Should you make a Long Term Commitment in These Times?

I once authored a column entitled “Worst mistakes occupants make”. Among these are - buying when you should lease, leasing when you should buy, signing a short term lease in a downward trending market, or signing a long term lease in a peak market.
 
To review.
 
Buying. A new, rapidly growing business generally finds a better fit leasing for a term than investing precious operating capital into a static purchase of real estate. Conversely, if the company has been around awhile, is privately owned, has generated a profit for the last two years, has an ownership structure that can benefit from depreciation, and can afford the down payment and debt service - enormous generational wealth can be created by owning the facility from which your enterprise operates.
 
Leasing. When an economic outlook is fuzzy - most operations hedge by making short term lease deals. In fact, much can be gained doing the opposite - think contrarian. While the world zigs - you should zag. But, I have seen companies goof by signing term leases when things are frothy only to see the monthly amount they pay be dramatically greater than current rates - and they’re locked.
 
Most would agree we are in a changing market with respect to industrial real estate. Those occupying retail and office spaces are way ahead of us as their markets morphed years and months ago. With retail it was pre-pandemic and office as a result of the pandemic. But, now here we are with an uncertain future for manufacturing and logistics spaces.
 
So, if you lease an industrial building and you are approaching a renewal - what strategy should you employ? Assuming the space still works for you - location, size, and amenities - feel out your owner. How does she view the current conditions. Is she bullish, bearish, or running for the exits? If she falls into category two or three - she’s probably willing to forego a risky vacancy in favor of constant cash flow. Read - make you a deal! Another idea is the “blend and extend”. We saw a ton of these used in the early 2010’s and they exchange a lesser rate today in exchange for additional years added to the lease term. Both are effective. Just know your owner, know your alternatives, understand your cost to relocate, and finally - be familiar with the cost to replace your tenancy.
 
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.

Three Pillars of Success in Commercial Real Estate

I was honored recently to be a podcast guest. Because of my tenure in the business and presence initiatives - I’m sought frequently. I guess they figure - after thirty eight years - I might have something to say to their audiences. My latest interview was at the behest of my professional coaching organization - the Massimo Group. If you’d like to listen - you may do so by clicking here. https://open.spotify.com/episode/2OHyYnWAG7imnyaMHGT5df?si=iy8zBft6QaCOFVnb4j_6ww. The founder and CEO, Rod Santomassimo, and I spent some time together discussing commercial real estate and my pillars of success. I believed them to be column worthy.
 
But before I delve in to the triplets - allow me to expand upon a question Rod asked at the outset: describe yourself in high school. In a word - a nerd. Too skinny and small for football, too slow for track, and afraid of a baseball - suffice it to say, I wouldn’t have been a Steve Fryer feature. But, I discovered golf. Sure. Golf is cool now - thanks to Tiger, Phil, DJ, and Rory. But in the seventies, only visored bespectacled misfits hit the links - with Arnie being the exception. But golf created a self reliance that no team sports can do. This prepared me well for a career brokering industrial buildings. My parents divorced during my high school years. Being the oldest of three siblings - I often found myself in the role of intermediary. Once again, good prep for advising owners and occupants of commercial real estate. So a self reliant intermediary I became.
 
Allowed during the interview was my list of three pillars of success.
 
Become client centric. By this, I mean your client’s best interest is more important than your fee - period. So many new agents suffer from commission breath. The fee takes priority over all else. After all, we’re commissioned sales people whose livelihood depends upon transacting. But, if at the expense of your client - your longevity will be short. Early in my career, I counseled many against purchasing when I believed they’d be better off leasing. I should mention, the fee for selling is greater than leasing. You see, buying requires a certain set of criteria - years in business, abundant operating capital, stable growth trajectory, and an ownership structure that can benefit from owning the building in which your business operates.
 
Cooperating agents are a great source of new business. Many view an agent within their firm or another as competitors. They certainly can be. But, I’ve found they can also be a great source of referrals. I’ve found if agents in your market know your skill set and expertise cooperation can exist. I attempt to be uber transparent - without compromising my clients position - with my fellow agents. This transparency has served me well over the years.
 
Do what you say, when you say. With clients, with agents, with friends and family - just do it! One of my keys is to only commit when I know I can and then don’t let anything - short of a frontal lobotomy - cause you to break your promise. This is such a simple concept - but not an easy one.
 
So, there you have it!
 
