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.

Is Your Real Estate Worth More than Your Company?

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.

Commercial Real Estate Climate

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.

Recession, Retrades, and Fundamentals

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.

What Should a Due Diligence Package Contain

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.