what you’re gonna get”. Limited due diligence occurred prior to close. How could it? Sellers (the S & L) needed cash, had a ton of loans on their books, and transaction speed was paramount. So folks who bought - discounted price to offset their risk, held their noses and jumped into the abyss.
 
Concurrently in mid 1986, we noticed a problem. New in my career, I did a lot of door to door canvassing - looking for someone who needed to move. On one particular project in North Orange County, we witnessed rampant vacancy, more weeds than fescue, and a couple of abandoned cars in front of one of the units. Danger, Will Rogers! Our instinct was correct - there was a deal. We just had to figure out who owned the project. Today, we have access to title holder information on our mobile devices. In 1986, you either called First American, Ticor, or Chicago or searched a bank of microfiche - similar to reviewing building plans in cities. Yeah. Cities haven’t progressed much past the mid eighties - but I digress. As mentioned, we connected with the buyer from Tennessee. Good news! To manage the sale of all the houses and such - a gentleman was deployed to SoCal. Great guy and we hit it off.
 
With a freshly inked agency agreement - we set about marketing the buildings for sale. Selling a listing in the eighties consisted of creating a brochure (no desk top publishing), planting a sign out front (not allowed lest we spook the few occupants who remained), contacting the neighbors (easy enough), figuring out which investors had bought a similar offering (reviewing hard copy comp sheets), and talking to our fellow brokers. Mind you, no multiple listing service existed - so available properties were paginated and MAILED to brokerage houses - snail mail - the horror!
 
A buyer was quickly identified through a CB broker, purchase terms negotiated and boom. Escrow underway. As an aside this was October of 1986. Massive changes in tax laws occurred on January 1, 1987. To wit, many commercial real estate write-offs were to vanish at the end of 1986 so our buyer made it infinitely clear that a close date could not eclipse December 31. Easy enough. We had three months. Hmmm. Things progressed as normal until…
 
The buyer called me in mid-December. We were scheduled to close in a week and I figured he wanted to discuss the details. Wrong! I’ll never forget his words. “Allen, I’m at the project. There’s a giant sink hole in front of the rear structure and it’s getting larger buy the minute!” At first, I thought he was joking. No such luck. Twenty minutes later, I’m witnessing a scene from the movie Earthquake. You could have buried a Volkswagen in the hole!
 
We spent two days discovering a water leak was the culprit and the city was responsible to fix the deluge. Cool. Oops. It was December 22. There’s this thing called the holiday season. Attempting to get anyone to respond quickly during this time of year is tantamount to moving an elephant with a pallet jack. Slow sledding. With the remainder of 1986 trickling away and our close dependent upon city workers - we resorted to unconventional tactics. A few In-N-Out lunches for the crew, a case of Miller Light - shhh it was after hours, and lots of praying yielded a successful close on December 30, 1986.
 
Our client was so thrilled with our performance - he attended my 30th birthday 11 days later. Yeah. That’s a story for another 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.

Friday, October 15, 2021

True Down Payment Amount

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As you’ve read here a number of times - purchasing commercial real estate is a great way to build generational wealth. It’s like a jelly of the month club. By that, I mean the gift that keeps on giving! Many who read this column founded an enterprise housed in a parcel of commercial real estate which they also own. So. The occupying company earns income through its business operation and pays rent for use of the building. Company value increases over time and the address appreciates. A double whammy! Southern California has countless entrepreneurial stories whereby a generation took a risk, formed a company, bought a location and succeeding family members benefited. I have the privilege of counseling these family owned and operated manufacturing and logistics businesses.
 

Recently, a conversation occurred which I believed column worthy. Specifically, how much should be allocated for a down payment when considering a buy? The easy answer is 10% of the purchase price if leveraged through the Small Business Administration and 20-30% when financed conventionally. Boom. Done. See y’all next week. But, there is substantially more to the story of originating a loan. So please stay tuned for a minute more. 

In addition to the 10-30%, suggested would be to budget for the following: 

Appraisal. Regardless of your lender choice - SBA, bank, insurance company, or hard money - an appraisal will be completed. Contained within the bank’s underwriting - this confirms the price paid is in line with the market. Plan on $2500-$5000 for this review. 

Environmental. Lurking beneath the surface of your purchase could be a problem. These unseen issues are caused by something toxic deposited in the soil. A review of the previous occupants in the building, messy neighbors, and the smokestack down the street combined with a look at old aerial photos - forms what is known as a phase I environmental report. Generally, this does the trick and provides a clean bill of health. If recognized environment concerns - such as stained concrete or containers of waste - abound, a phase II will be employed. Soil borings are sampled and tested. Recommendations range from no further action to remediation. Have you ever witnessed a pile of dirt inside yellow tape next to a gas pump at your local station? No. It’s not an episode of CSI. Aeration is one way to get the bad stuff out of the soil. Plan on $2500 for a Phase I to ?? If remediation is required.

Legal. You’re going to want an attorney to review the purchase agreement, title commitment, and draw your LLC formation documents. Budget around $10,000. 

Escrow and title. Sure. Seller pays for a standard policy but any lender policies or extended coverage are yours to bear. Plus, you’ll pay 1/2 of the escrow fees. Another $10,000 but dependent upon deal size. 

Survey. Not always necessary unless you’re after an extended policy of title insurance. Unrecorded easements, abandoned driveways, and recorded leases are typically not covered with a standard policy. Utility locations, property lines, and underground pipes are clearly mapped as well. $5000 is reasonable. 

Loan points. In addition to the interest payments due over the term of your debt - you’ll pay a percentage of your loan amount to the bank. 1-2% is pretty typical. 

Cost segregation. One of the really cool things about owning commercial real estate is the depreciation which lowers your income tax burden. The improved portion of your parcel - the buildings - can be depreciated over 39 years on a straight line. 1/39th each year. But, other components of the improvements such as walls, doors, glass, and air conditioning have a shorter useful life and if properly segregated - can be written off sooner. Usually your CPA can help with this. She’ll want to be paid, though. $15,000 seems fair.

Once you become the owner, gather and total your receipts. Add all you spent to the 10-30% down payment. What results is the “true” investment into your buy. 

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.

Friday, October 8, 2021

Random Commercial Real Estate Thoughts

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As one Register columnist once wrote - “they’re only opinions - but they’re all mine!” Today, I purge my inbox for another edition of a random Commercial Real Estate thoughts. I find the occasional purge cathartic. So here goes.
 
