Commercial Property - Buying, Selling and Leasing

The following is a summary of key points that we believe will be of help in your considering buying or selling commercial property. In addition, a summary of key topics on the subject of leasing commercial property is outlined below.

Buying Commercial Property

• Unlike residential property, the main driver for commercial property valuation is the income stream generated from the subject property. Therefore, more emphasis is placed on the analysis of income stream and total potential return. The following summarizes five of the most widely used valuation models that you will want to use in estimating the market value of a property:



• Gross Rent Multiplier (GRM): The Gross Rent Multiplier is calculated as the selling price divided by the annual gross income. If a five unit apartment building sells for $5,000,000 and the annual income is $250,000, the GRM is 20 ($5,000,000 / $250,000).



• Cost Per Unit (CPU): The Cost Per Unit is calculated as the selling price divided by the number of units. If the $5,000,000 building is 10 units, the CPU is $500,000 ($5,000,000 / 10).



• Internal Rate of Return (IRR): The Internal Rate of Return is a calculation of the total return on your investment, the traditional modelling time period being ten years. The IRR is used to compare relative values of several subject properties you may be considering to purchase. Running IRR comparisons is the commercial real estate investor's equivalent to working up "comps" on residential property.



• Capitalization Rate (CAP Rate): In essence, the CAP rate is the rate of return on a property presuming it is purchased with cash only. The CAP rate is calculated as the net operating income divided by the purchase price. The net operating income is calculated as the gross operating income minus expenses, not including loan payments. In our example, if a $5,000,000 has a net operating income of $250,000, the CAP rate would be 5% ($250,000 / $5,000,000). The CAP rate can also be used to run a quick valuation on any property simply by using the local area cap rate into the subject property's net operating income.



• Cash on Cash: Cash on Cash is calculated by dividing the cash flow generated from the subject property after loan payments into the down payment. If the net cash flow is $150,000 and your down payment to buy the property is $1,500,000, your cash on cash return is 10% ($150,000 / $1,500,000).



• Never make a final decision to purchase a property without reviewing meticulously every tenant lease related to the property. Key issues to consider include:



• CPI Clause: If a property has anchor tenants (tenants that occupy the largest spaces and are the major "draw" for business) who are under long term lease contracts, the CPI (Consumer Price Index) escalation clauses can be critical in the future potential income stream of the property.



• Kick-out Clause: Some anchor tenants may have "kick-out" clauses that permit them to terminate the lease at specific points in time through-out the lease.



• Rent Abatement Addendums to tenant leases often include what is referred to as a rent abatement clause. This is essentially free rent granted by the landlord as an inducement to secure a lease with a prospective new tenant. While rent abatement is traditionally granted at the beginning of the lease term, it can also be spread out of the course of the lease. For example, it could be contracted in the form of a month of free rent on each anniversary date of each new year. Any contractual rent abatement will need to be absorbed by you, the new property owner, and will negatively impact your total return.



• Before submitting an offer, double check the legal address and have a rent survey done for commercial buildings of the same type as the subject property. The rent survey needs to cover primarily the local area.



• Always submit an offer on a commercial property subject to inspection of:



• The books and records of the subject property.



• A copy of the rent roll.



• Background documentation on the maintenance of the property from the property manager.



• The existing financing. You must read the note to verify such issues as loan assumability, fees to exercise the assumption, prepayment penalties (which can be scheduled out over time) and the final due date of the note.



• Insurance costs. In Los Angeles County, insurance costs have risen dramatically over the past three years. New insurance can be almost double the cost of existing insurance.



• A current copy of any applicable rent control restrictions.

Selling Commercial Property

• If you presently own commercial real estate and have increasing concerns about the potential risks in holding real estate, the following are a number of strategies you may want to consider:



• Upgrading your commercial holdings from higher-risk/ higher return assets (e.g. retail strip centers) to lower risk/lower return assets (e.g. warehouse/ industrial buildings).



• Reviewing the current and future potential growth rate of the communities where your properties are located. If demographic and economic trends indicate stagnation in growth, consider re-positioning your holdings in either higher growth communities or communities with long term stability in growth and economic health.



