Owning
the building from which your company operates can be a great deal. After all,
the enterprise needs an address from which to transact business. Rent must be
paid to someone. Why shouldn’t that someone be you?
It
generally works like this. A suitable location is identified and negotiations
for its purchase commence. Owner occupied financing is originated from the
Small Business Administration - the SBA. Banks love this, BTW. Why you may
wonder? Under an SBA 504 program, banks only loan 50% of the purchase price.
The other half is made up of a government second trust deed of 40% and a ten
percent down payment. A lender’s risk is minimized and insulated by the Fed’s
involvement.
From
a buyer standpoint, you’re own for a pittance - only 10% plus points and
closing costs. If the resulting mortgage payment - called debt service in a
commercial buy - is proximate to market rent, you’re golden!
Don’t
forget the tax advantages. If structured properly - the ownership entity leases
the building to the business. Rent is paid by the occupant to ownership. Bank
debt gets paid by the owner. Bingo! Depreciation of the building improvements
over 39 years allows a tax break. Expenses related to the operation of the real
estate are deducted from the rent. And don’t forget, the real estate
appreciates over time.
Meanwhile,
the resident - your company - enjoys a stable payment and is protected from
market rate swings. It’s a beautiful arrangement.
I
have many family owned and operated manufacturing and logistics providers whose
real estate value far eclipses the worth of the company that lives there. How
can this be, you may be wondering? Allow me to walk you through an example.
First
the real estate. Let’s say your enterprise needed a 50,000 building for its
operation. If you purchased between 2000 and 2010, an investment of around
$4,000,000 was common. Back then, interest rates were a smidge higher than
today as you could borrow 30 fixed residential debt for around 6.25% and ten
year treasuries weighed in at between 4 and 4.5%. In contrast the rates today
look mighty good! But in the year 2005, if you financed 90% of your $4,000,000
acquisition at 6% - your payment was $27,031 per month. If we add $3300 per
month for property taxes, $750 for insurance and $1000 monthly for
miscellaneous expenses - your all-in figure was $32,081. If we equate this to a
rent per square foot by dividing by the square footage - your cost was $.65.
Today, that rental figure is $2.00! Even if you set up the occupant - your
company - with a lease that increased by 3% per year - today your figure would
be $53,025 or just over $1.00 per square foot. Therefore, because of your smart
move in 2005, your company has benefitted from an under market rent for 17
years. Presumably, this delta allowed the operation to function profitably.
Now
the company. Recall, a business’s worth is a multiple of the profit generated.
Sometimes this profit is given a fancy formula called EBITDA or EBIDA and
further defined by Investopedia - “EBITDA, or earnings before interest,
taxes, depreciation, and amortization, is a measure of a company’s overall financial performance and is used as an
alternative to net income in some
circumstances. EBITDA, however, can be misleading because it does not reflect
the cost of capital investments like property, plants, and equipment. This
metric also excludes expenses associated with debt by adding back interest expense and taxes to earnings.
Nonetheless, it is a more precise measure of corporate performance since it is
able to show earnings before the influence of accounting and financial
deductions.”
Thus,
a company paying rent in an owner-occupied scenario would understate its
building expenses by almost half. Recall, it’s paying $1.00 per square foot vs
a $2.00 market rent. When the profit of the company reflects a market amount,
the profit is less and EBIDTA suffers making the company’s value less as well.
On
the commercial real estate front, values have far eclipsed a 3% annual kicker
in rents. Today, a 50,000 square foot building - if you could find one - would
be in the $22,000,000 range. A whopping 450% increase over 17 years!
Next
week, I’ll describe the conundrum created with this imbalance.
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.
August
2022. Wow! What an amazing 2 and 1/2 years. I’ve written, in this space ad
nauseam, what we’ve experienced since the ball dropped on December 31, 2019. I
won’t bore you with a recap. Instead, today I’d like to offer an opinion on
where we are and what potentially lies ahead.
Industrial
has hit pause from its meteoric rise in values, office suites abound with
goodies for those willing to sign a term, and retail - especially Wal-mart,
Target, Ross, TJ Max, Tuesday Morning, Bed Bath and Beyond, and Burlington Coat
Factory are taking their lumps. With gasoline and food prices soaring - few can
afford discretionary spending like before. Consequently, earnings have suffered
as evidenced by Wal-mart’s 14% decline. Foot traffic in their stores is also on
the wane. For us, it harkens back to the deal. Are folks still transacting?
I
have thought about factors that motivate a transaction. I believe the three
factors that motivate the deal are: Attitude, Inventory, and Interest Rates.
All can influence the decision but in my opinion, only one factor can cause the
decision to be changed - a change in motivation!