Gender reveal. Some of you may have noticed my more frequent use of “she” when describing the gender of property owners or tenants. Yes. One of my readers scolded me. I realized I had erred and thus the morph. So sorry I offended.
 
Insomnia. My recent column on the number one problem I hear voiced by business owners - lack of skilled workers - met with some commentary. Specifically, my reference to our “subsidy” for those without work. The fact remains. Unemployment is rampant and we’ve done a poor job training our youth in the jobs that exist - specifically the trades. Electricians, carpenters, structural steel erectors, concrete finishers, roofers, and like crowd any construction site. These craftsmen create the concrete caissons commercial real estate agents are tasked to fill. Unfortunately, there’s a huge yawn with those trained in more white collar arenas - especially over a certain age. However, I don’t see these capable grey hairs as candidates to build structures.
 
Frothy or calm. Folks ask “how’s the market?” I respond with “it depends”. If your specialty is industrial - manufacturing and logistics properties and you represent owners - you are an order taker. You simply manage the flood of activity surrounding your offering and choose from a number of takers. Conversely - counseling tenants or buyers - finds your days filled with endless searches to locate an availability and setting expectations when one is uncovered. The rules pursuing an off-market offering change. Owner motivation is not as keen. Brokers who market suites of offices must deal with systemic uncertainty. Questions such as - “how much space do we actually need and when” are board room topics.
 
Coming downturn. “When will the music stop” columns always garner some interest. Inflation is rampant, supply chains disrupted, shortages of everything occurring, and national debt levels are rising yet we continue to torpedo previously high sale and lease comps. These days we are forced to price offerings as TBD - a hedge against leaving dollars on the dais.
 
Finally, what will the balance of 2021 bring? Many opine - more of the same. Some are wary and see the amount of government spending massing on the horizon and are preparing for a trove of tax law changes. After all, we must repay the debt somehow, right? Are tax strategies such as carried interest, tax deferred exchanges, and long term capital gains - which play into commercial real estate activity - in jeopardy? Many believe so. Others realize the massive lobby the real estate business leverages and are secure. Hopefully, any change will not be retroactive.
 
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.

Friday, October 1, 2021

Deal Issue? Now What?

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Last week I reviewed the the steps in purchasing commercial real estate. Whether you’re buying to house your company’s operation or simply to enjoy the rent a parcel of commercial real estate produces, the steps are essentially the same. The possible exception could be the financing portion - which some investors abandon in favor of deploying large sums of cash into the buy. 

Today, I will complete the orbit and describe some challenges that can occur and some suggestions on how to overcome them. 

From last week:
 
“Due diligence. Also referred to as a “contingency period”. Ranging from as few as 15 days to as long as 90 - a ton must occur during this time frame. Financing must be secured, title exceptions approved, inspection of the building - roof, electrical, HVAC, etc. accomplished, vesting documents drawn, financial aspects of the tenancy - if any - analyzed, and environmental health diagnosed. Whew! Within each of the main categories of approval - there are checkpoints which guide toward the end. Financing, for example, involves - credit of the buyer, the tenant, an appraisal, an enviro report, and lender concurrence. There’s a lot to be done in a short time. What if something isn’t approved? That, dear readers, is a subject for another column.”
So, here goes.
 
Generally, purchase and sale agreements include a mechanism for solving issues that arise in a deal. Specifically, the most widely used contract is published by the Association of Commercial Real Estate - AIR. Clearly defined within paragraph 9 are the various categories of approval items - inspection, title, tenancy, other agreements, environmental, material change, governmental approvals, and financing. Within the boiler plate language are roadmaps for resolution. If your contract is not the standard AIR form - results may differ. As always, it’s wise to seek legal counsel before engaging. But within the document - typically, offered are three choices - cancel, accept, or fix. A fourth creeps in which is a buyer and seller compromise.
 
Indulge me as we walk through some quick examples.
 
Let’s say a building inspector discovers the HVAC units are past their useful life. From experience - this is quite common. So, here’s what happens. The buyer objects to the condition of the cooling systems by disapproving a portion of the physical inspection contingency. You may be wondering. Wait, I thought the buyer was buying the building “as-is, where-is, with no seller warranties”. She is. But that refers to relying upon her inspection to alert her to any fixes necessary. Confusing? Yes, it is. Sure. A seller may simply refuse to repair or replace the units and cancel the escrow but cannot do so immediately. You see, here’s where the “mechanism” takes place. Buyer objects. Seller has 10 days to respond - yes, no, or maybe. A no vote on the recall - ooops, sorry. Wrong issue. If seller refuses, buyer can cancel the deal within another ten days, opt to continue and purchase with the faulty units, or accept a compromise - the “maybe” offered by the seller.
 
Financing is trickier. You see, if the buyer is unsuccessful in their pursuit of a loan by the date specified - generally, the seller can walk away. Therefore, it’s imperative to be quite transparent with the seller during the loan approval process. Because prior to the financing condition date - there may be some leverage. If an appraisal comes back less than the contract price - which causes a lender to renege on the amount - it’s recommended to level with the seller. Sure. You or the seller can cancel, additional dollars can be added to adjust for the delta - accept, an appeal can be made to the lender - buyer fix, purchase price can be reduced - seller fix, or a compromise between buyer and seller can be struck whereby buyer adds some dough, seller reduces the price - and voila!
 
I’ve witnessed these go every way you can imagine over my decades in the business. One certainty - there must be issues. It’s a thing. The next deal I close without one will be the first. But, fair warning. In today’s overheated industrial market, I’d not plan on a seller being terribly receptive to what’s referred to as a “re-trade.” Chances are there is a line of suitors waiting for the chosen buyer to blink.
 
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
 

Friday, September 24, 2021

Buying Commercial Real Estate - Closing the Deal

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Today, I focus my labor on the closing process. After all, I’m penning this post prior to the Labor Day weekend - so it proved prescient. Whether you rely upon the rent generated or for the utility gained by your business - an investor or an occupant - you execute a similar process to become a owner. Let’s dive in, shall we?
 
A search is conducted, a candidate for purchase selected and negotiation commenced. Simple. Once the terms of the buy are settled between you and the seller, a contact is drawn - known as a Purchase and Sale Agreement. Easy. But now the fun begins. The parties - buyer and seller must now complete the deal. What occurs after the paperwork is signed is the subject of this column.
 
Purchase and Sale agreements - whether standard or proprietary - provide a roadmap for how to proceed. Price, financing - if any, due diligence period, escrow holder, title company, deposits to open, deposits once contingencies are waived, and closing period are all neatly niched.
 
