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Mergers and acquisition real estate due diligence – or pay your dues

When companies acquire or merge with other competing or complementary firms, real estate is, as a part of the transaction, generally a small overall concern. However, we frequently see major risk being absorbed by the acquiring firm with potential for a very negative surprise down the road.

Here’s the error: Due diligence of the real estate is often relegated to their investment advisory firm and/or an M&A legal team to simply provide a cursory review of the legal terms of leased real estate without much attention to the business terms.

It becomes especially onerous when the selling principals have an ownership interest in the real estate and have either leased it back to their corporations, or will remain the owners of the property and lease it to the acquiring firm.  Realize that any lease developed by principals for leaseback to their own corporations, while perhaps near “arms length” rental rates, generally places as much operating risk as possible onto the corporation tenant.  They are often intentionally structured with maintenance and compliance requirements (replacement of roof or structural members, ADA or fire code improvements, environmental remediation) without ANY representation or warranties from the Landlord to the Tenant.

Certainly if it’s your corporation you can do whatever you want, but no intelligent or well-advised tenant would accept those terms in a market-competitive situation.  Except when they are doing an acquisition, that is.

Once, we saw a lease that required the Tenant to pay a net rent equal to the Landlord’s mortgage payment and, in the event that the Landlord refinanced the property, the Tenant would be responsible for the adjusted payment and all closing costs related to the refinancing.

This gave the Landlord the ability to pull out as much equity as any lender would provide, at will and upon any terms or amortization schedule that they desired, and the Tenant was obligated to pay the cost.  Unfortunately for our client, we were hired AFTER they had acquired the firm that was the Tenant from the former owner Landlord – and that is exactly what he had done.

It can be nearly as bad when the company is acquiring the business but not the real estate and doing a leaseback of the principal’s building.  Inevitably, the seller’s attorney wants to prove themselves clever enough to insert equally risk-shifting strategies into the new lease document.  Don’t allow it.

Here are three ways to protect yourself:  

  1. Every lease on acquisition property should be treated with the same process that is applied to any new corporate lease.
  2. Make it clear from the earliest acquisition discussions that all leases from the target’s principals will be on your own fair and balanced standard lease form.
  3. If they already have leased the property back to their corporations, require that lease be terminated at closing and the new one take effect.  Their attorneys will fight it of course, so make this a deal-killer absolute up front in the negotiations. It will prevent unreasonable risk being shifted to your firm.
multiple real estate locations

Real Estate Best Practices: Companies Managing Multiple Locations

Any corporation with more than one office/branch/site is large enough to have real estate portfolio objectives. With just a handful of locations, the C-level executives are likely very hands-on in determining the best solution as real estate opportunities or decisions present themselves. Once the number of sites grows to a point where that oversight is delegated though – whether placed under the responsibility of another staff member such as Regional VP’s, Controller, VP of Finance, General Counsel, or a dedicated Director of Real Estate – there are three styles that the management can typically be classified under:

1. Reactionary – Most direction comes from the field or operations groups as needs arise. Most often these type of corporations are decentralized in terms of real estate decision making. While the executive group must ultimately approve major obligations, the business case is usually created by a local or regional manager and the real estate department oversight role is to help facilitate the transaction.

2. Proactive – Under this category, corporate management is involved in defining some type of regular real estate objectives and the real estate overseer is often a relative direct report to the CFO or COO (sometimes their VPs in larger groups). Their actions are driven primarily by expiration dates of upcoming leases, and they usually communicate regularly with the field to determine needs well in advance or with sales/marketing to anticipate new facility requirements.

3. Strategic – The real estate group is the driver of real estate actions based upon corporate objectives and a portfolio approach is applied to reducing costs by evaluating efficiencies, forecasting demand, assessing market opportunities, and considering logistics if applicable.

In terms of involvement, each one of those levels successively requires a greater time investment. In terms of net profit, each level also successively provides a greater return to the corporation. Why?

