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.

No Response to Your Offer - Now What?

One of the most frustrating things we encounter as commercial real estate professionals - and you as a buyer of commercial real estate - is a "no response." Zilch, nada, zero, crickets, anyone - Bueller?, all describe that sinking feeling you suffer when an offer is made and hours or days pass with no feedback.

Believe me, buyers, we feel your pain as a "no response" is much more difficult to explain than a quick "no thank you!"

A great deal of emotion is expended deciding to pursue a property. When  met with nothing - the agony of defeat looms large.

So, why, you may ask, is my offer not receiving the red carpet welcome you believe it deserves? Indulge me as I proffer a few hypotheticals.

Your offer may not be very good. Many times, these days, asking prices make no sense are are not based on a real view of the market - I refer to these as arbitrary owners. Your well intentioned, researched and comp based offer may just not be enough to move the seller needle.

Competing offers may be in play. If a deal is priced right and there is no "hair", multiple offers prevail - and in some cases at above asking price. Occasionally, a seller will wait until he has several offers and then respond to one or all with a "best and final" request.

Seller decision making may be convoluted. Frequently, a commercial property is owned with an entity with multiple owners - thus decision makers. Allow a disagreement in direction to occur within the ownership ranks and - you guessed it - gridlock.

Something entirely un-related may have occurred. A death, extended vacation, business set back, a new lender requirement will cause a seller to re-think his strategy and delay a response.

Your offer may be too good. If a seller receives a full price offer immediately after listing - with limited contingencies, all cash, and a quick close - something curious occurs. Sellers may believe they've priced their offering too low and delay responding until a review of comps and availabilities can occur.

The seller may not have a destination for the money. As I have previously opined, sales of commercial real estate can create large tax liabilities. Tax burdens can be deferred with a 1031 exchange but if the seller is un-prepared for this shock - if I can't find anything to buy, I owe how much?- your offer may languish.

The seller may not have a place to move. Our market is encumbered with the lowest number of vacant buildings in history. Similar to not having a place to deploy the sale proceeds, if the owner occupant cannot find a place to move his business - a quick response is fantasy.

Are YOU Prepared for a Rent Increase?

You've opted to lease your business location - which means every month you pay rent to a landlord. Several considerations led you to the decision to lease versus own your building. We will leave the lease versus own conversation for another day.

Today, my goal is to discuss the dynamics that will cause your rent to increase - sometimes dramatically! Hopefully, the topics discussed here will prepare you for the call that your rent will soon balloon.

When a commercial real estate lease originates, the number of years - term, rent amount, rent increases, concessions - such as abated rent, building improvements and the like are spelled out in the document you and the landlord sign.

As the term of your commercial real estate lease can dictate increases in your rent, a brief explanation about length of leases is important to review.

Depending on the size of your space, lease terms range from month-to-month to ten+ years. A smaller space - fewer than 5000 square feet - normally means a shorter term - fewer than two years. Why, you may ask? Tenants that occupy small blocks of space are frequently start-up companies without the benefit of years of financial history. In some cases, these businesses are a payment risk. Landlords counter this risk by limiting the lease term - the overall amount of rent to which a tenant is obligated. Additionally, growth trajectory is tough to quantify with a new enterprise. Therefore, these operators are reluctant to commit long term lest they outgrow their digs.

With term explanation as a back drop, there are several other factors can cause rents to rise. I've ordered these from least to greatest:

Increases in operating expenses. Operating expenses include charges for property taxes, insurance on the building, common area maintenance - landscape, trash, utilities, parking lot sweeping, a share of capital expenses - a new roof or air conditioner, and in some cases property management. All of these charges are either baked into your base rent - a gross lease, or are paid for in addition to your base rent - a NNN lease. Unless your agreement specifies otherwise, as these expenses increase over the term of your lease - yep - your rent increases.

Pre-set increases throughout the term. Leases today typically carry annual increases in the base rent of 3%-4%. Gone are the days where the amount of rent paid each year increased by the change that occurs in the Consumer Price Index. Even though three to four percent annually seems steep compared with inflation - please understand, commercial lease rates have increased approximately 70% since 2009 - a staggering 8% a year! So, if you signed a ten year lease in 2009 with annual escalators of 2.5%, prepare for a bit of a jolt next year.

The sale of your building. The largest operating expense is property taxes. Recall, these are paid as a part of your base rent or in addition to your base rent. Annually billed at one percent of the assessed value of the real estate, property taxes can increase a maximum of two percent per year - unless - the building is sold for more than the assessed value. And then, WHAM! You are stuck with a huge bill.

The expiration and renewal of an existing lease. The coup de grace these days. Many leases expire and are slated for renewal - as our volume of leasing hit a peak in 2010-2013. A seven year lease originated in 2010 expired last year as did a five year lease commenced in 2012. Shock and awe are mild adjectives to describe tenant reactions to their landlord renewal proposals. Met with a limited amount of available buildings, many tenants have been forced to swallow hard and accept that their rent might increase 30-40%! Ouch!

Next week, I will discuss some strategies for limiting your rent increases - so stay tuned, faithful readers!