6 Credit Enhancements

Merry Christmas and Happy Holidays to you and yours, dear readers! With 2020 rounding third and heading for home - left in my stocking were some transactions that require a nudge in security. We generally see such enhancement requests in lease transactions although one of our lumps of coal is a sale. A review of our solutions is the subject of today’s missive - so buckle up.

As previously discussed, a lease deal is an extension of credit from the owner of the real estate to the occupant. Simply, a landlord will calculate the total consideration of the agreement by multiplying the monthly rent plus annual increases for the term of the lease. If our monthly rent is $30,000 with 3% yearly escalators over a five year span - promised is approximately $2,000,000. Don’t forget to layer in the cost of rent concessions, tenant improvements, brokerage fees, and the like. For our example, we’ll assume these add-ons escalate our amount by 10% - another $200,000. So, our title holder wants to be assured the new tenant can fulfill a $2,200,000 obligation. If after reviewing the financial information provided, a doubt exists - expect the lessor to push for an enhancement. The form and format can morph. Below are some ideas. 

Personal guarantee. Frequently the tenant is a corporation. The C or S version has is a legal unit with underlying owners. Depending upon the complexity of the corporation, the ownership may be an individual or a number of shareholders. In the case of the former, a simple understanding the individuals are responsible if the corporation defaults can shore up performance. Sans a tangible individual - like in the case of a publicly traded group - personal guarantees aren’t feasible. 

Additional security deposits. Quite easily. Typical upon lease execution - rent for the first month and a sum equal to the last is deposited with the owner of the building. Sure. Some lease language allows the security deposit to cover abnormal premise wear and tear - but the primary purpose is to insure timely rent payments. Increasing this amount two or three fold can give some parcel owners a reason to say yes. 

Letters of credit. Good in theory - tough in practice. In essence, requested is an amount of future borrowing sufficient to stem the bleeding. But, if the tenant is sketchy - encumbering their ability to seek financing is difficult. I’ve seen this requirement spook occupants. 

Entity guarantee. Multi-layered corporations create operating companies akin to the layers of an orange. Once you peel back the skin - where’s the fruit. Sought by a holder of commercial real estate? The company signing the lease needs to own the assets - cash - capable of paying the rent. If not, a hollow barrel exists. Try drinking from said barrel. Yep. Nothing there. We’ve solved this in the past by requiring a parent corporation to sign. Just make sure the parent has chops. If not you’ll have an empty guaranteeing an empty. 
 
Reduction in concessions. Generally, we see two types of tenant requests. One of those is free or abated rent and the other is above standard office improvements. In the first case, lessening the amount of free rent requested can solve the problem. Maybe - vs a free month - two half months can be substituted. Or, placing the abatement in the later years. With tenant improvements -  two issues exist. There is a cost associated with producing the over standard build out. Plus, if the tenant doesn’t live out the lease term, the owner is faced with above standard goodies which may not have appeal.
 
Other solutions. Maybe pre-pay some months of rent. A well funded startup with adequate capital reserves but a short time in business will find this palatable. Consider a 
shorter term. In our illustration above - going from five years to a three year term and a two year option to extend may be all you need to do. 
 
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 Non-Starters for Commercial Real Estate Deals

Commercial real estate transactions, akin to a dance, take two to tango. In the case of a lease - opposite are the tenant and landlord sometimes called Lessee and Lessor. When a building purchase is considered, a buyer and seller square off. Customary in both is a negotiation which precedes the agreement - a lease document or purchase and sale contract. Outlined in most negotiations is a set of deal points - price, term, concessions and the like. Generally, both sides of the aisle have representation - a commercial real estate professional or a real estate attorney. Depending upon the dollar consideration, both vocations may be employed. Frequently, a general outline is submitted by brokers and agreed to to by both parties and then attorneys fine tune the language. When a deal takes flight - it’s a beautiful thing. But, there are some requests which prevent lift-off. A few of these “Houston, we have a problem” are listed below. 

Termination clauses. Occasionally in a lease arrangement - especially with major corporations - an “opt-out” provision is requested. Simply, these give a tenant the right to terminate their lease prior to the expiration. Flexibility - in case the space is outgrown or exceeds capacity - generally is the reason. But these wreak havoc on the back and forth. You see, an owner expects a flow of income for several years. Rate, concessions, and motivation are reflected. If this stream can be interrupted - landlords view the worst case and react accordingly. A five year lease with a termination after three really is a three year commitment. 

Options to buy. Options benefit the occupant. Period. Terribly one sided and limiting - many owners simply refuse to consider them. You see, if the title holder grants an option to buy, he’s locked in. Sure. He can sell to someone else, but the new buyer must honor the option. It’s murky. Softer solutions exist. Rights of First Refusal or Rights of First Offer are examples. 
 
Special purpose tenant improvements. If you’re looking to a landlord to fund your freezer cooler space, add a clean room, or double the amount of private offices - expect some reluctance. Typically, dollars invested to modify a building are viewed for their reuse. An owner considers how valuable the adds will be to future residents and responds accordingly. 

No financing contingency. We sold a property earlier this year for the income it produced. Our buyer was a well-heeled investor with ready cash to deploy. He will not occupy the building but will own it and reap the returns. His offer did not require a loan - therefore his performance was not conditioned on a lender nod. However, most buyers who plan to house their business within the premises need some time to get funding. A seller unwilling to allow this contingency may force a buyer to look elsewhere. 
 
Closing extensions. A seller planning to re-invest the proceeds through a tax deferred exchange has strict timeframes to follow once the sale consummates - 45 days to identify within a 180 day completion. Therefore, we occasionally see extension requests. If closing is delayed, the clock remains at zero until the deal is done - thus giving the seller “free time” to find a replacement property. Buyers are in peril, however, as loan commitments or operational needs dictate their timing.  

Lengthy contingency periods. Sellers seek certainty of close. Extended uncertainty will kill most transactions. A great example occurs when a buyer contemplates a use change - like converting industrial to residential. Municipalities have something to say and they say things quite deliberately. It’s not uncommon for the rezoning - if needed - to eclipse 18 months. An awful lot can change in that period. Consequently, few sellers are willing to “tie up” their property on a maybe. 
 
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.