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

The Market Disconnect

As I’ve written, in this space, numerous times - uncertainty is a killer of markets. Please allow me to elaborate. When investors or business owners have a murky view of the future - reluctance to make commitments abounds. Conversely, an optimistic opinion of what’s coming leads to hiring, equipment purchases and operational expansion. Therefore, we see long term leases and commercial real estate purchases transacted. Uncertainty is rampant in office space. Covid lockdowns, which forced many of us to work from home - was followed by tepid reopenings, high gasoline prices and a reluctance to commute resulting in a hybrid workforce. When will all of this stabilize? It’s anyone’s guess. Great deals abound for those office space occupants willing to sign a lease term of five years or greater. In my opinion, office landlords are resigned to meeting the demands of tenants by offering free rent, abundant tenant improvements, moving allowances, and bonus fees for agents.
 
We see a different dynamic unfolding in the industrial sector. When interest rates spiked in mid June, we experienced a tectonic shift in buyer attitudes - especially institutional investors. Many are on the bench awaiting an indication of which way we’re headed. We saw a similar pause in March of 2020. But, six weeks later a boom of epic proportions transpired. This rabid appetite continued through the first half of this year. Record lease and sales prices resulted. But now, we’re witnessing deal retrades - a fancy way of describing requests for price reductions - and cancellations. Even acquisitions which appear to be accretive to investor portfolios are cratering.
 
However, on the flip side - occupants of industrial real estate are thriving. One of our aerospace clients has a nine figure backlog. Another one - who slaps adhesives on tape will record his best year yet. A moving and storage operation we counsel has experienced back to back to back revenue spikes. Three peat indeed! And finally, a group we advise who provides engineering for large commercial air conditioning projects cannot keep pace with the demand. When these business boons require additional space - occupants are met with one in every hundred buildings available. Yes. Correct. A 1% vacancy! Because there’s no place to move, renewal rates have increased. Companies are being forced to get creative in solving their need for space. Some have narrowed their stacking aisles and gone vertical. Oh, but wait. That he swing reach forklift that allows you to pick orders way up high cannot be delivered for 26 months. That’s right! Over two years from now. How’s a business to plan?
 
So what’s up? Why the massive disconnect between investors and occupants? Here’s what I believe is happening. Commercial real estate prices shot up so high with expectations of rent growth and lack of supply. Then we felt some global pressure with Russia’s invasion of Ukraine, followed by four decade high inflation which caused a rise in rates to tamp down price hikes and two quarters of declining GDP. Institutional investors, en masse, chose to be bearish lest they find themselves chairless when the music stopped. Meanwhile, business marches on. Folks are working, wages have risen, demand remains strong, and the stock market is appreciating. It’s as though enterprises didn’t get the memo. Aren’t we in a recession? Isn’t the cost of borrowing more? Yes and yes. But somehow this recession is different compared to others I’ve survived. Generally, we spend our way out of downturns. But this time, the lower echelon of earners is getting crushed by higher prices at the pump and grocery store. No disposable income remains. So it’s a recession of the consumer vs a structural issue with our economy.
 
Only time will tell if I’m right.
 
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.

Deal Cancellations Abound!

The commercial real estate market has an entirely new feel these days. Gone are the buyer fueled bidding wars brought about by too few buildings chased by too many occupants - the classic supply demand imbalance. We were clipping along at warp speed for the first five months of 2022 when bam! We hit a massive speed bump named the Federal Reserve. You see, to tamp down rampant inflation - the Fed raised interest rates - some would opine too aggressively. Buyers felt emboldened to behave - well, like buyers. Personally, our team has felt the impact as we’ve had three deals cancelled at the alter. Jilted indeed.
 
Our latest divorce - terminated transaction - was the representation of a private investor in his search for a suitable upleg purchase. He sold a property in June and now must redeploy the proceeds to defer capital gains taxes. As we scoured the universe of available leased buildings - we settled on single tenant net leased industrial buildings - ideally in Southern California. Flooded in our search area were sale/leasebacks. After all, net leased real estate is created by: one, an investor believing now is the time to sell or two, an occupant who needs the equity contained in her owner occupied facility. The latter was the genesis of our deal implosion.
 
Therefore, I thought it column worthy to review sale/leasebacks and some things to consider when pursuing them. So here goes.
 
I've advised a number of my clients recently to consider selling their commercial real estate and striking a three to ten year lease with the investor that buys it. A few have listened.
 
This structure, in our parlance, is known as a sale leaseback. Different than a straight lease and not a short term lease that accommodates a purchase, a sale leaseback allows an owner occupant the chance to sell at today's high prices and remain in the building - albeit as a tenant - and avoid a move.
 
It's a slick arrangement when the correct motivations are involved.
 