Price. Fairly straightforward but typically a combination of cash and debt. The seller - unless providing a loan - receives all the proceeds - less closing costs once a deed is recorded. Can this sum vary from what’s agreed? Yes. See “due diligence”.
 
Financing. Many deals we see these days are financed but not subject to lender approval. Confusing? Yes. But this seller’s market, in which we are mired, has produced this wrinkle. A seller may say - sure, Mr. buyer. Go get a loan. But, failure to qualify won’t allow you to cancel. Plus, if your lender is tardy - tough taco. In a more conventional approach, a buyer seeks loan proceeds to couple with her cash infusion to make the buy. If she can’t get a loan, she walks away and her deposit is returned.
 
Escrow. Generally, in California, an escrow holder is a clearinghouse to accept the agreement and conduct the symphony - also known as executing the deal. Deposits, documents, and closing instructions are all neatly folded into an escrow holder’s task.
 
Title. Most title companies also have an escrow department but frequently, these two functions are separate. Your title officer will produce a preliminary title report - a “prelim” early in your transaction. This uncovers things such as loans the seller has ordinated that must be paid, easements, liens, status of property tax payments, legal description, and other “exceptions”. A commitment to insure a clean title will be issued. Should a problem arise post close - you’re covered.
 
Deposits to open escrow. In commercial deals - there is no real standard. It’s whatever the buyer and seller negotiate. However, typically these run about 3% of the purchase price. Should the buyer elect not to proceed with the purchase and prior to waiver of contingencies - in most cases, the deposit is returned.
 
Due diligence. Also referred to as a “contingency period”. Ranging from as few as 15 days to as long as 90 - a ton must occur during this time frame. Financing must be secured, title exceptions approved, inspection of the building - roof, electrical, HVAC, etc. accomplished, vesting documents drawn, financial aspects of the tenancy - if any - analyzed, and environmental health diagnosed. Whew! Within each of the main categories of approval - there are checkpoints which guide toward the end. Financing, for example, involves - credit of the buyer, the tenant, an appraisal, an enviro report, and lender concurrence. There’s a lot to be done in a short time. What if something isn’t approved? That, dear readers, is a subject for another column.
 
Deposits once contingencies are waived. Ok. You’ve traveled the gauntlet of contingencies and are full speed ahead. You’ll now add some “skin” - in the form of an increased amount of money - to the escrow. Deposits, by the way, are generally applicable to the purchase. But, once you nod your head - deposits are non-refundable. Can you still back out? Sure. But not for free.
 
Closing. A cacophony of chords completes the transaction. Akin to a family reunion group photo - all must be looking at the camera and smiling before the image may be captured. Lender funds the loan, buyer adds the supplemental dollars, granting deeds are deposited and recorded, and monies are apportioned - seller gets hers, buyer gets title, lender gets a trust deed, and agents get their fees. Boom!
 
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.

Friday, September 17, 2021

Number One Concern

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Thanks to my neighbor Rudy - my staunchest critic and biggest advocate - for the column idea. As I pen this post from my garage office, I’m reminded of myriad conversations I’ve had lately with manufacturing and logistics companies throughout the OC and the IE. Ask any small business owner what their number one concern is these days - AKA what keeps them up at night - and universally you’ll hear…the lack of quality employees from which to choose. Doubt what I say? Just drive around and you’ll be feted with featured “now hiring”, “help wanted”, and “apply within” signs. One of our clients - who operates an adhesives manufacturing operation - has resorted to “bounties”. He pays his existing workers $500 per referral that result in a hire. His only qualifier is the new employee must stay for at least six months.
 
You may be wondering what any of this has to do with commercial real estate? Just this. Relocations are triggered by several factors. One of these is an expansion of commerce. Added business is fulfilled through the addition of employees, machinery or both. Commercial real estate houses said enterprises. If a building has capacity - ie: places for the extra folks to sit or spaces in the plant for the equipment - no issue. In the alternative - big issue. Now, the company must place a “band aid” by doubling up offices, adjusting the shop, or moving to larger quarters. As I’ve written ad nauseam - there is an acute lack of vacant industrial space in the market - so the problem compounds. But, this tete-a-tete will be tabled for another time. Today, I want to focus on the shortage of workers and my suggested fixes.
 
I read with great interest today how California’s unemployment rate is one of the highest in the nation. Hmmm. Then why is hiring such an issue? Some may opine. In the early days of the pandemic - our government paid people to not work. Good decision? Initially, yes. But, from what I hear from employers - the prolonged subsidy has created lethargy in our workforce. After all - why rise early, schlep the freeways, and encounter a cranky supervisor if you can make just as much by NOT working?
 
But in my view, the drought is more systemic. I believe we’ve done a substandard job - sorry for the pun - of preparing tomorrow’s workforce for the jobs that will exist when they graduate high school or college. Specifically, in our trades - carpenters, painters, electricians, plumbers, welders, contractors who repair air conditioning and heating, appliance and flooring installers, etc. there’s a huge imbalance. If you’ve a stopped up drain - good luck getting someone out to repair it anytime soon.
 
Most of these trades are learned through an apprentice program. Unions understand and train accordingly. But many times, a more seasoned non-union individual passes along her craft to the next gen. But what about vocational training in high schools? Remember the days of wood shop, auto shop and home economics? But how about building stuff?
 
The next gen should be willing to learn because the income potential is unbridled! Maybe these jobs lack a “coolness factor”. It’s not that appealing to work in a hot attic versus an air conditioned suite. Plus, we as a society are partially to blame. But, I won’t go there.
 
As to skilled labor such a CNC machine operators, plastic injection molders, die cut operators, truck and fork lift drivers - I believe the solution might lie within our community colleges. Wonderfully positioned - and state funded - to serve the local employer needs - these centers for learning are perfect! How about a partnership with the largest local job creators and academia to understand the needs and accommodating them?
 
With a little planning and leadership - we got this!
 
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.

Friday, September 10, 2021

Why Make it So Hard?

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My neighbor constantly reminds me my voice echoes with commercial real estate owners well above his pay grade. Certainly not my intention but I take any comments to my missives seriously and attempt to morph into a more meaningful messenger. Regardless of the size of a commercial real estate portfolio - one multi-family property or global holdings of distribution boxes populated with Amazon-eque tenants - investments are simple! Why do we make them so hard? You see, any investment of money seeks a return. Period. Sure. You’d like the return to be commensurate with the risk. But after all the fancy terms of capitalization rates, internal rates of return, replacement cost, source of capital, exit strategy, expense leakage, cash on cash, leverage, etc. it’s really about this. I shell out this much money and get this much back. Mic drop.
 
