Is Your Building Ownership a Mirror Image?

Commercial real estate ownership is a beautiful thing! What other investment can you own and experience the tax advantages of depreciation, passive income treatment, and capital gains - all while the asset is appreciating.

If you own a business that occupies your commercial real estate - even better! Now, you have the occupant (tenant) paying you (landlord) rent. I’ve witnessed this structure numerous times over the years - and it works the majority of the time.

Today’s column is centered around those few occasions when the structure hits a snag.

First a bit of background:

Common among commercial real estate ownership is an entity known as an LLC - Limited Liability Company. An LLC may have one or a number of “members” each with a percentage of the stake. The LLC owns and operates the real estate - collects rent, pays the bills, is registered with the state, and files a tax return. Generally the taxes owed are passed down to the members via a K-1. Great!

Common among operating business ownership is the corporation - generally a C or S Corp. Each have different rules of taxation - which is a topic for another day. Suffice to say this entity pays rent to the building ownership - LLC. Cool!

Here’s where things can get dicey.

The LLC and Corporation have different owners. More than once recently we’ve seen this. What starts as an LLC with members whose ownership percentages mirror the shares of the business corporation can morph over time. In one extreme example - we had a building ownership comprised of a church, an ex-wife, two of the original owner’s children, a non-profit, and a former health care taker. By the way - initially the LLC had one member - the proprietor of the company! Death of the original owner caused all manner of chaos - as you can imagine. The result? An eviction of the business and a forced sale of the real estate. Ugly!

The operating business changes hands. With the spate of merger and acquisition activity these days - this is quite common. Typically, the company is acquired, a lease is struck with the LLC and things proceed. Over time however, a disconnect can occur - a smaller footprint is needed, sales decline, expensive improvements are required, the business goes bust. All easy when the building and business are identical twins. Not so easy when the twins are fraternal.

The commercial real estate is sold. No problem if you’re happy to fork over close to half the gain the commercial real estate has enjoyed. Sell it and pay Uncle Sam and Cousin Gavin. Done! If, however, the LLC chooses to defer the gain through the use of a 1031 tax deferred exchange - the LLC - all of the members - must be in lock step. What if an LLC member wants to take his cash and move to Cabo? A complicated buyout must follow. We’ve witnessed what’s called a “swap and drop” in these instances. Simply, the LLC is disbanded and replaced with a Tenants in Common vesting. Now the “tenants” - upon the sale - can self direct their percentage of the sale proceeds. In practice, this is much more complex. Please seek tax and legal counsel before employing this strategy!

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.com.

What Can Make a Sublease Unmarketable - 5 Situations

I recently wrote about the Yin and Yang of subleases wherein I discussed the elements which make a sublease risky and non-beneficial to the owner and occupant of a building - “because subleases are generally unfavorable to the original occupant (sub-landlord) and owner (master landlord), risky, and complicated.” Also discussed was a definition of a sublease - “What is a Sublease? When a tenant must relieve himself of a lease obligation prior to the expiration of the lease, the need to sublease occurs.”

Today, I embark on an explanation of the five situations which can cause a sublease to be unmarketable.

The term of lease. We toured a space yesterday being marketed for sublease. A decision to vacate prior to the expiration of the lease was made by an occupant whose corporate headquarters are out-of-state. Now fifteen months remain on the lease obligation. Akin to a well shopped clearance rack at Nordstrom - the short term will appeal to very few occupants. You see - generally - a three to seven year term is sought by prospective tenants. A move is expensive, disruptive, and quite inefficient. Most are unwilling to move only to do so again a year later - if extension terms can’t be reached with the owner of the building.

Uncooperative owner. Owners ride the length of their leases through market swings. In the example above - additional years could be tacked onto the fifteen months - if - the owner will play ball. Where we are in a market cycle - up or down trending - can predict how a landlord will react to a request for a longer lease. If our market is improving - he has no incentive to strike today. Storm clouds on the horizon? Yes! Let’s deal.

No concessions. A tenant with remaining years on their lease wants out - as quickly and cheaply as possible. Consequently - requests for changes to the space - at the tenant’s expense - are not typically on the table. Furthermore - most occupants - who have vacated - are not interested in investing to re-furbish the interior. Therefore - a sad, worn out building greets prospective occupants. Not terribly inviting.

