Business Values - Part Deaux

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You’re reading this on Super Bowl Sunday. A celebration of a very long National Football League season that climaxes with the clash of the remaining titans - in this case our hometown Rams and rival Bengals. Enjoy the guac!
 
Two weeks ago, we discussed the circumstances under which a piece of commercial real estate housing a business becomes significantly more valuable than it’s resident. If you missed the column - you can quickly catch up here.
 
Follow the link below to view the article.
When Property Eclipses Business Inside
https://ocregister-ca-app.newsmemory.com/?publink=0e1e11bb0_1348306
 
Mentioned was - so what? It’s all paper until I’m a seller. Today, it’s time to continue the conversation.
 
Becoming a seller creates two tough challenges for owner-occupied commercial real estate - increased expense to the operation and “what do we do with the money”?
 
Increased expense. Occupants of commercial real estate generally purchase their business homes for very different reasons than investors who strictly look at the cash production. By this I mean, the business is the focus - and all efforts are made to enhance the enterprise’s value. Appreciation that occurs with the address is strictly a circumstantial benefit. Emphasis is placed upon machinery, equipment, and employees which drive revenue and in many cases provide a greater return on the company owner’s investment. Ask most proprietors and they’ll tell you - we purchased our building for our operation. Sure, collected is rent from the occupying company - an investment - but in many cases this payment is subsidized by the building owner.
 
What we’ve experienced locally is the operation clips along and produces its product or service - machine tooled parts, injection molded widgets, or storage and logistics for customers. Hopefully, sales increase and the enterprise’s worth is enhanced. Recall, this worth is a math problem that deducts expenses from revenue to form a net figure. A multiple applied and voila! Enterprise value.
 
Meanwhile, our real estate becomes more valuable simultaneously. Market conditions change, rent increases, capital becomes cheaper, investor appetites are voracious, supply contracts, demand for space increases and boom. So, if we look at the way commercial real estate appreciates (increase in comparable market value, replacement cost, or through a bump in rent and compressed cap rates) - by allowing the occupant to pay less than market rent actually devalues the premises.
 
Let’s take a look at a quick example. Assume rent paid by the enterprise is $8.40 per year. Market rent is $12.00 per year. If our return is 4%, the resulting values are $210 per square foot with the subsidy and $300 if the lease rate reflected market. On a 100,000 square foot box - that’s $9,000,000! But to reap the $9,000,000 and sell the building with our company inside suggests our resident must bear the added rent expense of $3.60 per year or $360,000. Reduced is the bottom line of our company. Unless an owner is exiting, reluctance in hopping an enterprise expense is assuaged.
 
What do we do with the money? If - and it’s a big if, an owner’s operation can swallow a big jump in rent, the next issue arises. Ok. I saddle my group with the $12.00 lease and take that unsolicited investor offer at $30,000,000 (from above, 100,000 square feet at $300 per square foot). After all, the interested party will allow the company to stay put, we avoid a costly move - and I pocket $30,000,000. Easy! Hmmm. Don’t forget. You’ll pay a bit of dowry for that gain. In some cases, up to 45%! Certainly, we can employ some tax deferral through a 1031 exchange, a Delaware Statutory Trust, or a partial exchange. But in the end - you’re trading the devil you know - your company is housed, they pay you each month, and you control the operation for the devil you don’t - another leased parcel of commercial real estate.
 
Many business owner opt to say “thanks for the free appraisal - but we’re not sellers.
 
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.
 

Shortage of Space - Now What?

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Two weeks ago, I got my Star Trek on and discussed space - the final frontier. If you missed the blast off, no problem. You can quickly catch up by clicking here. Follow the link below to view the article.
 
Rent, sell or buy: How real estate values are factored
https://ocregister-ca-app.newsmemory.com/?publink=13f98ef4d_13482ff
 
Ok, now that we’re back up to warp speed, allow me to continue our exploration by discovering ways to overcome the acute shortage of manufacturing and logistics buildings in our market.
 
As previously mentioned, a high demand for industrial space - fueled by the e-commerce boom - coupled with a lack of supply has fostered a game of availability musical chairs. There is simply not enough space for the need. Therefore, we must be terribly creative to fill the void.
 