Commercial real estate brokerage is simple. Why do we make it so hard? A real estate transaction - a sale or lease of commercial property - has two sides - an owner and an occupant. Now. The occupant may seek to lease or own and the owner may want to sell or lease - but you get the idea. Inject our representation and you now understand what we do. We are matchmakers of sorts. An owner engages us to locate a tenant or buyer to fill her vacant building and/or an occupant awards us the opportunity to source a location for their use. The former assignment is known as a listing and the latter an occupant representation. If you ask me what I do and I respond - “I sell commercial real estate” - you’ll probably wonder - “what the heck is commercial real estate?” But if I explain - “many of our clients are family owned and operated manufacturing companies experiencing a transition - such as a move” - my guess is you’ll have a better idea what fills our days.
 
Networking is simple. Why do we make it so hard? I’ve often opined - “the true value of a commercial real estate professional is the depth of her network.” Need a roofer? Got you covered. How about a legal professional to draw a new LLC? Hold on - I have several. Someone to install new warehouse racking? Yep. Got just the gal. But all of these examples are “downstream” of the deal. By that I mean the need is after - or “downstream” of the sale or lease. But, what about “upstream”? What classes of professionals see a transaction before it takes flight? The answer harkens back to what we do. Remember - “many of our clients are family owned and operated manufacturing companies experiencing a transition - such as a move”? If we focus on those professional service providers who complement not compete with our efforts - a treasure trove emerges. As an example - let’s say a manufacturing concern experiences a record year but leases their building. During a periodic meeting with her CPA these facts are discussed - revenue and leasing. If the CPA advises his client to buy a building - you get the idea.
 
Business is hard enough. Your commercial real advisor should make it easier for 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.

Friday, September 3, 2021

When Will the Music Stop?

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One of the benefits of a five decade tenure in an industry is hindsight. Yes. It’s always crystal clear! Unfortunately, looking into the future is a bit murkier. Sure. Folks try. Every January, we are festooned with economic forecasts from scholars. Doubt what I say? Simply tune in for the Chapman, Cal-State Fullerton, UCLA, Charles Schwab reviews and others. All will give their opinion on what the blossoming year will have in store for our economy. Predicted will be growth in commerce, changes in consumer confidence, outlook for interest rates, stock market trends, inflationary pressures and the impact of all of the above on real estate pricing. But it’s August, you may be thinking. Why look forward to January? Well. When you see Christmas decorations next month - you’ll understand. These next four months will fly by!
 
I’ve consumed several of these Nostradamus events over the years. One of the most meaningful was in February of 2020. Featured was a panel of experts assembled by Northwest Mutual. One of the gentlemen in particular gave a brilliant narrative on the forces that cause a downturn. From my notes - “mentioned during the preamble was a check of five factors which cause bear markets - inflation, recessions, commodity shortages, crazy market valuations, and uncertainty.” Hmmm. Sound familiar? For those scoring at home - we have seen all five since March of 2020. So where is the downturn?
 
In particular inflation. Commercial real estate rents have increased 134% since 2011. A whopping 13.4% per year. If we dissect this further, the last eight months have produced a rise of 12.6%. Annualized - that is 18.9%! Investors, therefore are ravenously absorbing buildings with crazy high rents at - yep. Crazy high valuations. Take a look at the pump. We paid $4.89 for a gallon yesterday on the way home from Arizona. Silly me forgot to fill up before we crossed the border. Lumber? The price of a 2 x 4 has gone from $2.00 to $8.00. Container loads from China have quadrupled as well. So where is the downturn?
 
Let’s talk about uncertainty. One thing that can kill a rally quicker than anything is uncertainty. You see, when businesses or investors are unsure of the future, they postpone buying decisions. This “pause” trickles through our world. During the financial meltdown of 2008-2011 - our real estate market was mired for close to a year. Prices tumbled. Buyers and tenants enjoyed amazing deals once they saw a clear path of improvement. We certainly experienced such a stall in industrial activity between March and June of 2020. But then, something quite unforeseen occurred. Industrial demand went on turbo-charge for the balance of 2020 and the first seven month of 2021. As buying habits morphed from trips to the mall to clicks on the keyboard - commerce adjusted, space was consumed, and record profits resulted. So where is the downturn?
 
Ok. Commodity shortages. Those raw materials used to make stuff - copper, lumber, oil, steel, etc. Since we rely upon our neighbors in the Far East for much of this production, and with the noted container load disruption - you got it. Short supply. Certainly, this adds upward pressure on pricing. Plus, you just can’t get things. If your fridge goes on the blink - good luck getting a replacement. Roofing for industrial buildings - the steel trusses? 13 month lead time! But where is the downturn?
 
Hopefully, you’re getting the idea. We’ve survived a “black swan” event - a once every 100 years pandemic and the resulting five factors - inflation, recession, commodity shortages, crazy market valuations, which should have cratered real estate. And the opposite has occurred.
 
So, where is the downturn? It’s coming, dear readers. It must. Will it be a spike in interest rates, another round of lockdowns, a power surge wiping out the grid, a burst of the pricing bubble, an attack on our soil, a Japanese-esque decade of zero interest and growth, something else, a combination? I only wish my crystal ball wasn’t so murky.
 
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.

Friday, August 27, 2021

When is Commercial Real Estate a BAD Investment?

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When risk outweighs return.
Our neighbor has a tidy portfolio of single and multi tenant properties. The good news? Single tenant buildings are easy to manage - one tenant, one rent check. Multi-tenant - such as an apartment building or strip center don’t crush your cash flow if someone bolts - but you have several rent checks to chase. For our neighbor to eliminate her management and convert to single tenant - a risk greater than her tolerance, ensues. Thus her balanced portfolio. Think of single tenant assets as a share of stock and multi-tenant as a share of a mutual fund.
 
Good for business. We recently represented a family owned construction company. The company found its origins in the 1950s in a part of town that was booming. Owning the location from whence the business resided was a solid plan. Flash forward. A decision was made, by the next generation, to shutter the enterprise. Boom in the 1950’s was replaced by blight in this decade. Consequently, with no occupant to pay rent to the family - the construction company was closed - and little upside - selling and redeploying sale proceeds became the direction. Therefore, an investment good for the business evolved into one less favorable years later.
 