Attitude:
I
have broadly lumped issues such as uncertainty, timing of a lease expiration,
business forecast, market conditions, time of year, age of the business, age of
the business owners, etc. into the category of attitude. As commercial real
estate practitioners, uncertainty is the attitude that causes the most pain. If
a business owner is uncertain about the future, a buying decision will be
postponed or a buying decision could morph into a leasing decision or your ten
year lease could become a two year lease or your new lease could become a
renewal at the businesses present location. In Southern California, the end of
2008 and the beginning of 2009 were particularly painful! We now are told that
the worst recession since the great depression began in December 2007 and ended
in June of 2009. While we can debate the end of the recession, none of us will
argue the beginning. Many of us in the business sensed a "change" was
coming at the beginning of 2008. Financing was becoming more difficult to
originate, values were at an all time high, the market was feeding off an
exuberance that many of us believed was unsustainable. Our worst fears became
reality in the fall of 2008 as the financial industry imploded, values
plummeted, and many real estate deals cratered. The uncertainty that resulted
carried into the early part of 2009 until after the Obama inauguration. Today,
CEOs deciding to bring back a workforce into the office are faced with
employees who are quite comfortable working from their kitchen table and $6.00
gasoline doesn’t motivate them to commute. With logistics buildings packed with
holiday merchandise and squeamish retailers - the situation is akin to
constipation. Something is needed to get things moving!
Inventory:
The
market's supply of suitable alternatives can affect the timing, and viability
of the transaction. We all have experienced a "seller's" market since
2019. In these times, the demand for space far out strips supply. As a result,
a seller can afford to be bullish and often is. You must carefully review the
inventory each day and put your buyer or tenant in the best position to make a
deal. Currently, the market is changing from a "seller’s"
market to an "equal" market. Meaning, the halcyon days of multiple
offers and TBD pricing may be ending. I saw my first “broker premium” for a
deal done by September 30th since 2014. What is that owner seeing and trying to
avoid? A costly vacancy - that’s what.
Interest Rates:
A
wide swing up or down can motivate a deal. We saw double digit interest rates
in the early eighties and have experienced record low interest rates for the
past decade. Since interest rates have spiked recently by a point or two, many
buyers have taken a “pencils down” approach to pursuing purchases.
Any
combination of the above can cause a change in motivation. In my
experience, this is the one thing that can cause a real estate transaction to
collapse. Let's hope for good attitudes, a balanced inventory, and affordable
interest rates!!
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.
As
I pen this, we are half way through July 2022 and Christmas decorations should
replace patio furniture next month. Anymore, it seems we have two times of year
- before Christmas and after. Before starts August 1st and after on December
26th. Everything else is just a footnote.
So
much has happened in the world - after Christmas. We’ve seen commercial real
estate values eclipse sanity, two quarters of declining GDP - read, recession -
inflation the highest it’s been since 1982, a global war in Ukraine, gasoline
above $6.00 per gallon, food shortages, folks losing their minds and opening
fire on innocents, brick and mortar retail foot traffic slowing to a crawl,
interest rate hikes, residential activity coming to a screeching halt, and
rumors of slowing in our market. My how things have changed! And in a
heartbeat.
However,
one thing that stays constant is commercial real estate fundamentals. You know,
those pillars from which we base our direction. In a changing market - it’s
helpful to keep these in mind. One fundamental is a lease agreement. Whether
renewing an existing arrangement or originating a new deal, the following
should help you bend with the changing times.
In
my experience there at least five "gotcha" issues that should be
addressed in any lease agreement. In my opinion, The AIR - Association of
Industrial Real Estate lease addresses these issues quite thoroughly - with a
few tweaks. In the case of an owner generated lease, the issues vary in their
treatment. The five issues are: Operating Expenses; Capital
Expenditures; Subordination, Non-Disturbance, and Attornment (SNDA); Rent
Increases, and Miscellaneous. I will define each issue, and suggest
"asks" during the lease negotiation. This is a layman's review as a
practitioner and should not alleviate the need to have all legal documents
reviewed by counsel. These issues are from a California perspective and may
vary by state.
Operating Expenses (Industrial):
Operating
expenses, also known as Op Exes are the expenses an owner incurs in the
operation of a property. These expenses include, but may not be limited to,
property taxes; property insurance; maintenance of the foundation, roof, and
walls; landscape maintenance; maintenance of the building's systems - plumbing,
electrical, HVAC, etc.; utilities; occupants share of the amortized capital
expenditures, etc. The costs are sometimes referred to as NNN expenses or
"gross-ups". These expenses vary greatly based upon an owner's
management preferences but are largely skewed by the amount of property taxes.
If you negotiate a NNN lease, the costs are paid in addition to your rent -
either as due or monthly. If the lease is an industrial gross lease, the base
year op exes are included in the base rent. I suggest postponing the base year
until the first full year after the commencement of the lease. If the lease
commences in February, this is a tough ask. If the lease commences in October -
not so much. I suggest asking for a cap on the increases in op exes over the
base year.