Lets look at an expansion scenario under each of those management styles. Let’s say that a location runs out of space for employees or product and needs to expand. For purposes of simplicity, we’ll assume that the corporation only leases space and does not desire to own property:

Reactionary – If left to chance, the timing of this event rarely occurs in coordination with the natural expiration of a lease. Therefore, the company’s only realistic option is to negotiate with the existing landlord. This situation is not competitive because the number of prospective bidders with contiguous space is limited to one. Further, the objectives met are usually that of the local manager and not necessarily the corporation. These objectives could be the same, although they may not be. The local manager’s compensation may not be directly tied to expenses, so the lowest cost solution might not be the driver – perhaps he cares more about investment of his time and/or business disruption. Certainly those are important factors, they just might not be top priority from a C-level viewpoint. This group may or may not use tenant representation, often selecting a local tenant rep “if needed” or for relocations but not necessarily on renewals.

Proactive – Under proactive real estate management, the corporate RE manager would have been alerted in advance through regularly scheduled conversations with the field. The space demand might have been solved by diverting some business to another branch with capacity (empty seats or warehouse space for example), or alternatives such as splitting off a function such as accounting or marketing into a new office could be considered. Even if the preferred solution is to keep everyone together, figuring out how to split the operation – and assuring that you have enough time to execute if required – will open up more alternatives both with the existing landlord and with other locations. This will almost certainly result in a more competitive market rental rate and terms. This group often has tenant representation.

Strategic – Because the strategic RE manager routinely forecasts space demand and tracks inventory of open seats (office) or storage capacity (warehouse) factored against growth rate metrics several years in advance, this need was probably anticipated occurring during the original lease negotiations. If so, the tenant likely has either expanded at the last lease event or has some type of negotiated expansion option in place. Alternate strategies such as diverting business to another branch, reconfiguring the space to add additional capacity, or a lease termination option may be utilized. In any event, the more options that have been explored or considered, the greater the flexibility of the tenant, and the lower the ultimate cost. This group virtually always has an integrated tenant rep corporate services partner in a strategic role.

So why doesn’t everyone use the Strategic Method? Well, you have to walk before you can run, and the Reactionary Method is the one that will occur by default since companies tend to focus on running their business and delivering their product. Real estate just happens to be seen as consequential to the operations, not a strategic component. In firms with fewer locations, the C-level executives and the local staff are usually well in sync so can usually do ok with a Reactionary plan. The issues arise as the company grows and management is not conversing regularly enough with whomever is determining real estate solutions. Eventually, the company usually gets stuck in some bad lease situations, or a decision is made by a local manager who promptly leaves the company, although his poor decision on a 5 year (or longer perhaps) lease obligation remains. At that point, the company usually ratchets up a level or two.

The reason that investment in real estate strategy provides such a high rate of return on time investment is that: 1) the savings are usually direct to the bottom line (ie. there is no cost of goods or significant capital investment), 2) the results are usually transparent to operations (saving an additional $.50/SQFT/Year on the lease won’t make any difference to the employees or production) and 3) the effects are multiplied over a number of years (3-10 are typical). Investing time in studying and effecting the best facility solution will always result in less cost to the corporation.

commercial lease demising

Commercial Lease Provisions: Tape on the Floor

Here’s a simple technique that has saved several dozen of our clients literally millions of dollars in lease costs, and is very applicable to the changes happening in today’s market. We call it the Tape on the Floor Option.

Many years ago, a utility client asked our firm to help them secure 25,000 SQFT of Class A office space. After some discussion, they revealed that they’d only have about a dozen employees to start although expected to ramp up to about 60 people within 18 months.

We located a building that had four vacant floors of about 25,000 SQFT each and made the landlord the following offer: The landlord would agree to have an entire floor painted and carpeted, and my client would lease just 5,000 SQFT with an option to take additional space at the same rent and a first right of refusal if the landlord found another user for the balance. Further, rather than put up a demising wall, we simply put tape on the floor with the understanding that should the landlord discover that we were occupying beyond the taped boundary, they could charge my client for the entire floor.

