If Your Building Sells - What Happens?

This week our team was contacted by an owner. Desired is to sell his building and re-deploy the equity into a college education for his children. A noble cause - to be sure - but one with some considerations.

Are you taxed? Yes! You see, once the sale closes, the Federal government will tax the long-term gain - appreciation of more than a year. Taxed at a higher level will be the depreciation re-capture. Don’t forget the new Affordable Care Act tax for any asset sold for more than $250,000. Oh yeah, and then our Golden State will want a taste as well. For those keeping score, all of the taxes can amount to almost half your gain! Ouch!

Outlined above is the first thing which occurs once your building sells - you’re taxed out the wazoo - unless of course, you employ some tax deferral strategy - which defeats the use of the equity for a college education.

What happens to your tenants? In our example, the real estate is occupied by three businesses - two of which have leases and one that doesn’t. The easy answer is - so long as the tenants with leases continue to pay their rent and abide by the terms of their contract - no interruption in their occupancy occurs. Assumed is the role of landlord by the new owner. Simply, he must adhere to the terms and conditions of the lease agreement(s) in place - the rent, term, increases, extension rights, etc. 

A much different story unfolds for the poor dude without a lease, however. You see - he is vulnerable. His rent can be jacked up or he can be asked to vacate. Best case, the new owner allows him to stay and offers a new lease with the same rent he enjoys - highly unlikely in today’s super-charged market.

Gotchas? Sure. Again, the tax man. Upon sale, the real estate is re-assessed for property taxes. Generally, property taxes are re-booted to the selling price. So who pays the increased amount? Yep. Generally, the tenants - assuming of course the leases allow for this “pass-through” - which most commercial leases accommodate. Who cares? Well, you should! You’re strapping your loyal occupants with an increase in their monthly out-flow. Or, short of the “pass-through” provision - the buyer pays you less because he must swallow the new property tax.

Special circumstances? Certainly. Before racing out to the market with that sale package - carefully consider your tenant(s) extension rights - options to renew their leases, ability to take over additional space, or ways to cancel. ALL of these circumstances can affect the value of your building. Did you agree to allow your occupant to buy the building through an option to purchase, a right of first refusal, or a right of first offer? If so - you must follow a protocol tantamount to a NASA launch sequence before openly marketing your holding.

Is your tenant the BEST buyer? Quite possibly. Short of any “rights to buy” you may have granted - the company who pays you rent each month could surprise you - and offer you the most. After all, they “live“ there and have for some time. In many cases, your tenant knows the building better than you do. Faced with a move vs converting their lease to ownership - buying can make sense.

Allen C. Buchanan, SIOR is a principal with Lee & Associates Commercial Real Estate Services. He can be reached at 714.564.7104 or abuchanan@lee-associates.com  his website is allencbuchanan.com

Why Hire a Broker - Just do it Yourself!

Selling a commercial real estate asset is akin to planning your daughter’s wedding - sure, you can do it yourself but things go much more smoothly if you have a wedding planner - AKA a commercial real estate professional.

Certainly, you can do a quick Loopnet search, establish a price, purchase a For Sale sign at Home Depot and wait for the phone to ring - set the date, book the church, rent some tuxes and order the cake - this is easy!

Vista Print will create a glossy brochure of your building, mail a few to the neighbors and the inquiries will start to flow - Wow! They do wedding invitations too? Cool! Invite aunt Marjorie and a few dozen friends and let’s do this!

Just got your first hit! They want to see the building next week. Oh wait, you’ve a day job and can only meet the buyers on weekends or evenings. Hmmm, this doesn’t work for the buyers- now what? I guess you could slip out during lunch - but what if the buyer is late or stiffs you? Time wasted - and on an empty stomach.

OK, you get them through. They like it. An offer will be forthcoming. I’ll bet you’re glad you’re saving that 6% you’d have paid the broker. Why don’t more folks do this themselves?

Your prospective buyers call. Do you have a recent appraisal? Does the roof leak? When will the tenant vacate? What will be left when the occupant leaves? I noticed the building doesn’t have central air. Do the cracks in the floor portend something serious? Would you consider seller financing as we have a small credit blip - a bankruptcy? Oh, by the way, my wife has her agent’s license - so we will be deducting 3% from our offer. Next!

Three different agents - who comb the area - call. We have qualified prospects who would like to see your building. Will you pay us a fee if we bring you a buyer? Can you forward to us any marketing collateral you have? Any idea how much electricity feeds the property? - as one of our buyers is a machine shop. One of our guys stacks products high in the warehouse. Will the sprinkler system handle high-piled storage? What is the zoning? Our buyer is a trade school. Will the city allow that occupancy without a conditional use permit? Hmmm. Feeling a bit overwhelmed?

Finally, your perfect buyer appears - dressed as Prince Charming. Let the wedding bells ring! After all, a commercial real estate deal is a union of sorts. You gloat a bit as your email buzzes with a full asking price offer. No financing required, quick close, as-is - alright! Done. But, not so fast. You see, this buyer has made three full price offers to three separate owners. His plan is to tie up all three - and jettison two of the three. Will you be saying I do? Or, I wish I had - hired that broker.

