Bob's Commercial Real Estate Answers

Investment sale

2009-11-20T16:57:00.002-05:00

I am happy to announce that I represented the buyer for 197 Scott Swamp Road, Farmington, CT. The 44,000 sq. ft. class A office building recently sold for $4.72 million. For all those investors out there, the cap rate beginning in 2010 will be just over 10%.

If you have a question on investement sales, please send them my way.

Why aren't there more commercial forclosures?

2009-10-02T11:05:00.007-04:00

Several clients looking to purchase commercial properties have asked me; "Why don't we see more commercial forclosed properties on the market for sale? Those of us involved in commercial real estate know that there are a number of commercial properties, especially in retail, that are no longer supporting the mortgage. Yet, these properties don't seem to be coming on the market. "

My answer is that at this time, banks don't have the management in place to handle properties if they foreclose on them. Putting management in place is expensive so they really don't want to take properties back. The banks would rather just sell the note at a discount and let someone else restructure the loan with the owner or foreclose on the owner if they can't work things out. If the new note buyer obtains the note at a discount, there is more financial ability to rewrite the note at a lower monthly payment, which the owner can hopefully afford. This will avoid the foreclose.

Eventually, if the number of foreclosures increase enough, which is probably what is going to happen to many banks, the banks will need to hire REO staff and take the properties back. When this happens, you will see these properties going on the market for sale.

Commercial Real Estate Health Insurance

2009-09-10T14:10:00.003-04:00

One of the landlords that I am work with on occasion called me and said he is having difficulty keeping tenants in his commercial buildings. Some tenants are simply closing up shop and handing him back the keys, while others are way behind on their rent. He jokingly asked me if President Obama's new proposed government run health insurance plan could be expanded to cover commercial real estate, since all his buildings seem to be in such poor health. I told him that if it did, with all the commercial property feeling ill at this time, the plan would go bankrupt in less than a week.

Land Lease

2009-09-04T13:14:00.006-04:00

Yesterday I recieved a call from a residential real estate agent who wanted to refer an established restaurant for sale. He said the restaurant was doing quite well and the building was very nice. He had been trying to sell the business and the building for quite some time with no success. He indicated that the owner of the restaurant owned the building, but not the land under the building nor the parking lot. I asked him how much time remained on the land lease and if there were any options to renew. He informed that there was less than five years remaining on the lease and there were no options to renew.

I told him that regardless how successful the restuarant has been and how nice the building was, without a long term ground lease, either with a long initial term, a number of options to renew, or both, he had nothing to sell. No savvy business person would pay for a building and a restaurant business without knowing if they would still have the right to remain on the property after a few years. Also, no bank would lend on the property for the same reason. I said the first priority is to negotiate a new ground lease or extensions to the existing ground lease which would allow the current or future restaurant owner to remain on the property for at least 30 to 40 years or even more. This would allow the owner of the restaurant to improve the property, grow the business and reap the rewards over time.

Some owners are dead set against owning a building with a ground lease. However, many major companies such as Wendy's, Walgreens and Burger King own buildings, but lease the land. The difference is that their ground leases give them control of the property for many years.

What is a CAP Rate?

2009-08-21T10:48:00.002-04:00

Jeffrey and his wife Michelle were very anxious about their sinking stock portfolio so they decided that they would sell some stock and invest some of the proceeds in commercial real estate. Neither Jeffrey nor his wife had ever owned commercial real estate before, so they began to educate themselves by looking on line at the various types of investment properties. It seemed that every investment property was being marketed with a quoted cap rate. Some properties had cap rates as low as 6% and others had cap rates as high at 12 percent. Jeffrey called me and asked me what a cap rate was and whether it was better to buy a building with a lower cap rate or a higher cap rate.

Although commercial appraisers will sometimes use a much more sophisticated method of calculating a cap rate, the simple version is widely used by the typical investor and by commercial real estate brokers. The cap rate (short for capitalization rate) is a method of comparing the return of different types of real estate investments at any point in time. The cap rate is calculated by dividing the net operating income (NOI) of any investment property by the expected sale price. The net operating income is determined by subtracting the property operating expenses from the gross income for the property. Basically, add up all the income and subtract all the operating expenses in any one year and you will have the net operating income. Now divide the net operating income by the sales price and you obtain the cap rate.