• Divesting (i.e. selling) your real estate holdings outright and minimizing the tax impact through the use of either a Deferred Private Annuity or a Life Insurance sponsored Structured Sale (Installment Sale) program. Both approaches should be considered in consultation with your tax advisor(s). They offer alternative ways for you to sell your property and secure much needed cash while minimizing a potentially significant tax hit. We believe both types of programs will become more widely used in the years ahead.



• Establish a short sale position in a derivative instrument based on the NCREIF Property Index (NPI). This is a new instrument made available through the investment bank Credit Suisse, under a two-year exclusive licensing agreement with the National Council of Real Estate Investment Fiduciaries. On a quarterly basis, payouts will be made between institutions with long and short positions. Payouts will be based on the total return (appreciation plus income) of different property types or classes tracked under the NPI Index. As well, the Chicago Mercantile Exchange will begin selling housing futures and options contracts in the second quarter of this year. Contracts will be based on the Case-Shiller Index, which tracks percentage changes in home values in various markets across the U.S.



• Marketing strategies should include one or more of the following:



• MLS listing as well as advertisement postings in the more widely followed commercial real estate web sites including C-Rex.org and LoopNet.com.



• Making your offering aware to commercial real estate agents who work with foreign investors. The combination of low mortgage rates and a relatively weak dollar has turned both commercial and residential real estate into attractive investments for foreigners, both in Asia as well as Britain and Europe.



• Direct mailing to owners of similar types of properties in the local area. Sometimes, these can be your best prospects!

Leasing Commercial Property

• The following is a summary of key elements of a landlord/tenant lease agreement you will want to keep in mind if you are looking for a commercial space to lease. The list is by no means complete and may or may not apply to your specific situation.



• Always have an attorney who specializes in real estate law review the lease before you sign it (referred to as "executing" the lease).



• If this is a new lease, try to negotiate one month of free rent (called "rent abatement") for every year of the lease term.



• Always inspect the space before signing the lease. If the space has been leased previously, it will probably need repainting and new carpeting. Landlords will typically pay for these upgrades, if asked to do so. Check for bathrooms compliance with Americans with Disabilities Act (ADA) regulations, the condition of the HVAC, piping, wiring, etc.



• While long term leases (5 years or more) may appear to be to the benefit of the tenant, this is usually not the case when you are starting a new business. If this is a business start-up, start with no more than a two-year term with at least one option to extend.



• Carefully review the "use clause", the clause in the lease that spells out the permitted uses of the space. Make sure the use clause is not too restrictive. As well, ask for exclusivity (non-compete clause), whereby the landlord pledges to not lease space to a direct competitor to your business.



• An area of potential controversy for retail leases is the stipulated hours of operation. Review this section of the lease and make sure the lease regulations for hours, especially on Sundays, will be acceptable to you.



• If you are leasing a retail space, you will most likely be leasing the space on what is called a "triple net" basis. This means you will be responsible for paying for a portion of the shopping center's total property taxes, utilities and maintenance expenses. Request a copy of the prior tenant's triple net charges in order to gauge what your costs will be. Also, try to ascertain the possibility of the landlord selling the property any time soon. A sale of the property will likely result in an increase in your triple net tax liability. If the owner has owned the shopping center for a decade or two, the increase in taxes may be substantial.



• Walk the area outside of your proposed space a number of times to see how the day-to-day parking usage will affect your business. If necessary, request specially marked spaces to be designated to your business if parking spaces are at a premium.



• If you operate a franchised business, get the appropriate written approvals from the franchisor. As well, make sure the landlord signs the franchisor's Collateral Assignment document - an agreement whereby the franchisor is granted the right to cure certain lease defaults (such as non-payment of rent) on the part of the franchisee.



• Don't presume that the security deposit will be automatically returned to you at the end of the lease term. Verify that the lease expressly pledges your money will be returned.



• If you are looking to lease retail space, landlords generally require personal guarantees on the lease if the lease contract is in the name of your corporation. Only in rare circumstances will a landlord waive this requirement.

Contact us if you have any specific questions regarding buying or selling commercial property or leasing commercial property.