Pushing Dirt

Believe it or not, seller-held financing has benefits for both parties.

One of the biggest advantages for the seller is that holding paper equates to an installment sale, which is a mechanism for deferring capital gains tax. The seller only pays capital gains tax as the principal balance is paid down. An interest-only seller-held note offers the greatest opportunity for savings as no principal is paid down during the term of the note.

This tax benefit is so compelling that a vehicle called a Deferred Sales Trust has been developed to take advantage of the installment sales rules to allow sellers to defer taxes without holding paper. Refer to http://likekind.org for more details.

The benefits for the buyer are fairly apparent: the seller might be the only source available to finance a particular project, or may offer better terms including higher leverage, a lower rate, or a longer amortization. A buyer can potentially, when permitted by the lender with the first trust, to secure a second mortgage from the seller to garner even greater leverage. While the seller may want to qualify the prospective borrower, the process of securing the loan is likely going to be less painful.

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Commercial properties generally require a lengthy study period during which the prospective buyer completes necessary due diligence. The due diligence requires the work of third parties like engineers (who complete environmental studies and boundary surveys) and appraisers. The prospective purchaser will also want to study the condition of the property, interview tenants, and work on lining up financing.

The buyer will customarily offer to put up an earnest money deposit to be held in escrow while this work is completed. Most buyers demand a 30 to 60 day due diligence “study period” during which their earnest money deposit is fully refundable if they opt not to proceed with the purchase. Even though the deposit is fully refundable during the study period, it conveys a certain seriousness in the purchasers intentions.

At the peak of the market, in some cases I saw buyers willing to put up a non-refundable deposit upon contract execution. Typically those buyers reviewed leases and other due diligence information rapidly and before signing the purchase and sale agreement — effectively mimicking an auction purchase.

That said, at the end of the day, the amount of the earnest money deposit is a matter of negotiation between buyer and seller. The buyer wants to keep the deposit as small as possible, and the seller would like to see a larger deposit.

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It is one method by which expenses are recovered by a landlord from a tenant. NNN is short for “net net net” and is used interchangably with the phrase “triple net.”

Terms like NNN or “triple net” don’t mean the same thing to every real estate professional so only a lease can give you a definitive answer. To most however, this means that on top of your monthly rental payment, you as tenant are going to be responsible for paying your pro rata share of all operating expenses, including common area maintenance, common utilities, real estate taxes, and insurance.

Some expenses like management fees and maintenance of the roof and structure are passed through in some “net leases” and not in others. Again, the lease governs.

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Real estate commissions are fully negotiable, and it’s dangerous to engage in a dialog in a public forum about specific rates charged. It could be perceived as price fixing which is not kosher.

Speaking generally about the shift in market conditions, I think it’s safe to speak to the following trend: In the “landlord’s market” of a just a year or two ago, landlords would typically offer 1/2 of the the commission they would pay to a broker that brought a new tenant to them.

Now we’re seeing brokers asking and getting a “full” commission on renewals. The landlords are more fearful of losing tenants and are doing what the can to keep the broker that “controls” the tenant happy.

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The term “CAM” is technically short for “common area maintenance.” In the narrowest definition it means just that: building expenses related to maintaining the common areas of a building.

It’s unfortunately in the parlance of the commercial real estate industry become interchangeable by some with “operating expenses,” ie all operating expenses.

I’d encourage you to be precise: if you mean “all operating expenses including real estate taxes and insurance,” say so. And if someone refers to “CAM,” you may need to press them to clarify what they mean.

There a wide range of methods by which landlords recover some all or none of various expense categories.

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Question - What is net operating income? Does it equal cash flow available for debt service?

Answer - The fact is that net operating income does NOT equal cash flow available for debt service.  Items like a capital reserve, major capital improvements, tenant improvement expenditures, and commission expenditures need to be subtracted from net operating income to get to that bottom line of “cash flow available for debt service.”

As such, a capitalization rate (net operating income divided by purchase price), while a good sort of yard stick or rule of thumb indicator, is not a necessarily a particularly good indicator of yield. Consider two different investments:

• Building A is a brand new 30′ clear warehouse leased to the US Government on a long term basis, and
• Building B is a 1980s office building with 20 tenants, local and regional credit, with gradual lease rollover.

Both trading at a purported “10% cap rate.”

Building B is going to require recurrent tenant improvement expenses and leasing commissions where Building A does not.

So why buy Building B?  Well, there are potentially lots of good reasons. Perhaps the rents in Building B are below market. There is arguably less risk in building B, because if a single tenant moves out, you’re left with an empty building. Perhaps building B is located in a better market with more dramatic rent growth. Perhaps the price per square foot of building B is well below replacement cost, and in the case of building A you’re paying more than it would cost to build the building.