Credit of the occupant. An owner with an Amazon lease will not be terribly interested in accepting anything less. Why should he? He has Amazon on the hook. If Amazon has decided the unit no longer meets their needs and vacates - the owner can be quite selective in backfilling.

An above market rent. Any lease in SoCal originated after 2015 will most likely be above the going rate today. So grouped with your amazing credit, a short term lease, an uncooperative owner, and an unwillingness on your part to paint and carpet - you could be stuck. So what’s the answer? Conduct a fire sale of sorts. Take a look at what you owe and figure 75% of that amount. Now market your sublease at that reduced rate. You might just find that unicorn willing to transact.

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.com.

Six Tough Commercial Real Estate Conversations - Cooperation Can Help!

Cooperation is a reality in commercial real estate deals. Meaning - a buyer and seller or landlord and tenant - must reach an agreement. Simple. But there are other layers of cooperation which factor in - the professionals representing each side - brokers, lawyers, lenders, CPAs, and the like. All must genuflect at the alter of a deal for it to close. Generally, the level of cooperation is enhanced when the advisors do their jobs. That is - conduct the tough conversations which should precede any transaction. Indulge me while I describe a few of my favorites.

The disruption of a move. Sure. Moving to save a few dollars may seem like a good idea. But, a move is expensive! Once physical moving expenses, the potential loss of key employees, downtime, fixturization of the new facility, and customer confusion are weighed - are you really saving? Have you considered things such as internet speed, a new phone number, website changes to reflect the new address, revised marketing collateral? Add any sort of complexity to the use with which you utilize the building and a costly use permit may be needed. Someone must consider the true cost of a move before you wander into the market.

Taxes, taxes, taxes. Uncle Sam, the state of California, and the Affordable Care Act will all want a major taste of your sale proceeds. The time to understand the impact is before you plant that “for sale” sign. Easy math. You can plan on approximately 40% of your gain to be consumed by taxes. Whaaaat? That’s correct. A tax professional can run the numbers for your specific situation. Sure. You can employ certain tax deferral strategies - a 1031 tax deferred exchange, a charitable remainder trust, or an installment sale - but all come with complexities which should be fully vetted.

Market realities. Small business owners that buy or lease commercial real estate are smart. They read. They listen to their customers. They’re informed. In today’s market - unrealistic owners get crushed. The halcyon days of crazy asking prices, waves of buyer interest, and feeding frenzies have vanished like La Niña. Sure. Deals are transacting - but, at a more normal pace.

Condition of the building. During the go-go days of 2016 and 2017 - a buyer would overlook repair necessities such as the roof, air conditioning, paving or exterior condition. Not anymore. We recommend a pre-sale inspection to identity any issues and an assigning a cost estimate. Even if you opt to wait on the fixes - you know what they will run.

Limited availabilities. The weird thing is demand still exceeds supply - there are fewer buildings on the market than buyers. What’s changed since last year? Buyers are proceeding more cautiously, offers well below asking prices are the norm, and market times have increased.

Complete information. Access to scaled drawings, an office layout, a building inspection highlighting the condition and needed repairs, a current title report, copies of leases, expenses, maintenance contracts, and utility bills - all can hasten the timing of a transaction. Buyers will ask. Have them ready.

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.com.

Operating Expenses - A Primer

Generally, January is the time of year when your landlord will present you with an invoice for expenses - in addition to your base rent. This assumes - of course - that you lease your business home. However, if you own your business home - take heed - as you may be able to take a few more dollars from your left pocket and move them into your right pocket - by asking your occupant to pay for some stuff. This column is designed as a primer for these expenses.

Let’s define a couple of key terms - shall we?

Operating Expenses. Typically defined as the costs of maintaining the commercial real estate in which you reside.

Lease form. Forms of leases vary as widely as days of the week but commonly are either net or gross. Meaning - your base rent is net of the operating expenses - or in the case of a gross lease - your base rent includes operating expenses.

Now let’s dive in!

What expenses are included as operating expenses. Biggest in this category are property taxes. Currently, property taxes are based upon roughly 1% of the building’s assessed value. I say roughly because certain cities may add fractions to this percentage. You can easily check on the amount through your county assessor’s website. Next, insurance on the property - which is different from the liability policy you carry for your business and contents.