Many times, the solution is found in the problem. By that, I mean a dissection of the “why” reveals a new direction. Did your company secure a piece of business that cannot be fulfilled in your current location? Has the growth come organically through an increase in the industry? Did you add employees? Has the way in which you conduct your business changed? Have you acquired a competitor or another product line that must be folded into your operation? Have you purchased new machinery or processes that require additional space? Has one of your suppliers asked that you warehouse some of their product where before the product was dropped shipped directly to your customers? Have you brought a formerly outsourced function back into the operation?
 
Specific answers to these questions may determine how we solve your space issue (and what type of space you need - production, warehouse, or office). Let’s spend the rest of our voyage assuming you’ve added a sales staff and the shortfall is caused by a need for additional office employees.
 
Generally, industrial space has a portion of its area devoted to a traditional office environment complete with reception, privates, and possibly a shared cube domain. This “office” is bolted on to the plant or warehouse and may be single or multiple stories. Typically 5-25% of the square footage houses office staff. Therefore, adding additional office space to your location could do it! On the surface this appears to be an easy fix. However, please consider the cost of construction ($100-$125 per square foot depending upon walls, plumbing, upgraded finishes, etc.). If you own, you may be over improving your building for the market and this could affect future resale timing and pricing. If you lease, you will need the owner's approval AND you will be leaving the improvements in the building if you move at the end of your lease. Some occupants have found great utility in modular furniture - flexible layouts and you take the furniture with you if you move. Other considerations are the city in which you operate (the improvements will have to be permitted) and the parking ratio. Generally, office space will require 4 parking spaces for every 1000 square feet of space. Most industrial buildings are parked 2 spaces per 1000 square feet (including office, production and warehouse). You may be limited as to the amount of office space you can add to an existing configuration.
 
Add an office mezzanine:  All of the considerations outlined in the previous paragraph apply here as well. The differentiation is that in addition to adding office space you are also adding square footage to the overall structure by creating a second story. Parking, city permitting, clearance in the warehouse (because you don't want the second floor to be sufficient for Klingons only), cost (structural footings are required to brace and support the mezz and are consequently 40% more expensive than first floor office space). If you create an office mezzanine, are leasing the location, and renew your lease - be prepared for the landlord to base your new lease rate on the "increased square footage" including the new mezz space you added.
 
Lease additional space close by: Whether you own or lease your location, a temporary fix to your space needs may be accomplished by leasing space close by. Please realize you’ll be less efficient with a function close by vs within your confines. The upside to this strategy is that the excess space (if the lease is flexible) can be discarded at the lease expiration (if the space is no longer needed) or renewed until a more permanent solution can be achieved.
 
Allow the function to operate virtually. Not an option a mere two years ago - now quite prevalent in industries across the US. Certainly cultural, management, productivity will be considered but it’s a great alternative for some.
 
You may be wondering how we discover plant and warehouse boons. That, dear readers is a planet for another trek.
 
Columnist note: Today marks my seventh year anniversary as a SCNG columnist! Thank you to all who’ve made the sojourn so enjoyable. Here’s to seven more!
 
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.
 

When Commercial Real Estate Values Eclipse the Business Value

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As mentioned previously in this space - many business owners in SoCal have opted to own the premises from which they ply their trade. We refer to this as owner-occupied. Benefits of this structure are plentiful - tax advantages, appreciation, and facility cost stability - to name a few. The other alternative for an operation is to lease their business home. They become a tenant and the monthly rent they pay is sent to an unrelated landlord. Today, I’ll focus on owner occupied real estate.
 
In both circumstances, if properly nurtured and managed, the enterprise value grows. It’s quite common for that plastic injection molding operation or your neighbor who’s company tools aerospace parts to be worth several million dollars. I should mention here - the business valuation appreciates independently of the real estate’s worth. Sales generated by the company - top line revenue - is apportioned to account for expenses such as employees, raw materials, plant and equipment, etc. Resulting is a measurement called EBITDA - earnings before interest, taxes, depreciation, and amortization. Multiplied by the industry norm is this net figure. Generated is an estimate of valuation. There you go. I’ve just simplified the role of an investment banker into one paragraph. In practice, the process is much more complicated - but you get the idea.
 
Now, let’s dissect the ways in which commercial real estate becomes pricier. When considering a parcel of commercial real estate, we look at three metrics - income approach, comparable sales, and replacement cost.
 
