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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.
real estate timing

Facility & Office Managers: Where’s Doc Brown’s DeLorean when you need it?

In honor of Back to the Future, let’s talk time travel in commercial lease negotiations…because business decision makers often need it. Many companies wish they could go back and start things sooner or change that one clause in the lease document that they overlooked in haste. Who would have thought that a holdover provision would prove so important in a simple lease renewal? Why does the landlord take so darn long to respond to our counter offers? Maybe we should have just bought a building or built to suit. Unfortunately, options are drying up and Doc Brown’s Flux Capacitor doesn’t exist.

In real life, from a commercial tenant’s perspective, timing is the most critical and telling element in negotiations. Even the most experienced facility and office managers may not list commercial real estate as a core competency, and often greatly under estimate the time needed to negotiate deals appropriately. Time until occupancy (or renewal) correlates directly with the quantity of available alternatives, and with expanded options comes virtually boundless leverage. Savvy business operators (or their assigns) monitor local market conditions and their leasing positions regularly…whether leases are approaching expiration or not. Spotting an opportunity or requirement with 2 or 3 years lead time, a company has options to lease space, purchase buildings, or build pretty much anything they want to from scratch. Options galore and minimal stress.

Conversely, as time dwindles, so do your alternatives and negotiating advantage…and your landlord knows it. For most businesses, anything less than 2 years from expiration rules out build-to-suit options. Inside of 12-18 months eliminates the realistic chance of purchasing a building to occupy. Inside of 6 months means the options you find for lease need to fit just right, because you don’t have time for significant tenant improvements or permitting. If a deal falls through at this stage, you’re really in trouble. Relocating becomes difficult if not impossible in this time frame as well. Anything less means you’re telescoping the negotiation process and leaving plenty of money and business risk on the table. For no other reason other than simply waiting too long, you’re basically resigned to accepting whatever your current landlord offers you.

Timing is also very “telling” for your current landlord. It’s a subtle, but relentless force in renewal negotiations. Even with all the backchannel conversations, strategy, and crafty bluffing you think you’re doing in a real estate deal, you can’t hide timing from your landlord. Landlords often “slow play” negotiations as they understand that the later it gets, the less options you have…thus increasing their odds. At some point, all the strategy in the world leaves you captive and forced to renew in place.  You won’t get a reminder from your landlord 18 months in advance of lease expiration to begin looking around for alternatives. You can’t blame them for this…it’s their job to keep you paying rent and maximize returns for their properties. It’s up to you and your team to figure this out.

Even if you have no intention of ever relocating your facilities, the negotiation process and required timing is exactly the same.

Here’s a recommended solution. Like legal counsel or your family doctor, there’s nothing that says you can’t have real estate representation “on retainer” ongoing. You can find an established, proven ethical corporate real estate firm to track important dates, keep a pulse on market conditions and establish performance metrics for you…even if there aren’t any leases coming due for a while. Hire a proven firm now while there’s nothing going on…preferably one that doesn’t represent owners or landlords. If you don’t like what they’re doing, you can just cut them loose.  

When it comes time to act, a competent firm (like The Avocat Group) will ensure that you’re signing good leases under fair market terms, and making sound business decisions in the first place. They’ll help you get the timing right and monitor threats and opportunities while you’re busy doing whatever it is that you do. Ongoing, they’ll also track and report on real estate related performance metrics so that you look like the hero. Proactive decisions based on actual data and analysis mean a higher likelihood of success, not to mention job security for you.

As originally posted by Casey Bourque on LinkedIn

commercial lease commencement dates

Commercial Lease Commencement Dates

A typical commercial office or industrial lease states something to the effect that the “The Commencement Date of the Lease shall be the later of X date or the date that the Landlord delivers the Premises to the Tenant.”  (Note:  If it says the “earlier of X date ….”, your landlord is really giving you a raw deal.)

This Commencement Date language protects you in case the Landlord is late in completing construction and you don’t get possession when planned.  Right?  Wrong.  Here’s why:

Suppose that you are planning to take possession of a property on or before June 1st and your existing lease expires May 31st.  As is not unusual in commercial real estate lease transactions, getting the construction completed on time is a push but appears not unrealistic.

A week or two before June 1st, the Landlord informs you that the space will be delivered June 5th.  Your new rent will be prorated so that you don’t pay for June 1 – 4.  That’s fair, isn’t it?  Probably not.