Once the lease was signed, we met with the landlord’s rep and explained the growth plans of this VC-backed company and convinced him that it was in both parties’ interest for him to focus his attention on filling the other floors first, since my client was likely to grow into the rest of the floor. In fact, every 2-3 months, we ended up going back to the landlord and moving the tape to capture another few thousand feet to accommodate a few more rows of cubicles. Eventually they did take the entire floor and ultimately we ripped up that lease and executed another for two floors in a different building owned by that landlord.

Here’s the point: This particular client was prepared to take and pay for 25,000SQFT from day one. If the landlord had approached them the day after the lease was signed with another tenant who wanted the remaining space, they would have almost certainly exercised their refusal option and paid the full rent. However, that never happened. Instead, the landlord focused on leasing the other floors, and my client avoided paying full price for the space for well over a year – and earned a six-figure savings in rent.

Here’s why I’m telling you this now: 1) It helps to have a flexible landlord with a fair amount of vacancy to make this idea work well, and many landlords are starting to fit that profile nicely, 2) You might be looking for ways to contract or minimize expenses with the thought that your business will rebound to previous levels when the economy turns, and 3) This is a perfect maneuver for companies that are able to downsize although would like to stay in their existing space and plan/expect/hope to restore themselves later.

This solution works equally well for office or industrial users. Why not ask your landlord to put the “tape on the floor” and negotiate a lesser rent? Rather than have your space cut down in size, agree to wait until they have another user before the demising wall goes up. Which may be never.

key performance metrics

Corporate Real Estate Best Practices: Key Performance Metrics

Every business has a learning curve as it grows, and the collective wisdom learned along the way becomes an invaluable knowledge base.  This is especially true in regard to your facility strategy.  By analyzing  what was done right and what could be improved in each new location or lease renewal process, you can develop rules to achieve the greatest return and avoid pitfalls.

If your firm has multiple branch locations, try this simple exercise:  Take your annual Total Occupancy Costs (Rent + all Operating Expenses) and divide by an annual revenue metric such as Adjusted Gross Profit or Gross Sales.  For example, if a location has $240,000 in TOC and AGP at that location last year was $5M, then your real estate costs represented 4.8%. Now do that for each site.

What you’ll find, of course, is that each location has a different real estate cost as a percentage of revenue.  The magic question is:  WHY?

Some locations will be more efficient than the others.  You need to dig out the reasons behind that efficiency. Likewise, some locations will be grossly inefficient.  You can also learn from them what not to do.

If you are a sales organization, perhaps one facility has more seats/SQFT than the other.  If each sales person brings in an average of $200K per year, then every 5 extra seats in that facility represent $1M in revenue.  Fit them in without increasing the square footage, and you’ve just added some real value for your organization.

You can be certain that there are more savings to be had by developing best practices for your unique business operations than in negotiating another $1/SQFT off of the rate.

The same is true when it comes to using a real estate representative.  While local market knowledge is always important, it is more critical that they have a detailed understanding of these nuances of your company:

  • WHY renew or relocate?
  • WHERE is the ideal location?
  • WHO will use the space and in what way?
  • HOW does the space compare to your competitors?
  • WHAT makes a layout efficient? and most importantly, 
  • WHAT is the long term objective for this part of your business and how can you structure a lease that will help accomplish those goals in the most cost-effective way?

Using metrics like the one described above, and taking the time to understand what makes your space efficient for your operations or not, will ultimately deliver more cost effective space solutions.

operating expense pass through

Operating Expense Pass Throughs – Protecting Yourself

I’m not crazy about condominiums.  Here’s why:  Other people (the condo association – which is often controlled by a very small group of individuals) get to vote on how to spend your money.  Some of those choices may not add value for you or to your property.  Operating expenses on leased commercial property work the same way.  The management company, which is the property ownership or someone under their direct control, gets to decide what expenses get passed through to the property tenants.  So what expenses do they pass through?  Every single one that they can possibly get away with.  There are only two methods of protection for tenants, and I’d estimate that more than half of all leases don’t fully take advantage of them.