So it just goes to show you that a cap rate should only begin your underwriting. You’ve got to take into account return of time (internal rate of return), the market, the building condition, and on and on.

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Owing to excess capacity, I’m pleased to offer inexpensive financial modeling/discounted cash flow analysis in Argus available for office/retail/industrial/flex buildings from my in-house financial analysis group to third parties.

Output in Excel is free plus we provide the source Argus (.sf) file to share with clients.

Attractive full color custom reports also available at an additional charge.

Introductory price while we grow this business: $100 + $10 for each tenant. Includes one free set of modifications.

Turnaround in 2 business days or less.

Email me at ckubler@klnb.com or call 301-455-8840 for more details.

A consequence of the utterly lousy commercial real estate market is that suffering landlords and sellers are likely going to need to start to pay higher commissions. Those higher commissions will be needed to lure the best seller and landlord representatives, who are risking more taking on assignments in this market: despite their best efforts not every space will lease and not every building will sell. Representatives of buyers and tenants will demand even higher fees, and deserve them: they control a very precious commodity in today’s market…at least in the case of creditworthy tenants.

I’m not going to win many friends among owners for saying it, but it’s time for brokers to start demanding higher commissions. Don’t get green with envy for the brokers. The volume of investment sales transactions is down 70 to 80 percent. Leasing transactions are not moving robustly either, with tenants staying put and renewing for very short terms in many cases.

The opportunity for brokers in this market is representing the most motivated of sellers: those that are facing distress and must sell to raise cash. We’re seeing many more of those sellers in places like Michigan, Ohio and Florida. In the Washington DC area the distress is primarily in vacant buildings or residential land.

Established auctioneers are a busy lot, and brokerages are ramping up groups to market distressed assets for sale or to deal with workout situations.

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As the market continues to struggle we will continue to see the amount of sublease space available to grow. Tenants with unneeded space are especially motivated to move sublease space. Their goal is not to create value in a building or positive cash flow but simply to “stop the bleeding” of rent that must otherwise be paid for unwanted space. As such they slash asking rents and make vicious competitors to owners with space to move.

Landlords competing with sublease space can highlight some of their advantages including an ability to offer renewal terms, to fund tenant improvements, and to offer expansion or relocation within a larger portfolio.

Tenants should take a hard look at sublease opportunities on the market
as they can offer a phenomenal opportunity for savings. Tenant brokers may not push these options as subleases can be more difficult to transact, and may offer smaller commissions (owing to shorter lease terms). It may also be more challenging to collect commissions from sublandlords. As such you may need to push your broker to seek out sublease opportunities on your behalf and make sure your broker collects the fee he or she has earned.

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Square Feet Blog picked up a story on a story about a class action law suit accusing Marcus and Millichap and a businessman of colluding to sell net leased property at inflated prices and and then close the businesses renting the space.

Sophisticated owner-occupants of space can use sale-leasebacks to their advantage. These sale-leasebacks are effectively financing transactions, allowing the user of space to get cash without racking up debt on its balance sheet. The transactions unlock “trapped equity” that a business can deploy to grow its business.

Sophisticated buyers of net leased property in most cases are careful to set leaseback rents at market and to avoid paying more than the “replacement cost” of the asset, i.e. the market value of the land plus the construction cost of the building in today’s dollars.

What is true is that most ‘individual, freestanding ’single tenant net leased properties” have been and remain grossly overpriced to this day. buyers  of freestanding triple net retail buildings at the peak of the market were paying $500 per square foot or (much) more and tolerating yields of 6% or lower for a 20 year lease with a drug store in a tertiary location. The buyers have typically been private buyers often with 1031 exchange dollars to invest.

Some groups like Cardinal Capital made tens of millions by buying well “wholesale” from users and then selling to these private buyers at “retail” prices.

Whether there was intent to defraud these private buyers in the case the LA Times story highlighted is unclear. In most cases these private buyers have simply just made poor decisions by overpaying for these properties. They’ve paid well over replacement cost and made bets on companies with questionable credit all in the name of deferring capital gains taxes. I don’t begrudge the brokers representing sellers in these cases; they were doing their job by fetching the best prices for their seller-clients. In the realm of commercial investment real estate, there is generally a presumption made that the parties to the transaction are sophisticated. Transaction timetables typically allow for a significant due diligence period during which buyers are expected to study to the building, the market, and the tenant.

Unless it’s a distressed or “value add” scenario, I’d never recommend a single tenant net leased asset to one of my clients in need of 1031 replacement property. I’d rather see them pay their taxes.

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