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.

Should you Acquire a Special Purpose Building?

Commercial real estate assignments ebb and flow between buyer opportunities and seller representations. Occasionally, we’re asked to market a special purpose building or find ourselves considering one for our clients to purchase. These unicorns can portend great risk and must be evaluated carefully. But before I launch in to how I caution buyers against said beasts - allow me a bit of explanation.
 
A general purpose industrial building has broad appeal to the universe of buyers. Most structures fall into this category. Such things as power, warehouse clearance, loading doors, and single story office space will be found on a typical buyer’s wish list. If an address curries favor with a narrow slice of occupants - we call these special purpose buildings.
 
We witnessed a spate of these constructed in the mid eighties as our industrial market adapted to the surge of microelectronic manufacturing. Needed was a hybrid between a high rise office and a down and dirty place where stuff was made. Enter Research and Development or R&D locations. Sporting more parking and a higher percentage of office space where engineers could work bolted onto areas used for manufacturing - this product type was dramatically overbuilt. Unfortunately, as supply was increasing - demand was falling as more of this genre’s output was shipped overseas. Thus we found ourselves with a whole class of industrial construction with limited flexibility - special purpose. Many lay fallow for years. Those that secured residents prayed for their longevity lest they’d be stuck with a costly void.
 
Another one we see is a facility improved with food grade infrastructure as they are rarely morphed into anything else. Sure, the next guy might be able to use some cold or frozen space - but generally the floor drains, washable walls and the like end up in the scrap heap.
 
Buying a parcel with special purpose improvements becomes challenging for myriad reasons. Chances are the occupant uses the intricacies and so long as he’s in residence - you’re golden. If he bolts, you’re scrambling to replace his tenancy. You see, a substantial investment went in to the goodies - now you must pay to remove them. This assumes of course that what underpins is marketable. Frequently, it’s cheaper to scrape the whole thing and start new. We saw this on the countless aerospace campuses occupied by the lines of Boeing, McDonnel Douglas and Beckman. Built specifically for the use they housed - no one foresaw a time when a retool would be necessary. Why would they?
 
Rarely are sellers prepared to hear the downside and how this impacts the price a buyer may be willing to pay. In the case of the aforementioned campuses - owners had to realize the buildings had no value and all would be based upon the land underneath. A bitter pill indeed!
 
Now for the good news. If you’re fortunate to find one of these with a mammoth credit tenant and a long term lease - great upside is to be found. The bad news is if there’s a vacancy. However, because the location is so unique - there are no places to move. We refer to this as a “sticky” tenancy. The improvements cause the occupant to “stick” in place and not relocate.
 
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.

A Conversation with a Private Investor

Investors in commercial real estate come in different shapes and sizes. Recall, I define an investor as one who relies upon the rent an occupant pays for her livelihood. All investors - institutional, public, or private have in common this requirement - a paying tenant. You may be wondering. Do investors ever buy a vacant building? Sure. But trust me. They understand the time and expense necessary to originate a tenancy. If they miscalculate - there goes the return on their invested dollars. And this loss can never be recouped.
 
Recently, we were engaged to assist a private investor redeploy proceeds from the sale of another piece of commercial real estate. He’s deferring the gain through use of a 1031 exchange. If you’re unfamiliar with an exchange - here’s a brief description. A seller transacts. The proceeds are placed with a qualified intermediary. Time starts. Replacement(s) must be identified within 45 days and purchased the earlier of 180 days from close or the filing date of next years tax return. An equal amount of dollars and debt must be spent on a like kind income property(s). If orchestrated correctly, the income taxes on the gain are deferred. Simple. But, please consult your tax, accounting and real estate professionals before undertaking.
 
Last week, we toured a couple of alternatives and I believed our conversation was column worthy.
 
While his sale property was in escrow, we spent a couple of meetings discussing his qualifications for the buy. What emerged was a desire to acquire a single or dual tenant industrial building with a triple net lease. The return should be north of 4.5%, and should provide a reasonable remaining lease term. Credit of the tenant is important and the rent being paid should be at or below market.
 