Protection #1:  Operating Expense Exclusions.

Most commercial leases say something to the effect that the landlord may pass through all expenses (or the expenses over a base year) related to the ownership, maintenance, and operation of the project.  As long as these expenses are market competitive, that’s fair or at least customary, right?  Wrong.  The landlord should only be passing through the costs of maintenance and operation, not ownership.  Ownership could include costs of refinancing, marketing the property for sale or lease, legal costs related to the ownership structure, accounting fees for ownership tax returns – even income tax.  Taxes are a cost of ownership.  My point is, you need to exclude those costs and any other costs with specific language because the landlord’s thirty or fifty page document (or more, I’ve completed leases of more than a hundred pages and the landlord’s attorney didn’t have a single word in there by mistake) allows everything including their Christmas party, executive meetings in Las Vegas, and hiring family members to provide management or lawn service.  You need to have a long list of what is NOT allowable, and argue to get them into every lease.  You won’t always succeed on every item, though you should always try.

Protection #2: Auditing.

You need to audit the Operating Expense Reconciliation that you receive from your landlord annually.  Why?  Because if you have used Protection #1 to modify your lease in any way, you can bet that whomever actually does the bookkeeping has never bothered to read the changes that you made to the provision.  My firm has seen landlords ignore negotiated caps or limits included in the lease and include capital improvement costs, expenses directly for the benefit of a another tenant, costs related to code issues that existed before the tenant’s lease commenced, and costs for services that were not competitively bid and significantly out of line with the market.  If you don’t have the time, expertise, or resources to audit the reconciliations yourself, hire an outside firm on a contingent basis. Most importantly, do it in the first year of your lease, so that you 1) put the landlord on notice that you are the “auditing type” – most tenants are not – and will nail them on any inappropriate charges and 2) identify any issues early in the relationship, since most leases prevent you from challenging expenses or auditing prior years after a certain period – some as short as 30 days after receipt of the reconciliation.

A recent trend that we’re seeing is the inclusion of six-figure executive salaries(with titles such as Asset Manager or Director of Properties) usually split between several properties.  As the economy puts the pinch on commercial landlords, they are allocating as much of their overhead as possible to their portfolio’s operating expenses.  If you are lucky, you’ll have inserted language into the original lease that prohibits salaries above a property manager.  And if you’re smart, you’ll audit the operating expense reconciliation to enforce your rights.  When it comes to pass-through expense, Less is most certainly More.

Market Rate Audits for commercial leases

One of the easiest and most effective ways for a corporation to keep real estate costs low is to regularly perform Market Rate Audits on their leased locations.  Often many companies get caught up in reactionary tasks such as simply handling leases as they come up for expiration, so they never get ahead of the curve with a proactive approach.

Here’s how the Market Rate Audit usually works: Whether a firm has just a handful of locations or several hundred, each lease with less than 5 years remaining in term is evaluated and compared to actual available alternative spaces in their respective markets.  Rather than rely on the general occupancy and rate statistics published by the large landlord rep firms such as CBRE, JLL or C&W, this exercise involves actually identifying specific spaces that, if the lease were expiring in the next 12 months, would be feasible for a relocation.

While nobody has a crystal ball to predict what rates will be in the long term, rates for the next 18-24 months can be forecasted surprisingly well by looking at occupancy, absorption, and property under construction. Knowing existing feasible alternatives combined with construction – it takes generally 18 months or longer to get entitlements, permits, and build a new commercial facility – can give a very precise picture of what rental rates will be over the near horizon.