Today, I want to spend a moment and discuss the downside of a sale leaseback.
 
The message it sends to the market. When a sale leaseback is listed and marketed for sale, the buyer’s questions range from - "why is she selling?" to "is her company leaking at the gills and needs cash to survive? Generally, there is a story. Its critical to understand the story, why a seller is selling, and how the current financials present. Our challenge recently was the creditworthiness of the occupant and the seas of red ink we were asked to navigate. In the end, we said - next.
 
Rent. Value is determined by taking the rent a company is willing to pay and packaging the rent as a return on investment. Simply, if the business can afford to pay $10,000 per month or $120,000 per year and the return is 5% - resulting value is $2,400,000. Easy, yes? Now the fun begins. Where is $10,000 per month in relation to what other comparable buildings achieve in rent? It's either above, below, or at par. Par or below - you're golden. Above and you're scrambling. You see, an investor looks at the worse case scenario - if the occupant spits the hook after a year, can't pay the rent - or worse files bankruptcy - then you’re stuck with a building you can't rent for the same amount she was paying. Thus was our conclusion in the failed deal.
 
Operating company is strapped. One of the befits of owner occupied real estate is the flexibility when times get tough. As an example, we own the office building we occupy. We’re the owner and the tenant. When our revenues dipped in 2009 and 2010, we simply reduced our monthly payment - to ourselves. Once an arms length investor enters the fray - you’re simply a tenant and the flexibility evaporates. In our cancelled scenario, rent was inflated in order to get the most dollars out of the sale. The problem was the rent was unsustainable.
 
There are tax consequences. As we've discussed, selling appreciated commercial real estate comes with a heavy tax consequence - unless a tax deferred exchange is employed. Yes, equity is feed, but at a significant cost - in some cases up to 35%. You may be wondering why this matters. Unless the seller has carefully thought through these consequences - the deal can screech to a halt.
 
Fortunately, we still have the engagement and are proceeding to the second possibility. This time the seller is arms-length from the company. So we’ll see.
 
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.

Is Your Real Estate Worth More than Your Company - Part Deaux

Last week we spent some time examining those fortuitous business owners who’ve enjoyed the good fortune of occupying - with their business - a facility with which they hold title. Their companies have enjoyed steady rent over the years with no need to sweat dramatic increases. Appreciation in commercial real estate values has eclipsed the businesses worth - in many cases.  As we talked last week - subsidized rent can play a role in enterprise valuation. After all, the cheaper the rent, the more profit an operation generates - which is used to project a company’s multiple. 
 
My question is - does it matter? You own both - the real estate and the enterprise. Both have more decimals than before. Business is worth more due to a rent of less than market. Real estate because of forces around us such as scarcity, demand, lack of new building starts, etc. So what? 
 
Here’s what. You now believe it’s a great time to liquidate your equity by selling the operation. Generally, two genres of business buyers will come knocking - a private equity group or a strategic operator. 
 
In the former, a goal could be to acquire a number of companies like yours, create value, and sell the bigger unit. Typically, they’ll utilize the existing footprint and attempt to operate without moving. A boon for your building ownership - IF they’ll pay a market rental rate. Don’t forget, the profit of your group is partially bolstered by the rent discount. A huge bump in rent could crater the profit of the company. In one instance, I’ve seen the difference in subsidy and market cause the profit margin to be zero! 
 
An option could be to sell - rather than lease - the real estate. Akin to selling a used car and buying a new one - this arm wrestling match rarely results in a maximum number for both your enterprise and your real estate. Many times the company  buyer will inflate the price of the business at the expense of the real estate - only to then create a long lease and sell the facilities to an investor. The proceeds are then used to “buy- down” the business acquisition. 
 
If favor is garnered by a strategic operator, a new set of circumstances occurs. Operating within the same industry, this buyer type views the acquisition as a way to expand market share, geographical reach, or specialization. Typically, they have adequate facilities and don’t want the real estate. Now you have a costly vacancy that must be filled. 
 
Finally, you should consider your return on investment. Assume your investment is the real estate from which your enterprise operates. Therefore the return is the amount of rent you charge divided by the price you paid. Structured as a home to your operation vs a return driven investment - you’ll likely leave shekels on the sideboard. Plus, now the parcels are way more valuable. The same rent divided by a new larger value will cause the returns to diminish. 
 
So what’s the answer? So long as you own the operation and the buildings are needed - it rarely makes sense to sell them. Certainly a transition - death of a principal, a move out-of-state, divorce, loss of a key piece of business - can skew direction.  
 
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.