Metrics are skewed. Replacement costs, rent, capitalization rate and return, sustainability of the income stream, and exit plan are ALL considered by most investors of commercial real estate. Should one of these measures of an income property’s value need alignment a future problem may arise. As examples. If you buy a Starbuck’s location and pay $1000 per square foot for a building go that can be replaced for half that amount - your basis is artificially inflated. So long as Starbuck’s stays current, no harm. But if folks start brewing coffee at home and store sales wane - you see where I’m going. Finally, investors focus on a return on their money. If a check is written to acquire the asset then the return is the cap rate. Easy. Layer in some debt and the answer is a bit more complex. Simply. If the capitalization rate exceeds the interest rate on your mortgage - positive leverage occurs. This is magical - as the return on your invested down payment now is greater than the overall cap. Clearly the opposite occurs when a borrowing rate eclipses said capitalization.
 
Tax laws change. When Ronald Reagan was President. Yes. I was around the industry then. But I digress. At the end of 1986 - a tectonic shift happened with our Federal tax laws. Lower marginal rates of taxation were swapped by eliminating certain write-offs. I believe our present depreciation rules - 39 years - were examples. Real estate bought with certain tax shelters in mind were no longer great investments.
 
Improvements are specialized. We toured a building last week with a client. Our occupant processes food but does so in an ambient environment - no specialized freezers or coolers are required. The vacancy we walked was complete with tons of cooler space. Our premise was some of the cooler infrastructure would translate to our use. For those who need these special purpose goodies - rent is not an object. As the cost to create them is astronomical. But for those who don’t - which is a much greater universe of tenants - they won’t pay for the extras.
 
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.

Friday, August 20, 2021

Things to Consider When Buying a Building

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Commercial real estate ownership - especially when it houses a business operation in which you have a stake - stabilizes your costs, provides some tax breaks, and appreciates over time. The trifecta!
 
Cost stabilization. If you rely upon a series of 3 to 5 year leases for your location strategy, over time your rental rate will increase based upon the change in the consumer price index or by a fixed annual amount. Sure, you might time a dip in the market with an expiration - but don’t count on these ends meeting very often. So, using fixed rate debt over a 20 to 25 year amortization period can provide a level amount.
 
Tax breaks. Infinite are the incentives Uncle Sam provides for those who own income property. Mortgage interest, operating expenses, and depreciation can all be deducted. In some cases - capital outlays, such as a new roof or parking lot can be expensed.
 
Appreciation. Depreciating an appreciating asset is one of the marvels of commercial real estate investment. As an example - say you buy a structure for $5,000,000. The improved portion (not the land) can be depreciated over 39 years. But at the same time - over a ten year span - your $5,000,000 could be worth double!
 
With these benefits, you may be wondering. Why don’t all companies own their buildings? Why would anyone lease? And what should be considered before buying?
 
Fluctuating space needs. Many fast growing operations opt to lease vs own. You see, the amount of square footage required can vary. If you own and outgrow the footprint - money is tied up in a facility that is obsolete. Conversely, a series of short term leases and options to extend can handle the fluctuations without consuming precious capital.
 
Use of the down payment. Most finance an owner occupied commercial real estate purchase through the Small Business Administration - SBA. Originated is a loan(s) for 90% of the buy with the balance coming from the borrower. But 10% of a $5,000,000 deal is still $500,000. In some instances, this capital can be better deployed in new employees, machinery, or equipment.
 
Financeability. A lender considering making a loan will look at the credit worthiness of the borrower as well as the occupying entity. Is the business cash flow - after all the expenses are paid - sufficient to service the debt?
 
Company structure. As mentioned above, depreciation - for those who can benefit - is awesome. Publicly traded companies frequently avoid ownership of their buildings so that depreciation doesn’t ding their earnings.
 
Age of the principals. Years - an important consideration as commercial real estate ownership is a long play. Meaning. If the principals are in their eighties - chances are great - they won’t live to see the appreciation. Certainly, their heirs will thank them.
 
Exit strategy. Owning for an operation should also be considered in light of your horizon for the enterprise. Simply, if you plan to dispose of the business within the next five years - what remains is the facility. I’ve witnessed this work quite well as the acquiring group needs a place to live and signs a lease. I’ve also watched the value of the operation be diminished because a duplication of addresses occurs.
 
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.

Friday, August 13, 2021

Two Things that Derail Most Sale-Leasebacks

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You’ve opted to own the location from which your company operates. A great move by the way! A Limited Liability Company was formed and owns the building. Presumably, the LLC’s members are similar to that of the occupying group.
 
You struck an agreement with the resident - your enterprise - to pay you (the LLC) an amount of money each month for the use of the address. In effect, you’re paying yourself. It’s a beautiful thing! Tax benefits are afforded the ownership LLC - depreciation of the asset, write-offs for any mortgage interest, property taxes, and operating expenses. Over time, the LLC’s investment appreciates.
 
Your occupying business pays rent just as it would to a landlord who has no stake in the company. Plus, because the owner of the real estate and operation are synonymous - if business ebbs and flows - so can the rent you pay yourself monthly. We are fortunate to have such a situation. We own the building from which we ply our brokerage. Each month Lee & Associates Orange - occupant - pays Taft Lee, LLC - owner - a dollar amount that provides a nice return on our investment. However, during the term of our ownership - we have deferred rent increases, banked reserves for a new roof, and kept the rent commensurate with market conditions. We can do this because we are the landlord AND the tenant.
 
Generally, a business or ownership transition will create a commercial real estate decision. As an example, if you acquire a competitor - will the real estate you own and occupy adequately house the marriage? Conversely, if you sell the business - your “tenant” - does the buyer of the business have their own location? Thus making yours excess? An election to move your enterprise out of state requires some time to facilitate and the equity in the real estate to buy your new location. In all cases - as you can surmise - you’ll make a decision. Keep the building or sell it.
 
When selling is chosen, one of the strategies employed is a sale-leaseback. By definition - a sale-leaseback inserts an investor - the sale - to replace the LLC ownership. The group - your company - stays in the building - the leaseback - and pays rent to the investor.
 
With that as a backdrop, let’s discuss what the title previews - two things that derail most sale-leasebacks.
 
The operating company cannot afford a market rent. Remember. One of the reasons you own your business location is to provide flexibility during tough times. Maybe the amount you allow your operation to pay is well below what comparable rents are. This is done because your two interests - business and building - are satisfied. In order to maximize the value of your investment, however - you’ll need to shore that delta. Someone buying your real estate - and relying on rent - is only concerned with a return on their money. Therefore, the price an investor will pay you is based upon a formula - known as a capitalization rate or cap rate. A cap rate is determined by net income (rent less expenses) divided by purchase price. The relationship is inverse - lower cap rate, higher price. But, the higher the rent - the higher the price…within reason. If the group housed cannot afford a market rent - the sum an investor will pay will result in a lower value. As a seller, you’d like to max your sale proceeds - but don’t want to saddle the business with an unsustainable monthly rent. Dilemma!
 
