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.