Finally, common area maintenance which is a broad category of expenses which can encompass mowing the grass, trimming the trees, sweeping the parking lot, disposing of the trash, exterior lights, property management, changing the air conditioner filters, and reserves for capital expenditures such as roof replacement. Treatment of these CAMs - as they are called - varies widely among owners. Simply, some may not bill for these until due whereas others may budget for them monthly. Still others may not ask for any reimbursement.

What expenses are not included in operating expenses. A major system replacement - such as a new roof or air conditioner - or, changes made to the exterior of the building - like new pavement or parking lot lighting - falls into a class known as capital expenditures. As noted above - some landlords budget for these through reserves while others bill their tenants when the changes occur. Please check your lease. Treatment of these costs should be outlined. Commonly - language allows your owner to bill you for portion of these expenses spread over time - but not a lump sum. Expenses related to accounting, mortgage interest, entity fees, and business licenses should not appear on your invoice.

Gotchas. If an ownership change occurred recently - property taxes will increase based upon the sales price. As a tenant - you generally shoulder this bump. Watch out for generalized expenses. Most leases allow for you to reasonably audit any expenses you’re asked to reimburse. If you don’t understand a line item or if your owner simply sends you a flat amount to pay - ask for back-up. Check to see if your lessor can require you to paint the exterior. This clause killed a deal for me recently. 

Finally, anticipate these costs when you negotiate your next lease or renewal. Simple things like asking for operating expense increases to be limited or moving a base year forward can save you loads.

Allen C. Buchanan, SIOR, is a pricipal 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.com.

Commercial Real Estate Advice - When Do You Need It?

Seemingly an easy retort? Certainly. I need advice when I’m buying, leasing, or selling. These three circumstances would apply to either side of the aisle - whether you are an owner or an occupant of commercial real estate. Ok. Done for this week. Well, not quite and since I’ve a few more words - indulge me as I share a few more situations in which commercial real estate advice may be necessary.

A transition. Twice last week, I counseled occupants that shared this circumstance. Both enjoy the benefit of owning the buildings their companies occupy. When the buildings were purchased - Bill Clinton was president. Ownership of the business and building were synonymous - albeit with different entities. Flash forward. Due to a couple of untimely deaths - the LLC building ownerships only have one common link to the operation’s management. Plus, in one case, the company finds itself with too much space - in other words the building no longer works. Where before both occupant and owner sang from the same song book - now the music is a bit off key. Needed is a careful parsing of objectives and a clear path forward.

Efficiency discussion. How do you get the very most productivity out of your manufacturing location, your suite of offices, or your retail store front? Often, the answer is not a move but a re-tool of the flow of the operation. Countless times I’ve toured a warehouse distribution building with the premise - the operation is out of space. Sure. The floor is consumed but the inventory is only stacked to half capacity. This “cube” space is free if you can utilize it. You see, commercial real estate is billed by the square footage. Simply, you pay for the floor area - not the volume of the building. A better investment - vs a move - might be in a new forklift to reach the heights of the building’s ceilings.

An alignment of motivation. What is optimal? Often, I find an in-depth discussion leads to a solution no one had considered. For instance. If operating capital is needed - why sell a building you own with no debt - only to suffer the consequences of Uncle Sam’s outstretched hand. A better cure may be a re-finance of the building’s equity. Another circumstance. Why hold out for the last dime with your occupant who is approaching the expiration of his lease? A simple math exercise should show you how costly replacing his tenancy will be. Share the savings. If he renews - even at less than a market rate - you both win.

What is ahead. Many of my meetings these days start with the question - how is the market? My response. We are seeing signs of cooling - variance in closed amounts vs asking prices, more time on the market, fickled investors, a more cautious - “let’s wait and see” attitude from occupants. The crazy thing - this slow down in activity hasn’t resulted in a rise in our vacancy - but it will. You heard it here.

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

The “Brady Bunch” of Facilities

Our week was highlighted by two meetings which were of particular interest - thus my desire to share. Common among both operations with whom we met was the recent acquisition of a competitor.

Akin to the comedy sitcom of the 1960’s - The Brady Bunch - where two families were melded into one - both companies now find themselves with the task of managing the excess or inefficient capacity.

As you know, if you’ve watched reruns - Marsha, Greg, Bobby, Cindy, Peter, Jan, Mike, Carol, and Alice ultimately co-habituate peacefully - although five seasons and 117 episodes were consumed telling “the story of a man named Brady.” A similar saga occurs when two businesses are joined at the hip.