What to do with the proceeds? Your ownership LLC with a related company paying you is a tidy investment. If you sell the real estate, where can you reproduce the return? Recall, you’ll need to accomplish a tax-deferred exchange into another income property or be faced with a whopping tax bill. In the three transitions above - acquire a competitor, sell the business, or move out of state - a sale-leaseback could ensue. However, each presents complexity. Buying a competitor is easy - especially if you need more space. No lease-back needed. You simply sell the smaller and exchange into a larger. Boom. A business sale - especially if the business buyer doesn’t need your real estate - is challenging. You’ll have to fill a vacancy by selling or leasing. The timing of an out of state move works great for a sale-leaseback. Simply, point A is sold. Lease is created for two years. Point B is bought and rented short term while you prepare to move your enterprise. Lease expires on Point A and the relocation to Point B completed.
 
More on these later.
 
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.

Friday, August 6, 2021

Three Additional Ways to Avoid Rent Increases

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If you attended last week’s column - you learned the two main ways to avoid a rental rate increase - know your owner and understand the value of your tenancy. If the bottom of your birdcage housed the Real Estate section prior to consumption - here is a brief recap.
 
Industrial lease rates have increased a whopping 134% over the past ten years. Recall, our market for manufacturing and logistics space was awakening from the ether of the 2008-2010 financial reset - errr meltdown and they’re were bargains galore. Now with the classic increase in demand from pandemic fueled buying and a pinched supply of available buildings - rates have skyrocketed! But, you may be fortunate to rent from an owner that appreciates your worth as a tenant and wants to avoid a costly vacancy if you bolt. If this is your situation and you’re approaching a renewal - count yourself among the lucky. Conversely, if maximizing the monthly income is your landlord’s objective - you could face an increase of double what you’re currently paying.
 
But, there is hope. Please keep in mind these three strategies to stem that spike in your monthly payments.
 
Buy a building. Historically, purchasing has been costlier than renting on a pure monthly outlay basis. Meaning - if we stack a mortgage, allotment for property taxes, insurance and upkeep together - the total will be higher than most leases. Plus, you must come up with a sum to bridge the gap of what a bank will loan and your purchase price - 10-25%. However, this is many times shortsighted when looking at a projection over the life of a company’s occupancy. You see, lease rates escalate over time - generally fixed at 3-3.5% annually. And, when a term expires, your landlord will bump the number even higher to compensate for the market variance. Currently, we’re seeing a huge boost in rental rates which eclipses that 3-3.5% annual escalator. Some find it better to own, finance the buy with fixed debt - thus stabilizing “rent”, enjoying appreciation and the tax benefits that accrue. A word of caution. If you enter the buying fray - be prepared. Structure your A-game with proof of your down payment, lender pre-qualification letter, and a well reasoned story of your desire to purchase.
 
Move to a cheaper geography. Once, the Inland parts of SoCal were cheaper, newer, and alternatives were plentiful. If you’re a logistics provider and you look East - this affordability gap is quickly narrowing. However, there are still “deals” to be found. Don’t forget areas just outside the state borders - such as Arizona and Nevada. You might even find a business climate that welcomes enterprise with goodies - tax breaks, employment incentives, and fewer regulations.
 
Do more with less. We toured an operation recently. Occupied was a big chunk of a larger address. Since they leased the space five years ago, several distribution centers had been added to their supply chain thus lessening their need for the square footage they leased locally. By trimming their premises by 40% - a great building popped up which fit their requirement. Another client of ours took advantage of the relative softness in the office space market and peeled away that portion of the company. Eliminating the people component from their warehouse created several new buildings to consider. Don’t forget. Your additional capacity might be found if you look up and maximize your stacking. Frequently, a group will believe they are out of space because their floor is consumed. Ignored is the two or three feet in height not used. With the advances of material handling equipment - you can literally use every inch if you narrow your aisles and pile your product high.
 
More on these later.

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.

Friday, July 30, 2021

Dramatic Rent Increases - Ways to Avoid Them

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Lease rates for industrial properties in Southern California continue to rise! To place this in some context, if your direction - as a business owner - was to rent a location in 2011 and your operation consumed 100,000 square feet - you could expect to pay around $45,000 per month in rent. Of course, charges for things like property taxes, insurance and maintenance would have been in addition to the $45K. But, the additional charges would have added around $12,500 per month - bringing the total to $57,500 - $.575 per square foot. Flash forward to our pandemic fueled shortage of space these days and a comparable building leases for $135,000 per month! For those scoring at home - that’s a 134% increase in ten years. Or, a 13.4% annual increase. Simply nuts! Am I saying if you rented an address in 2011 and signed a ten year lease - when your lease expires this year - you can expect your rent to more than double? Yes! You got it. Wow! How are businesses able to afford such a whopping spike? Better still, are there strategies you can employ to stem the bumps? The answers are - I don’t know and yes. Indulge me as I outline a few ways to lessen the blows of gigantic rent inflation.
 
Know your owner. The gentleman to whom you send your rent each month, falls into a category of investors. Your tenancy is singular or multiple. Unfortunately, if you’re one of many and his buildings are full - your leverage is limited. You see, he may opt to push rents even if a move-out ensues. He’ll simply replace you. Conversely, if your rent is the biggest part of his retirement income - a bit more realism happens. If you relocate - and his music stops - so does his lifestyle. He’ll be more flexible with you to keep you in residence and avoid a costly vacancy.
 