May I Make Changes to a Commercial Lease?

We just completed a very simple - or so it seemed at the outset - lease transaction on an industrial building in the City of Orange.

Well over half of our deal volume is in leasing and the other portion is sales. Unlike our residential counterparts - leasing is a BIG part of what we do!

So what added the complexity to a straightforward deal? The lease and appurtenant comments by tenant's counsel!

This episode begged the question - can changes be made to a commercial real estate lease? The easy answer is - certainly! Everything in a transaction is negotiable. The more difficult concept is "when" you should request changes to the lease language. That - dear readers - is the subject of today's post.

Recently, I authored a column entitled "Gotcha clauses in a Commercial Lease". At a minimum, you should ensure you have a complete understanding of how your lease addresses these items.

Next, carefully consider a few things.

How badly does my company need the space? You see, the expansion needs of your business can easily trump - sorry - the addition or deletion of a clause in your agreement. In other words - if you are adamant plumbing repairs be the landlord's responsibility - and you lose the space because the owner is unwilling - that could be costlier than unclogging a toilet.

Are there backup suitors willing to snatch your position if you attempt to die on the freeway of lease language? If so, you might want to tap the brakes on the tenor of your language negotiation - lest you end up in a heap on the 405.

How much is the total consideration of your lease? This figure is easily computed. Take the monthly rent multiplied by the annual escalations times the number of years. As an example, if the year one base rent is $10,000 and you've agreed to a rent increase of 3% annually for 3 years - the total consideration is $376,362 - a big amount of money - but an owner may be unwilling to spend attorney dollars changing a standard lease agreement. Conversely, if you're talking about a 15-year lease for $5,000,000 on an owner lease form - an investment in counsel is a good one - for both parties. 

Finally, consider the owner of your building. If the landlord owns numerous square feet of space and is used to change requests - a few minor tweaks may be in order. If you are dealing with a mom and pop who own one building - changes may be more difficult. A multinational owner with millions of square feet will have an arsenal of attorneys ready for an arm wrestle - so lawyer up!

My Property Didn't Appraise - But Why?

Recently, I counseled my sister-in-law. She is selling her house and the appraiser was scheduled to visit.

Although this column is commercial real estate focused, some of the same appraisal principles apply - plus my associate suggested I write something about the process and how slight assumption variations can cause wide swings in value.

So to all y'all out there with a bad number, here's why.

Reason one. Lender review. Since the financial music stopped in 2008, banks have been very careful to ensure appraisers don't have un-tethered reign. Consequently, appraisers are engaged by the lender - not the buyer or seller - and a strict review process is conducted once the appraisal is submitted. I've had appraisers assure me we were OK - only to have the review disagree.

Reason two. Rear view mirror. Comparable sales and leases are tantamount to a fair valuation - and are known in appraiser speak as the market approach. However, past history - done deals - only show you where you've been - not where you're headed. In an up-trending market, a sale that occurred three months ago may dramatically understate the current conditions.

Reason three. Assumptions. Market approach - has a second cousin - the income approach. Necessary for a proper look are recent lease transactions and the capitalization rate investors are paying. You remember capitalization rate - or cap rates, right? - a percentage measure of the net income divided by the purchase price. Well, in order to get there, an appraiser must assume a lease rate - tough to do because lease comps are not readily shared by commercial real estate professionals and a cap rate. As a cap rate is a measure of risk - the higher the risk, the higher the cap rate - the rate used can swing a valuation dramatically. Simple math - Income of $100,000 with a cap rate of 4.5% yields $2,222,222. But increase the cap rate to 5% and we get $2,000,000 - a delta of almost a quarter million dollars.

Last year - in this space - I provided four solutions if find yourself on the short-end of a valuation. In case you missed it, you can quickly catch up by clicking this link. The punch line - Seller reduces the price, buyer ups his down payment, parties cancel the deal, and/or compromise.

You've Really FOUR Choices with your Commercial Real Estate

This week, I had the pleasure of advising a family. Held as income properties were two parcels of commercial real estate which had been in the family for years.

As the ownership morphed over time due to succession, the heirs were looking for counsel - thus they contacted me. The conversation which ensued I believed was column-worthy - so here goes.

As a qualifier, these folks are arms-length investors - they reap the rent the buildings generate and do not occupy either building with a business.

So, if you own commercial real estate as an investment, I believe the ownership directions are fourfold:

Continue to own and manage the buildings. Vacancy throughout the term of ownership has been minimal - the family has managed to keep the spaces filled by offering below market rents. This is a great strategy for a long-term hold. Avoided is the origination of a new tenancy which costs time - abated rent and vacancy - and money - tenant improvements and broker fees. In some instances, originating a new lease can consume 25% of the expected rental revenue! Wow. That's a big bite just to nudge a tenant up to a market rate and risk them moving.

The next three scenarios could potentially generate a taxable gain - which is the subject of another column.