Example: An office building has two tenants paying a total of $60,000 in rent for the upcoming year. If the building expenses are expected to be $20,000 per year, then the NOI is $40,000 ($60,000 - $20,000). If the sale price is $400,000, then the cap rate is 10 percent ($40,000/$400,000). If the NOI was only $20,000, then the cap rate would be 5 percent. Since every investor would prefer earning $40,000 versus $20,000 of NOI, a higher cap rate is more desirable.

It is very important to understand that the simple cap rate is only one indicator of how the property is performing at a given moment. It does not take into consideration market conditions, lease terms, condition of the property, location of the property, local competition or financing terms. If the property income is expected to rise or fall sharply in the near future due to rent increases or lease expiration, then a cap rate that is higher or lower than typical may be appropriate. The cap rate is only a first look indicator of whether a property is approaching your personal investment criteria. In the current market, one of my investors won’t even consider looking into a property unless the cap rate is above 9.0 percent. If the cap rate is at least 9.0 percent, he will look into the property in more detail.

Option to renew a lease

2009-08-12T12:30:00.000-04:00

A landlord is questioning the benefits of a tenant’s option to renew their lease.

Ed inherited a half empty commercial building from his father. The one tenant in the building had an option to renew their lease. Ed asked me if he should offer new tenants an option to renew their lease as well.

It is important to understand that an option to renew a lease benefits only the tenant. An option allows the tenant to evaluate the market conditions near the end of their existing lease term to determine if rental rates have changed. If current market rental rates have moved higher and the option rate stated in the lease is lower than market rates, it will be beneficial for the tenant to exercise their option to renew. If market rental rates have moved lower and the rental rate quoted in the option to renew is higher than the current market rates, the tenant can approach the landlord and try to negotiate a lower rent. The option to renew does not obligate the tenant to remain in the space in any way until the option is exercised. If the tenant is not satisfied with the new rental rate the landlord is offering, the tenant can relocate to another building. An option to renew with stated renewal rates puts the tenant in the driver’s seat and is generally not a benefit to the landlord.

When is it a good time to buy commercial real estate?

2009-08-04T15:49:00.002-04:00

Carol emailed me- When is it a good time to buy commercial real estate?

Hi Carol,

That is a very popular question and it seems that everyone has their own answer. I often hear investors say that when interest rates are low you should be looking to buy. I hear some investors say “Lock in at a low interest rate while you can”. I disagree. I think the best time to buy is when the interest rates are higher or when the economy is in the tank, so prices are lower. Commercial real estate is all about the numbers. If the interest rates are higher, then the same NOI will support a smaller mortgage. If buyers can only get a smaller mortgage, then they will have to pay less for the property. Therefore sale prices tend to drop. If the economy is in trouble, demand for space shrinks and vacancies rise. As vacancies rise, rental rates drop and so do the property NOIs. A smaller NOI supports a smaller mortgage, so sale prices tend to drop.

When prices are lower I tend to find properties with much more upside. If you are fortunate enough to have cash, it’s time to go shopping. If you don’t have cash, it’s time to be creative. I tend to look for properties with owners who have owned the property for a long time. If they have owned the property for a while, there is a much better chance that they will not be under water with their mortgage if prices drop. Better yet, they might be able to offer some attractive owner financing. This saves bank and appraisal fees.

Here’s the kicker: If you buy enough properties when interest rates are higher and prices are lower and then sell or refinance when interest rates are lower and prices are higher, you just might be able to quit your day job!

Like Kind Exchanges

2009-08-03T16:46:00.002-04:00

Sandra heard that she can use a 1031 tax deferred exchange to avoid paying capital gains taxes when she sells her investment property. She owns a mixed use property with small retail spaces on the first floor and three apartments on the second floor.

Hi Sandra,
Unfortunately you can’t avoid paying the IRS the capital gains taxes. At some point, you will have to pay Uncle Sam. However, if you use a 1031 “like kind” exchange, you can replace your present property with another property and defer the payment of the capital gains tax until some time in the future. The key is that you have to replace your existing property with another property.

Basically you would sell your real estate investment and replace it with a “like kind” property. In your case, real estate for real estate. You can’t sell your real estate investment and buy stocks with a “like kind exchange”. Normally if you were selling your property and not completing a 1031 tax deferred exchange, you would have your accountant calculate the capital gains taxes and you would pay the IRS the taxes due in the year that you sold the property. However, if you found a replacement property and followed the strict rules of completing a 1031 exchange, you could defer paying the taxes until you sold the new property. If you wanted, assuming that the IRS doesn’t change the law in the future, you might use a 1031 exchange again when you sell the second property and defer the taxes again. Not a bad deal!