Know your value. As a tenant, your worth is two-fold. First, the capitalized income you pay each year determines the dollar amount of the investment. Simply, $100,000 in annual rent - at today’s cap rates of 4.75% suggests $2,105,263 ($100,000/4.75%) - if a sale or refinance was considered. Why is this important? A bank would lend a percent of this amount if your owner needed cash. Plus, the market would gladly pay him this figure if a decision was made to cash-in or redeploy the money into another income property. Second, your tenancy is costly to replace. By this I mean - free rent, downtime, refurbishment, and professional fees - are forked over to secure a paying customer. So, let’s say the title holder of your location believes he can get $100,000 a year if you bolt. You currently pay him $80,000. If he’s correct in his assumption - he can achieve approximately $538,406 if he’s finds a five year tenant ($100,000 with a 3% annual rent escalator). However, if he lays fallow for two months, incentivizes the new group with one month of free time, paints and carpets the offices, and pays a commercial real estate professional 6% - count on an up front expenditure of $72,303 - ($16,666 for downtime, $8333 in free rent, $15,000 for fix up, and $32,304 in fees). If we subtract $72,303 from our expected new income stream of $538,406 our net take is $466,103 - $93,220 per year. You’re willing to pay him $90,000. So, he could be slightly better off replacing you. But, if any of his assumptions are wrong - he sits four months vs two as an example, he is better off renewing you at $90,000 per year. Plus, presumably you’ve paid on time, taken care of the premises and sent him a Christmas card. Those intangibles have credibility. He may have to chase the new guy to get his rent.
 
Know your alternatives. Don’t forget. You could buy a building, consider a cheaper area or opt for a shorter lease term.
 
More on these later.
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.

Friday, July 23, 2021

3 Random Commercial Real Estate Thoughts

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As we now have eclipsed six months of 2021 - I know, right? Costco already has Christmas decorations displayed alongside the red, white, and blue sheet cakes! But I digress. Anyway, I thought it would be fun to review what this year has brought and what I see for the balance of 2021. It’s good to periodically clear my consciousness of clutter, so I appreciate your indulgence.
 
One year ago - July 2020. One year ago today we got some great news on a deal we were transacting. The due diligence period ended, the buyer waived contingencies, and we proceeded to close the escrow on July 17, 2020. Boom! Why do I mention this? You see, this offering was originally launched in February 2020 - great timing, huh? We quickly received an acceptable proposal and put the property under contract - just in time for the United States to hit the pause button. As you would expect, the deal blew up, we waited, and re-launched the marketing in June 2020. Our new chronology proved to be prescient as buying activity had returned with a vengeance. Candidly, the uptick in industrial demand has not stopped - if anything it’s even more frothy that it was a year ago. But why? Manufacturing and logistics concerns were deemed essential. Replacement parts were needed for anything relating to home or auto. Because people were stranded at home - they spent hours staring at their computer screens and ordering merchandise. All of these factors caused businesses - who make and ship things - to explode with commerce.
 
What is taking so long? I had a nice conversation yesterday with a moving and storage company with whom I network. He had just visited a tech company in the in the Inland Empire that is experiencing a transition. Apparently, a decision has been made to largely work remotely and therefore their former bristling bank of office suites will not be needed. They’ll attempt to find a surrogate to replace their tenancy. This is a classic example of the decisions that will be made by office occupants throughout the balance of 2021. Now that we have a clear path forward - well, until the next speed bump - folks are starting to return to the office - or not. We have a much clearer picture of exactly how much square footage operations require. So to my question of what is taking so long? The uncertainty that a market upheaval experiences. When California shut down in March 2020 and we were forced to hibernate in our homes, no one really knew what the future held. As we emerged from the ether after 90 to 120 days we discovered that industrial activity returned to its pre-pandemic turbo charged trajectory but the office world was still mired in lock down. Uncertainty is painful! Decision gridlock ensues. Long term commitments - such as a multi-year lease renewal - are postponed.
 
Skate to where the puck will be. Overused but so descriptive - “Wayne Gretzky famously opined, “I skate to where the puck is will be, not where it has been.” It's a popular quote because it vividly illustrates something that everyone wants to do, but may not understand how. You may be wondering what this has to with Commercial Real Estate? Just this. Predicting where lease rates and sale prices will be in the upcoming months is next to impossible! Especially with inventory planned or under construction. Admittedly, prices will be higher - but how much higher? Placed is a huge burden on commercial real estate practitioners to provide proper guidance to our clients. Afterall, we don’t want to leave shekels on the sideboard. Vacancies are expensive, however. So, if you press - which can cause a delayed occupancy - is the expense worth it? During this time I generally recommend pricing on a to be determined basis which unfortunately is a bit of a cop out. Occupants like to negotiate from an established ask - not a - you tell us what it’s worth to you.
 
Let’s do this again next January - the predictions, not the Pandemic - and see how accurate we were, shall we?

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.

Friday, July 16, 2021

Sublease or Buyout?

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We have previously discussed the ways in which you can extract yourself or your company from a lease obligation. As a quick recap. Leases are contracts which allow occupancy for a certain period of time (term) and for consideration (rent). As an inducement for your tenancy, an owner (landlord) may offer some goodies - free or abated rent, an allowance to fix up the place, or a right to extend your lease or buy the premises (options). In return, you agree to pay on time, stay the full period of the lease, and take care of the building. Easy, right? Not so fast.
 
Sometimes circumstances arise whereby the agreement must be tweaked. In the extreme - a dramatic decrease in revenue - leading to bankruptcy. Conversely, an uptick in sales could cause the need for more space. If a competitor is acquired or if the operation is sold - another shift occurs. Now, you have redundancy - too many facilities serving the same purpose. What to do with your lease(s)?
 
Remedies abound. You can sublease the building, buy-out, allow the term to expire, reject the lease through a bankruptcy, or default. Clearly the last two are not recommended as there are legal consequences - but they are a way clear.
 
Most opt for one or a combination of the first three - sublease, buyout or term out. But what are the differences and when should they be used. Please allow me to dive a bit deeper.
 
Sublease. Simply, you locate a surrogate. A group to replace you. But, don’t forget, there may not be another you readily available. Did your operation lease the first building you toured? Probably not. You considered multiple locations until you found the perfect fit of lease rate, landlord motivation, amenities, concessions, and term. Now, you are the landlord and must meet the nuances of tenants in the market. All, while having little flexibility. Your goal is to get out - with as little downtime and expense as possible. Remember, your rent and term are known. Where is that rate compared to comparable availabilities - above, below or right at market. If you’re below - count yourself fortunate! You’ve something to offer. But, how do you deal with an enterprise seeking a three year lease when you’ve committed to ten. Plus, you’ve consumed the inducements. By that, I mean your free rent burned off or the new carpet is old now. To compete, you may have to consider offering some giveaways. Subleases are messy! I’ve found the the most success when the rent is below market, a lengthy term remains - 5 years+, and the building is in pristine condition.
 