You will be forced into a holdover position in your existing space.  If your lease is silent on the subject, most States provide that a landlord can charge double rent during a holdover period.  Many commercial leases address this issue and specify some increased rent penalty from between 125% (if you negotiated it up front) to 200%.  In addition, since rent is paid monthly, you are obligated to pay for the entire month – there is almost NEVER a provision for a daily prorated  holdover rent.  Further, you may be liable for other costs incurred by the landlord.

If he has leased the space and plans to commence build out for a new tenant, you’ll likely get charged for the overtime incurred to get them back on schedule.  If you are delayed long enough for his prospective new tenant to bail, you may get sued for the entire value of the failed lease.  Meanwhile, your new landlord’s liability is limited to compensating you by not charging for the four days of rent that you didn’t have use of the premises.  Ouch.

So how do you protect yourself?  The lease should state that “the Commencement Date will be later of June 1st (in this example) or the first of the month following delivery of the Premises by the Landlord with substantial completion and and a Certificate of Occupancy.  In the event that the Commencement Date is other than June 1st, the Landlord will pay $X for each month or each partial month of delay.”

The $X should equal the new rent plus your holdover penalty, and should include any damages charged by the existing landlord if the tenant is liable for such costs.

In addition, you should state that, in the event that the lease has not commenced by X date, the tenant may terminate the agreement on X days notice.  You can’t wait around forever.

real estate is like poker

CRE 101: If you can’t spot the sucker at the table…

Don’t be so naive to think that just anyone in your company can handle your office or facility lease negotiations. It’s not like leasing an apartment, but more like playing poker against Doyle Brunson (2-time World Series Champ/Hall of Fame). Just like your landlord, Doyle would be plenty nice to you and let you go on believing you belong at the table, but at the end of the day, he’ll have your money…and you’re none the wiser.

In commercial real estate, an institutional landlord’s core competency is to maximize the investment returns on their properties. That’s all they do, every day…and they’re really good at it. Not to mention, they hire teams of professionals to help them fill space at the best possible rates, under the most beneficial terms. A landlord’s entourage includes an army of attorneys, architects, property managers, and real estate brokers – all charged with representing the interests of the landlord.

This representation can include the obvious stuff like the landlord’s broker marketing available space to new tenants, or his real estate attorney crafting language in a lease document. It can also involve not-so-obvious stuff like when the property manager pops in to say hello or strikes up a conversation in the hallway. Yes, he wants to know how the AC is holding up, but he’s really gauging your likelihood of relocation, or whether you’re starting to look around at options. Again, like in poker, they’re thinking of this stuff all the time, and the little things add up to big leverage.

Larger sized space users dealing with 7 and 8-figure lease obligations understand full well the business risks involved with playing at such an immense disadvantage.  With so much at stake, these firms choose to either make real estate a core competency with an in-house real estate department, or outsource this expertise through dedicated corporate real estate firms. Either way, in capturing co-broke commissions, there’s enough money to go around to pay for this expertise, often with surplus to hire in-house legal, architectural, and construction management services. It’s a no-brainer for these guys.

Smaller and mid-sized firms are the ones who often miss the boat when it comes to managing facility related expenses, quite literally leaving money and business flexibility on the table. They only think of their lease when expirations come up, and even then wait way too long. Landlords slow play the deal and tenants find themselves captive, without options. Imagine that, Doyle had the cards all along…he’s so lucky.

Unlike poker, there’s money literally set aside for the benefit of tenants…if only they choose to use it wisely. 

In most markets, 6 – 8 % of a commercial tenant’s total lease obligation is committed to brokerage commissions by landlords. This is not an arbitrary number, but a market driven expense for the landlord to best attract vetted, viable candidates to lease space.

This money is split between the landlord’s broker and tenant’s broker, paid out whether the tenant has representation or not. Roughly half the commission goes to the landlord’s broker for their role in marketing the space and getting the deal done. The other half is allocated to the tenant’s broker for introducing a bona fide candidate tenant to the landlord’s space (even in renewals). The landlord is happy to pay this fee to keep his building occupied.

Sticking with our poker analogy, real estate offers tenants the chance to bring some paid expertise to represent their interests on their side of the table. Unless you know how the game is played, nobody on the landlord’s team will ever tell you this.

Think of Phil Hellmuth (another World Series Champ) sitting down next to you at the poker table helping you play your hand. Doyle won’t be pulling the same tricks with Phil that he would without Phil being there. It’s the same in real estate…and it’s already paid for.

If you hire a good firm, this means you get full scale deal coordination, negotiation and strategic insights (stuff you’ll never think of), evaluation of all alternatives, integration of real estate into overall strategic planning, and a host of other services getting you to the finish line. If tenants are clever, there’s often money to spare which can be allocated to legal, space planning and/or construction services.