First on our list was a single tenant property that could be divided once the tenant vacates. Currently, the building is occupied by the owner who is moving out of state. Because his new business home is not yet completed, he is looking for a short term lease back of a year to 18 months.
 
After the first property visit we looked at option number two. The occupant of the building was once owned by the owner of the building. We frequently see this when a business owner decides it’s time to cash in the chips but sees merit in retaining ownership of the real estate. In this case - it’s now time for the owner of the real estate to move her money into a more tax friendly state - therefore her motivation to sell. Encountered was an operation that has a significant amount of money invested in the infrastructure of the building and 4 1/2 years remaining on their term of lease. Located in an emerging area - but not quite mature - one could sense we were pioneering a bit.
 
So here’s what our client had to say about both alternatives.
 
He really likes the first building we looked at although he understands an amount of money for re-tenanting the building must be considered. After all, this will be addressed in early 2024. Our client was concerned that the owner of the building has time until his new building is completed and therefore might not be terribly motivated. Additionally, the owner had unrealistic expectations of the property’s worth especially based upon the economic storm clouds we see massing on the horizon of inflation, rate increases and the threat of inflation. He’ll offer, but at well less than the ask.
 
On to the wild, wild west. We discovered the owner of this building would like to carry a loan. If favorable terms can be negotiated, this could actually be a win. Because the property is located in a developing area, the term of lease becomes critically important. Insufficient are the 4 1/2 years that remain. Consequently, we will ask to have a longer-term deliver to us upon the close of escrow.
 
Ok, nets cast. Time to harvest the bounty of investor interest.

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.

How will we Know When the Market Changes?

Much has been written lately about economic storm clouds massing on the horizon. If you doubt what I say, pick up any periodical, listen to talk radio or a network news broadcast and mentions of inflation, interest rate hikes, and the Fed’s remedies will abound. Akin to a desert monsoon that starts with a puff of clouds and morphs into something larger - everyone senses the deluge is coming but are uncertain how extreme the soaking will be. Full disclosure. Neither do I. 

 
Certainly, my years of experience and witness of several downturns can add credence. But, the reality is all are different in their causes. Take 1990-1994 as an example. Loose lending by savings and loans and their ultimate demise, over building, and Iraq’s invasion of Kuwait catalyzed the boom years of the late eighties to a screeching halt. 
 
How about 2008-2011? Easy money to unqualified home buyers coupled with another spate of massive construction starts was ill prepared for a pause in the music. Many were left without a chair as the financial markets froze and lending ceased. 
 
Today, the culprits are the pandemic which left us home bound and computer key happy, stimulus checks, and supply chain clogs. The classic case of too many dollars and too few goods took effect causing consumer prices to spike. Not since the Carter years have we seen inflation this high. 
 
Caught in the crossfire is real estate - commercial and housing. Housing has started to slow as buying power is directly impacted by pricier loans. Even though inventory of homes for sale is low - offerings are sitting around longer and the frenzied pace of January 2022 is a distant memory. 
 
So when will we know the commercial market is slowing? The following will provide some guidance. 
 
As I’ve mentioned, commercial real estate trends follow residential by 12 to 18 months. But we’ll sense a slowdown soon - if it’s coming. 
 
First, listings will languish. What flew off the shelves earlier in the year will take longer to lease or sell. Recall, our vacancy is at historic lows. So, this won’t happen next week. But, maybe an offering that generated multiple offers will settle for one or two. 
 
Next, owner motivation will shift. The longer a vacant building lays fallow, the more desire an owner will have to fill it. 
 
Pricing will stabilize and then decline. With occupants on the sideline, owners will be forced to deal. One way to do so is through a reduction in asking prices. 
 
As rents adjust, so will values. Recall, the price an investor will pay is a return on the lease check a tenant writes each month. A decline in this amount coupled with an upward move in capitalization rates causes the price per square foot to decrease.  

Believe me, I’m watching all of the above quite carefully. Just today - while guiding a tour - the conversation centered around “where are we going” as it pertained to our owner’s situation. Yep. An entirely different rhetoric was rampant a mere three months ago. 

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.