Let’s start with the easy one first - replacement cost. You’ll need some land. Curbs, gutters, storm drains, maybe some demolition, and loss due to street widening are called off-sites. An architect will charge you to design, engineer, and process your new build through the city. A contractor will quote construction. Money may be borrowed which adds a layer of expense. Finally, to compare with an existing structure - depreciation is deducted. Now you properly have estimated replacement cost.
 
Comparable sales are a great gauge of commercial real estate value - normally. These simply view the market in the rear view mirror. In our over-heated industrial playground - if only the reverse is considered and not where the puck is going - you’ll miss a big chunk of equity. Therefore, in addition to COMPS, please contemplate what’s available and what those alternatives portend.
 
Finally, the most complex - Income approach. Regardless of the commercial real estate genre - apartments, industrial, office, retail, raw agricultural land - ALL can generate a dollar amount per month - rent. The amount and associated risk of said rent form a valuation labyrinth. Let’s say that manufacturing facility which bears your company’s name pays your LLC $12.00 per year in rent. Coupled with a risk defined return of 4.5% would suggest a value of $266 per square foot. Easy.
 
As you’ve gathered, two buckets of wealth are created - company plus brick and mortar. What’s uncanny today? How far the values of business homes have exceeded the company’s worth. This week I witnessed an example - six fold! Both figures were accurate as the owner recently paid a consultant to value the operation and we received an unsolicited offer to purchase his real estate.
 
Ok, so what? You may be wondering. It’s all paper until I’m a seller. That, dear readers is the topic for next week. So, stay tuned.
 
So, there they are - my 2022 predictions. Stay tuned this time next year to see how I did.
 
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.
  

Commercial Real Estate Space - Definitions and Uses

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Space. As Captain Kirk proclaimed - “space, the final frontier!” Today, my mission is to explore a different kind of space - that which folks use to make, store and ship things. In the commercial real estate realm, regardless of genre - industrial, office, or retail - space is measured by the square foot. Simply, if the floor-plan of a building is 100 feet long by 100 feet wide, the square footage is the product - 10,000 square feet. This measurement is then used to compute rental amounts, sales prices, and percentages of operating expenses.
 
Rental amounts. In California, our rental or lease rates are quoted in monthly terms - IE: $1.00 per square foot. Places outside California may annualize the rates - $12.00 per square foot. So, using our 10,000 square foot building and the lease rate of $1.00 per square foot - our quoted monthly rental amount is $10,000 per month. Easy.
 
Sales price. A parcel’s sale price takes into account one of a couple of metrics. First, if a lease of $10,000 per month is in place and an owner decides to sell, the annualized rent forms a return to an investor - say 4%. Therefore $10,000 annually is $120,000. $120,000 divided by our return of 4% yields a price of $3,000,000. On a square foot basis - $300 ($3,000,000 / 10,000 square foot building). Should our example be vacant and our potential buyer desiring a company address - the resulting value will be the comparable market per square foot number multiplied by the square footage. Lately, we’ve not seen a great variance between what an investor will pay vs an occupant. The “occupant premium” - whereby someone housing a business would pay more is a galaxy away.
 
Operating expenses. Leases have an additional component worth mentioning - the way in which operating expenses are reimbursed. You see, in addition to rent, other costs abound. Property taxes, building insurance, roof maintenance, parking lot sweeping, elevator repairs, mowing the lawn and trimming the trees are examples. If you’re under a Gross lease - these expenses are baked in to the monthly check you write. With a Net lease - you pay as you go. As you can gather, regardless of the form, the expenses are yours. Square footage applies based upon the percentage of the premises you occupy. Say your 10,000 square foot home is stand alone. Yep, all those operating expenses are yours. Conversely, if the 10,000 square foot space is a suite on the tenth floor of a 100,000 square foot office tower - your portion would be 10%.
 
Uses of space. Generally, occupants - whether they lease or own - put people, machinery, or products in their space. When you visit your CPA this spring to gauge the amount of your refund - you’ll visit an office. Within the confines are people. A trip to your local mechanic’s shop will evidence lifts, tire rotation equipment, and diagnostic machinery behind the front desk. Products abound in a T-mobile store. But wait. Don’t all these different types of commercial space have people, you may wonder? Sure. But the way operations employ folks is the difference - computing your marginal tax rate, changing your oil, or convincing you to upgrade to an iPhone 13.
 
Next week, I’ll delve into the acute shortage of industrial space and some suggestions on creating new space. So, stay tuned. Kirk, out!
 
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.