In the first case, growth had occurred organically - with great products marketed to a number of customers who saw the value and bought more. With an increase in sales and the need for more space - each operator looked to proximate buildings to house the explosive up-tick in orders. Each enterprise functioned - albeit a bit clunkily.

Flash forward. Packaged were two groups that essentially served the same buyers but from different operating facilities. The “marriage” created a behemoth of inefficiency - with receiving, manufacturing, storage, shipping, sales, marketing, accounting, and management essentially quintuplicated. 

Now considered is a consolidation into one facility - essentially moving the Bradys into a house in Studio City. Carefully vetted in the weeks ahead will be the disruption of production, moving costs, future needs, available buildings, disposing of the existing lease obligations, and return on investment. Should be fun!

Our second group achieved its size through acquisition. Consumed was any competitor in its path. Awesome. But the wake is similar to the Brady union - you’ve two sets of kids - pairs of whom are the same age. In commercial real estate parlance - the business has duplicated its distribution footprint serving the same geography. Complicating the equation - a trend in logistics - higher ceilings and larger truck courts. Allowed is the occupation of fewer square feet - stacked higher with product and accessed by longer trucks containing more inventory.

 Ultimately, a distributor can occupy fewer square feet and store the same amount of stuff. We now must figure out where the employees live, proximity of the centers to their customers, and the right sizes for the mirrored buildings. Just a simple puzzle to solve!

Stay tuned in the week’s ahead for an update on our progress.

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

The Downside of a Move out of State

Yesterday, I concluded a meeting with a local manufacturing and distribution company. Family owned and operated by two California born and raised principals - the business has experienced exponential growth over the last couple of years.

That seven year lease signed in 2015 - which was to adequately house the operation - has now become a liability - as the operation is bursting at the gills. All measures have been taken to efficiently use the space available - creative material handling, automation, storing product off-site, outsourcing - but the fact remains. The company will have to move before the lease terminates in 2022.

Three options are now on the table - a relocation down the street to a space 50% bigger or a move out of California - to either of two business friendly states. Moving a mile or two down the road is a simple fix with measurable benefits - more space, less disruption, employees retained, done! However, this ownership has seized the opportunity to consider another - more forward thinking and long term solution - a move east - like well east of the 57 Freeway.

As previously described - a move out of California carries significant upside - a more business friendly environment, fewer regulations, cheaper housing, no state income taxes, and utility subsidies.

But with the ying of reasons to move - there is also the yang of negatives. That downside - dear reader - is the subject of today’s column. So, before you load that moving van - please consider the following.

Lack of available buildings. Even with the desperately low availability of commercial real estate these days - we still have created a base of existing buildings which totals billions of square feet. Anaheim alone has close to 100,000 million square feet of existing industrial buildings. A visit to Allen, Texas or Greenville, South Carolina and you’ll find acres of vacant land - but very little standing inventory. The oweness is placed upon you to build your own facility. Even with a land gift and streamlined permitting - you’re looking at 12 to 18 months of construction. Don’t forget the land freezes in certain places east of here. Oh, yes, and consider other delays - such as rain.

Skilled labor shortages. If your operation requires a level of expertise to operate computer numeric machines or tool medical devices - you may be sorely disappointed in the pool of employees. Granted, states are working with community colleges to train people with the necessary chops - but you’re still looking at a deficit.

It’s difficult to move back. Once you decide to sell that home in Corona Del Mar and move to Nashville - the barriers for re-entry are akin to an Apollo spacecraft returning from Lunar orbit. Sure, you can keep your place here - but our golden state will want a taste of the company’s profits - which defeats the purpose of an out-of-state location.

Cultural differences. There is no place quite like California - even with its warts. This from a man who lived his formative years well south and east of here. It’s said in the South - “folks will treat you nicely - but, won’t trust you unless they trusted your grandfather.” Where do you think the “old boy network” originated? My 85 year old mom still refers to her neighboring Cooper Rubber execs as the Yankees up the street. The family moved there in 1965! Just sayin.

The WEATHER! Folks who have never experienced six weeks of sleety ugliness each year take for granted the 300+ days of sunshine we enjoy. What’s overlooked is the loss of employee productivity where weather is a factor. Sure, four seasons are cool - unless you have to live through them. If you want to see leaves turning - or snow - just make a weekend jaunt to Oak Glen. There! Seasonal fix administered.

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