Many people fail to consider that leases are just like mortgages – a financing tool to occupy or control a property. And just like mortgages, when rates are low, it makes sense to restructure them and capture the lower rate.  Likewise, if rates are escalating and lack of new construction would not provide additional supply – the rules of supply and demand apply here of course – it may also make sense to lock in early before rates increase further.

The benefits of a Market Rate Audit to the corporation are:

  1. They become proactive to manage rental costs to take advantage of low points in the market.
  2. They become aware of any significant increases – many markets have rebounded to rates above their prior peaks – so no surprises.
  3. If market terms become unfavorable they have adequate time to plan alternatives such as build to suit options or even shifting facilities to other markets.
  4. The audits can be done on contingency with the auditing firm only billing to the extent that savings are immediately realized.

The Market Rate Audit is a low risk, low cost, smart portfolio strategy to take a proactive approach to corporate leases.

Are you paying for imaginary space?

If you go into the grocer and purchase, for example, three pounds of salmon, you can be relatively certain that you now possess three pounds of salmon.  However, if you lease 30,000 SQFT of space in an office building, can you be relatively certain that you possess 30,000 SQFT?  Absolutely not.

Here’s why:
To start, there is the concept of “rentable” and “usable” space.  In summary, “usable space” is the space actually contained within your walls, and “rentable space” is the same number plus your proportionate share of all common elements such as elevator lobbies, bathrooms, fire stairs, and mechanical rooms.  If you lease half of a floor, the rentable calculation would apportion half of those elements for your use and add that amount to your usable calculation.

The American National Standards Industry (ANSI) has created very detailed specifications on how to create accurate measurements.  For example, dimensions are taken from the interior of glass windows to the mid-point of the wall for any walls shared in common with other tenants, etc.  This standard has been adopted by The Building Owners and Managers Association (BOMA) and some landlords agree to adopt these standards.  Fair enough.

But there is another scenario which can cost you thousands, perhaps even tens or hundreds of thousands of dollars over the term of your occupancy:  Phantom Space.  This is when either the usable or the rentable numbers or both are inflated above the actual or proper numbers.  Sometimes this occurs because the Landlord or their representatives choose to ignore the ANSI/BOMA standards in favor of their own.  These may be based on a measurement of the landlord’s choosing (the drip line of the roof for example) or could be, well, anything that they decide which may or may not be based on a real metric.  Illegal?  No, because all aspects of a lease are negotiable – including the basis for measurement – and the landlords that do this almost certainly have very smart attorneys who put language in the lease that will indemnify them and prevent recalculation to any reality-based standards.

Do you think this is a low risk concern?  A May, 2014 article in the Wall Street Journal details how the MetLife Building has somehow grown from it’s original 2.4M SQFT in 1979 to 3M SQFT today.  Indeed, NYC is notorious for floor measurements that have in some cases exceeded the outside measurement of the actual building.  Many real estate firms, including one quoted in the article that purports to represent tenants, turn a blind eye to the practice and shrug it off with the attitude, “It’s an important enough market that they (the Landlords) can make their own rules”.

How do you protect yourself?  Take these precautions:

1. Insist that measurements and rentable adjustments be done in accordance with ANSI/BOMA standards.  Note that The International Property Measurement Standards Coalition mentioned in the article is working towards a global standards, although it will likely be years before it is adopted in any significant way – and more likely never by unscrupulous landlords.

2. Hire your own architect, rather than relying on the Landlord’s architect.  The architect, like most professionals, has a fiduciary responsibility to their client.  Make sure that you have someone on whom you can rely for accurate and honest representations.

3. Include language in the Lease document that affirms measurement to to ANSI standards and allows for adjustment if a discrepancy is discovered.

4. Be certain that you have a tenant representative that insists on the items above, manages the transaction to meet ANSI compliance, and will not passively accept the non-conforming measurements of unscrupulous landlords.

When it comes to Phantom Space, Less is More.