Capital Expenditures:
Capital
Expenditures are expenses that are largely non recurring such as roof
replacement, parking lot replacement, drive and landscape modifications, etc. I
suggest there be a mechanism in the lease to specify any expense exceeding 50%
of the cost to replace a capital system (roof), be the responsibility of the
owner and the cost be amortized over 12 years at an agreeable rate of interest.
Subordination, Non Disturbance, and Attornment:
This
is defined as the financing holder's means of securing their interest and the
outcome of any foreclosure. Also known as an SNDA, this clause causes the lease
to be subordinate to existing and future financing that is placed on the
property. As a tenant, a request that the lease be non-disturbed (terms not
modified), should be sought in return that the tenant agrees to attorn
(recognize) an owner that becomes the owner through the foreclosure of the
underlying debt. Requiring ALL of these is important in my opinion - especially
during economic times that could suggest a high likelihood of foreclosure. I
suggest the lease clearly provide for ALL of the components - S, ND, and A, and
that where possible the lender be persuaded to sign an SNDA recognizing the
lease.
Rent Increases:
These
are defined as increases in the rental schedule during the term of the lease.
Generally, the increases are throughout the term of the lease and could vary
based upon the change that occurs in the CPI or a fixed annual amount.
Throughout 2021 we saw these fixed amounts escalate. Recently, a lease was
written with 5% annual bumps! Wow. Almost double the amount we saw in 2019. Caps
and Floors are always suggested to hedge against a rampant inflationary
increase.
Miscellaneous:
Former
and existing cabling removal, Americans with Disabilities Act - ADA
requirements (and who is responsible), city permitting, subleasing and
assigning, rent abatement vs FREE rent, and options to extend and purchase
should all be carefully vetted and when necessary, negotiated.
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.
Due
Diligence. Simply, a time frame allotted to a buyer for studying a purchase.
Generally, there is no obligation to proceed if something untoward is
discovered. Also referred to as a contingency period, a “free look”, or in some
cases an option - these 30-75 day periods are chock full of action.
As
a buyer of commercial real estate, you’ll either occupy the premises or simply
collect rent from the tenant. Regardless, your consideration of the buy should
revolve around three things - physical, financial, and utility. Physical
aspects are things such as as the roof, mechanical systems, construction
quality, title, and age. Financial characteristics include the amount of
rent the tenant is paying, operating expenses, financeability, and
capitalization rate. Finally the utility - can your operation function
successfully?, will the property have broad appeal to the next occupant?, and
the location.
You’ll
need to engage some consultants to construct your due diligence package. If
you’re lucky - the seller will pass along a good portion of the deliverables.
If not, you’ll start from zero. My best example? We once closed a deal in 15
days. Why? The seller had bought the property a year earlier and was able to
send us everything we needed to analyze the purchase. So, what will you need?
A
physical inspection or a property condition assessment
Environmental
Phase I - also known as an ESA - environmental site assessment
Mandatory
disclosure form
Property
information sheet
ALTA
survey
Soils,
geotechnical information
A
preliminary title report
Appraisal
- if you’re borrowing money
Existing
loan information - if you’re assuming financing
Zoning
report
Plans,
permits, and approvals
Income
and expenses
Rent
roll
Copies
of leases, and estoppel certificates
Financial
information on the tenants and guarantors
Pending
litigation
Seismic
investigation
Utility
bills
Association
documents, CC and Rs
Once
complied, please keep three things in mind when deciding to go forward and
complete the transaction.
Time frames: Loan approval and the components of
that approval - appraisal, environmental, financial take time. In most
instances, 45-60 days - if you and your lender are in sync and you provide your
lender a complete package of information for your loan approval. Make sure your
agreement with the seller allows you adequate time for your loan approval and
that you can extend the time frame if needed. While your lender is crunching
the numbers, the appraiser is scouting the market for comparable sales, the
enviro engineer is reviewing the records of previous hazardous uses; you and
your team can busy yourselves conducting the balance of the investigation.
Responsibility: Ultimately, the responsibility of
analyzing the purchase is yours, but you will want to engage a bevy of
consultants to provide reports for you. Your lender will generally hire
the appraiser and environmental engineer. But, I would suggest that you have a
commercial building inspector check out the building. You probably will want
your lawyer to review the title report and discuss with you the most
advantageous ownership entity for you. If you are planning to make changes
to the building, an architect's guidance is invaluable. The architect can also
help you with city permitting and ADA path of travel concerns. Building
those new offices or adding a truck loading dock will require a
licensed general contractor. Team with one early - maybe have the contractor
check out the condition of the building for you as well as the commercial
inspector.
Recourse: Typically, you conduct your due
diligence - loan, property condition, title, permitting, etc. and conclude that
you are a go or no go for launch. Make sure your agreement allows you to
cancel the sale, for free, if something is amiss - the property is
environmentally contaminated, cannot be financed, is too expensive to improve,
or the city will not allow you to occupy the building with your use.
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.