If you intend to complete a 1031 “Like Kind” exchange, it is best to speak with your accountant first before you put your property on the market.

What is the true return on your investment?

2009-07-28T17:14:00.005-04:00

An owner of a small retail strip talked to me and said that if I could find him another property that gave the same return on investment as the one he already owned, he would buy it in a minute. He grinned when he told me that he bought his property 18 years ago for $375,000 and paid off his mortgage. He put $100,000 down on the property when he bought it and his income after expenses was now $100,000/year. I knew of his property and it was quite nice. He had kept his property in good repair and there were reasonably good tenants in property. I knew approximately what the property was worth and I told him that I would show him several properties with a yearly return of around 12.5% on his money invested. He looked at me with a blank expression and then he said "What are you crazy?". He said he invested $100,000 and each year he earned $100,000 and that's a return of 100% per year.

I explained to him that his property was worth approximately $1,100,000 . I told him if he sold the property today and paid off the capital gains taxes and other expenses such as commissions, attorneys fees and conveyance taxes, he would probably net around $800,000. He agreed with my sales analysis. I also told him that he really had $800,000 invested in the property and not $100,000 so his yearly return on investment was $100,000/$800,000 or 12.5%.

He stood there stunned for a moment and then he smiled and said "Yea, but my initial investment increased 800%". I said "You are right! When do you have time to look at some properties?"

Lease Options-Locking in the rate today.

2009-07-27T13:29:00.004-04:00

Tenants often want to have an option to renew stated in their primary lease. In this difficult leasing environment, many tenants are pushing hard for low rates in their primary lease today and also low rates in their options to renew in the future. Some landlords are so desparate to lease their vacant space today that they are reluctantly agreeing to the low option rates when the tenants renew in the future. On the surface, this may seem like a win for the tenant. However, the owner can usually only go so long with low rent before the funds start to run short. This means that the landlord may not have the funds to make capital improvements to the property when they are needed. The driveway, roof, and mechanicals may not get replaced at the end of their useful life. Usually the tenant ends up paying for the repairs to these items in their lease either as part of the NNN costs or through above the base year reimbursements. As the building and grounds get older, the repairs can really start to add up. In reality, the building and grounds could suffer and the tenant may end up paying more in rent than they initially thought and also have to live with a property that is looking subpar.

Squeezing the landlord a little is expected in a down economy. However, choking the landlord is never good for either party.

Warehouse Availability- North and East of Hartford, CT

2009-07-24T14:35:00.002-04:00

A very recent search for a warehouse need of 10,000-15,000 sq. ft. in the areas north and east of the city of Hartford, CT turned up a large supply of available properties for lease. Landlord's were quick to call me back and many called me twice. A number of buildings were completely vacant. If you are looking for warehouse space in the same area, there are quality properties for as low as $4.00/sq.ft. NNN. There are short term sublease properties available for less than $3.00/sq. ft. NNN. Landlord's are very anxious and are willing to do what it takes to make a tenant happy.

Rentable vs. Usable

2009-07-23T14:51:00.001-04:00

Question:
A tenant in a multi-story office building asked: Hi Bob: My lease indicates that our office suite is 2,400 rentable square feet in size. However, when I measure the interior of my suite, we actually have closer to 2,000 square feet. Is my landlord overcharging me? Tom

Hi Tom:
The amount of space you measured in your suite is often referred to as "useable square feet". Your lease indicates that your rent is calculated using rentable square feet. Like most landlords of multi-tenant buildings, your landlord charges each tenant for its pro-rata share of the common areas (hallways, restrooms, janitorial closets, cafeterias, work out rooms, and lobbies etc.). Vertical penetrations such as stairwells, elevators shafts and HVAC duct chases are excluded from the calculation. The landlord will determine the total common area space and then add a proportional amount to the useable area of the space you rent ("add-on factor"). The new total is called "rentable area".

For example, if you occupy 1,000 useable square feet in a building that has 10,000 square feet of useable space and 1,000 square feet of common area, your rentable square feet would be 1,100 square feet. 10% of the common area space is added on to your useable square feet because you occupy 10% of the useable space in the building. In a typical building, the add-on factor would be between 15% and 25%. If you have 2,000 useable square feet and the add-on factor is 20%, then your rentable area is 2,400 square feet.

Sincerely,

Robert Gaucher
O,R&L Commercial