Sell the buildings leased. Remember those rents at below market rates we discussed? Yeah. That is the downside of selling the buildings leased. You see, the value is determined by the cash flow produced - less cash flow equals less value. So, if your desire is to maximize your sales price by selling with tenants in your commercial real estate, you should consider moving the rents to market - potentially suffering the vacancy and re-letting. Easy math would analyze the expected increase in the selling price minus the cost to re-rent the buildings if necessary.

Sell the buildings vacant. Your ideal buyer for the real estate may be the tenants the buildings house. Afterall, they are in residence and may dream of owning the space they occupy. Approach them. If you receive "no interest", explain your strategy of allowing their leases to expire and locating an owner occupant to buy the buildings. Their tenor may change. In most cases, an occupant will pay more than an arms-length investor - because occupants look at utility - investors at their returns.

Scrape the buildings and sell the land. Sadly, at some point, the improvements eclipse their useful life and the underlying land is worth more than the land with a building. You'll need to take a look at the necessary upgrades - roof, air conditioning, seismic, parking lot, plumbing, electrical, etc. A review of the costs to bring the building up to "market standards" will help you determine the value of your building improvements - and whether they are worth salvaging.

Four Ways a BUILDING adds to Business Profit

Your decision to relocate your business was well reasoned. Considered were the operation and growth trajectory. Analyzed was the best deal structure for the company - lease or own. You endured countless tours of the available commercial real estate that met your criteria. Negotiations and paperwork followed - and culminated in the lease or purchase of your new business home.

If you decided to buy - alright! echoed your rejoice when the title officer called with word your "recording was confirmed" - which meant you finally owned a building.

So now that you've moved - can the building make your business more profitable? Humor me as I build a case for profitability - you know - revenues minus expenses.

If you chose to buy a building:

Your "rent" is fixed. Expenses are generally lumped into three broad categories - the cost of sales, operating expenses, and miscellaneous. The amount of rent paid is an operating expense of the business. Whether the "rent" is paid to an alter ego of the company's ownership or paid to an arm's length landlord, matters. If the owner of the building has no relationship to the business ownership - his sole motivation is to collect as much rent as possible. At the expiration of your lease - expect an increase in rent. Conversely, if the occupant and owner are mirrors of one another - a favorable rent can be achieved. If the debt financing the acquisition is at a long-term fixed rate - even better.

Regardless of leasing or buying:

Employees are happier. Pride of ownership in your location causes employees to produce more - because they are happier. A private office, a collaborative work environment, clean lunchroom, ample parking are all intangibles that create a positive work environment.

The operation is more efficient. Lack of space or poor space utilization means you are spending time unproductively. Classically, we see this when products have evacuated the plant and are temporarily stored outside during operating hours. Paid are the people moving the stuff in and out - when they could be producing more goods. Also, by properly maximizing the height of a building, you may be able to occupy fewer square feet - fewer square feet - fewer dollars spent - more money in your hip pocket.

Customers can find you. If you can't be found - you are invisible. The right location with close freeway access can boost your business - just because more customers will flood your doorway.

Five BIGGEST Mistakes Owner Occupants Make

If you own commercial real estate you either occupy the buildings with your company - owner occupant - or you rely upon the rent paid by a tenant - investor. I have clients that are both owner occupants and investors - they own the building from which their company operates AND they own additional commercial real estate which is leased and provides a nice income to supplement their day job.

With that differentiation as a benchmark, I want to describe the biggest mistakes I've seen owner occupants make.

Not having a current lease agreement. Generally, an entity owns the building and a related entity occupies the space. In the case of an owner occupant, the two entities may be tied by a common individual - Allen C. Buchanan, LLC owns the building and Allen C. Buchanan Company is the resident. Cool. Many times - because Allen, LLC is collecting rent from Allen Company - no official lease exists. After all, money is going from the left pocket to the right - no need to have that in writing. The fun begins when something happens to the individual and now his heirs must piece together the understanding. I actually witnessed a manufacturing company be forced to move when the heirs smelled dollars and no lease had been executed.

Over improving. You know that house down the street from you that is larger than the lot will allow? Yeah. We have the same with industrial real estate. When the physical space will no longer allow for growth - adding employees or machinery - many owner occupants add square footage to their building through second stories or production mezzanines. If a building was not designed to have an upstairs and one was added  anyway - the resulting product becomes difficult to sell.

Not fully utilizing. The opposite of over improving is not fully utilizing the space that exists. Frequently, a re-work of the manufacturing flow or warehouse racking will find much needed and under-utilized space.

Keeping the building when the operating company is sold. I wrote about this in a recent column entitled "Be Careful If You Sell Your Business and Wind up the Landlord of a Vacant Building". Inherent in this issue is the belief that if you sell the business and the business buyer is prepared to continue leasing the building - you are golden. Weighing your options - sell the building or keep the building - revolves around this question - would I want to own the building if it was vacant?

Using the real estate as an ATM. Frequently, banks view real estate as better collateral than other business assets - goodwill, account receivables, inventory, equipment. Observed are cases where the amount of money owned against a location are far in excess of the sale value. Maybe not an issue unless you are forced to sell the building.