Buy-out. An owner of commercial real estate spends significant dollars to originate your occupancy. First, he sat vacant while his agent marketed the availability and searched for a tenant - all while continuing to pay the bank and operating expenses. Secondly, that free or abated rent is another cost. Third, painting the offices and adding new flooring isn’t cheap. Finally, he paid professionals to negotiate the lease. All told, an owner will outlay 15-25% of the lease term’s rent in origination costs! He then recoups the expense over the term. Therefore, if you approach your landlord with the question - “what’s it going to take to let me walk?” - he will account for all of the above. Generally, tenants find the price too steep and opt for another avenue. But, I’ve encountered situations where buyouts make sense. Typically, a spread exists between the stated rent and current market. A mid term remains - 2-3 years. And little cleanup is necessary.
 
Term. Clearly, the easiest. But seldom used. Why you might ask? Because the ends rarely meet. Sure, if you could time your company’s demise with the expiration of your tenancy - boom! Problem solved. Unfortunately, the dangling participle of term generally must be severed.
 
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.

Friday, July 9, 2021

What’s MOST Important to an Investor

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Recently, we discussed two types of investors - those who use their own money to make buys and those who don’t. We refer to the former as private and the latter as institutional. As you’ll recall, private investors generally will secure debt as a supplement to their down payment whereby an institutional group will have ready pools of equity ready to deploy.
 
I’m astounded by the volume of activity with both classes these days! We launched an offering last week. So far, we’ve had over 76 inquiries and two offers. We expect the deal to trade at a record price. Another example. A Class A building just leased - prior to completion. Completely unsolicited, an investor offered to buy it - subject to the new lease - at a return and price per foot that would’ve shattered any top. Our client said, no thanks! It’s just too difficult to find land and secure city approval to build. Their plan is to hold long term.
 
Both of the above are great illustrations of the title of this column - What’s most important to investors? Indulge me as I discuss of few of my observations.
 
Generally, motivation - what’s important - starts with money. Specifically, the source of those dollars. With our new offering, the owner of the real estate bought the building to house his operation. He coupled earned funds with a 90% loan from the Small Business Administration to close the deal in 2013. Flash forward. His business model changed in 2018. No longer needed was the warehouse. We found him a tenant to replace his occupancy. He then morphed into a private investor whereas before, an owner occupant. So why sell? After all, the tenant is providing a nice check each month. Two reasons. A move out of state by the owner to a tax friendly state means he’ll escape California state taxes if he sells. Plus, the market is hot! Taking the boot and buying elsewhere will yield more. What’s most important? Net cash flow - what remains after he pays the bank and income taxes.
 
Now, in the case of the new Class A lease and unsolicited offer - we have a different set of circumstances. Let’s start again with the money. Prior to 2019, our client teamed with a Canadian pension provider. Structured was a fund with a clear objective. Acquire industrial deals in infill markets (those like the OC that are largely developed). Existing structures and sites that require repurpose are considered. Dollars invested will provide a return for pension recipients for years to come. Therefore, if a new project is developed and sold, a bigger problem emerges - where to invest the profits - because there is a shortage of investment grade real estate. What’s most important? A long sustainable income stream.
 
Are any institutional investors sellers, these days? Rarely. Those who tap Wall Street for investment equity - such as Real Estate Investment Trusts - are governed as to how much they’re allowed to dispose of annually. Others who buy on behalf of pension funds - such as CalSters and CalPERS - must keep a percentage of the pool in asset classes such as commercial real estate. Sure. They could reap large gains by selling, but as mentioned above, then what? Cash returns in a bank or T-bills are puny. What can cause a sale? Remember our client - with the Canadian pension dollars? Typically, when a business plan is executed - dollars deployed - there is a sunset on the arrangement - 5, 10, 15 years. You’ll therefore see properties hit the market whose underlying funds have matured. If their timing is now - what a bonanza! 
 
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.

Friday, July 2, 2021

Are Tax Deferred Exchanges Worthwhile?

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One of the perks of our profession is we get insights into future legislation at the state and federal level that can affect our livelihood. You see, the commercial real estate lobby is quite influential. Recall, the enormous push that occurred last year in California to defeat Proposition 15 which would have altered the way property taxes are calculated for commercial properties. 

Presently, there is talk in Congress to gut tax deferred exchanges that are accomplished through section 1031 of the Internal Revenue code. Payback for the enormous infrastructure plan must come from somewhere and wealthy commercial real estate owners are a likely target. 

Yesterday, I consumed a webinar hosted by David E. Franasiak, a Principal and Attorney at Williams and Jensen, PLLC and Julie Baird, President of First American Exchange Company. Discussed was the Biden Administration’s American Families Plan. Underpinning the direction - “The President would also end the special real estate tax break which allows real estate investors to defer taxation when they exchange property - for gains greater than $500,000”. Dissected were the three main components of the plan - a limit of $1,000,000 for couples filing jointly, Section 1031 would effectively be killed, and the proposal - if passed - could take effect for deal closed after December 2021. 

As a quick review, tax deferred exchanges allow title holders of commercial real estate to defer capital gains taxes upon the sale of an income producing property. Certain criteria and time frames must be met. Otherwise, if a sale occurs - approximately 50% of the appreciation is consumed by Uncle Sam and Cousin Gavin. Therefore, motivation to sell would be stripped except in extreme cases. 
Today, I’d like to look at exchanges from a different view - do they really matter to those without commercial real estate ownership? As I’m admittedly biased - I’ll simply offer three thoughts to consider. 

Commercial real estate transactions employee a significant number of people. My premise? Elimination of transactions lured by tax deferral would also crater all the jobs associated with those deals. I once calculated 32 different folks were involved in a purchase. Specifically, escrow agents, title officers, environmental surveyors, roof inspectors, general contractors, sub-general contractors - air conditioning, electricians, plumbers, flooring. Not to mention professionals such as CPAs, attorneys, and wealth advisors. Loop in a few brokers and the ensemble is complete. Dollars earned - by those involved - are circulated back through the economy and groceries are purchased, rent is paid, and college funds established. And, state and federal income taxes are paid from their earnings. 

Small business owners who reside in commercial real estate through ownership use the tax deferred exchange mechanism to expand their operations. Keep in mind, business owners use the IRS section 1031 to purchase larger facilities and grow their businesses. Operational growth means equipment is purchased, workers are hired, and taxable revenue is created. 

Elimination of the tax deferred exchange mechanism would reportedly generate $19.5 billion over 10 years on a $2.4 trillion stimulus package. Unfortunately, the increment is so small - it’s akin to a rounding error. Too often, we lose sight of the unintended consequences of actions we take. As an example, when access to home loans was expanded in 2006 - the sub-prime meltdown resulted. Granted, there was more to that story - but you get the idea. 

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.