Dramatic Rent Increases - Ways to Avoid Them

Image Attribution: www.dreamstime.com 

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.

3 Random Commercial Real Estate Thoughts

Image Attribution: www.clipart-library.com 

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.

Sublease or Buyout?

Image Attribution: www.istockphoto.com

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.

What’s MOST Important to an Investor

Image Attribution:www.clipart-library.com

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.

Are Tax Deferred Exchanges Worthwhile?

Image Attribution:www.exchangeauthority.com

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.