Naturally, as deal sizes reduce, there’s less money to go around on both the landlord’s side and the tenant’s side. You may not be able to get Phil Hellmuth, but then again, you’re probably not playing against Doyle Brunson either. In any deal above just a couple thousand square feet, you should be able to interview and find a suitable tenant representation broker to guide you through the process and ensure best possible economic terms in your next lease. The system allows for you to have representation, choose wisely.

If you don’t properly evaluate your alternatives, you won’t even know what a “good deal” is. A pair of 7’s might be a good hand in some games, but certainly not in others. In real estate, you have to work hard to see the other players’ cards.

The part where our poker comparison falls apart is when the deal is done. In poker, it’s obvious that you lost when all the chips are with the other guy. Commercial lease transactions are far more sinister. The devil is in the details in terms of what the market will bear…rent escalations, pass through operating expenses, maintenance obligations, holdover/assignment/subletting provisions, insurance requirements, legal terms, and and endless array of clauses often egregiously in favor of the landlord. Worse, opposing brokers and landlords allow you to go on thinking you’ve gotten a great deal under fair terms. Except perhaps later in hindsight, you won’t ever know you’ve been had.

As originally posted by Casey Bourque on LinkedIn

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.

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.

What’s a Renewal Option Worth?

It is a great time to be a tenant, and here is another example.  Because almost all options are written with the assumption that rates will climb forever upwards, we’re seeing some interesting effects as rental rates tumble.  Some options are literally not worth the paper they we’re written on.  However, declining markets have made some usually unattractive renewal options have new value.  Here’s why:

In an appreciating market, it is typically most desirable for a tenant to have a “defined” option.  That means that the rent is spelled out in an actual dollar rate/SQFT or a percentage increase over the last year of the original lease term.  Simple enough, and in a declining market, of limited value.

In recent years, however, many landlords resisted defining future rates and instead insisted on “market rate” renewals.  You can guess where this is headed, right?

If the options provided for market rate renewals and especially if the option has a well constructed method for determining market rate – such as an appraisal or “comparable space within the project adjusted for concessions and construction allowances” – there may be a tremendous opportunity to lock in attractive rental rates.  Best of all, many options can be exercised at any time before a certain date meaning that the tenant can lock in while rates are low even if the expiration is years away.

Be prepared for the landlord to scream bloody murder because they may have a more optimistic view of future market conditions.  At the time of writing, many markets are still in relatively early stages of decline so if your expiration is a long way off it may be best to wait it out a bit longer.  Real estate values are difficult to predict more than 18 months out although can be gauged with relative accuracy within the next 18 months.  Watch your market(s) closely and exercise your market options near the bottom of the cycle.

Better yet, simply inform your landlord that you will be exercising the option, show them the justification of rates, and then negotiate revised terms beginning now.  You may be able to structure immediate rent relief and negotiate in expansion or contraction, immediate improvements, or other concessions.  Either way, you should end up paying less rent.

A better way to manage commercial construction

If you were around and fortunate enough to have a cell phone 30 years ago, you most likely had a Motorola “brick”.  It made calls.  It did not have a camera, email, mapping or navigation function, calculator, clock, or play music.  It could act as a paperweight, mini-dumbell, or a defensive weapon in a pinch.

Now, think about how much has changed in cell phones in the last 30 years.

Do you know how much has changed in the construction process during that same 30 year period?  Not much.

We still construct offices and buildings using the same process, with mostly the same materials, in the same way.  Sure, there have been some token design changes and there is often a greater focus on energy savings.  Many of these changes are style trends rather than cutting edge innovations, like switching from autumn colors and wood paneling to white finishes and glass.

Here’s how most new building construction projects happened then, and how most still work today:

Imagine a series of adjoining but unconnected rooms.  They have walls but no ceilings.
Execs from a company are sitting in the first room.  They decide they need a new building.  How big and where?  They pick a size (let’s say 50,000 SQFT) and some boundaries, write it on a piece of paper, and throw it over the wall into the next room which contains their real estate advisor.

The real estate advisor does some quick calculations and determines that they’ll need 4-5 acres of land, so goes out and identifies some properties and the company purchases one.

The advisor takes the requirement for a 50K SQFT building and the survey, and throws it over the wall to the next room which contains an architect.

The architect then designs the building.  Perhaps there are issues because the real estate advisor didn’t properly estimate water retention requirements.  Or setback restrictions.  Or utility access.  Or department of transportation mandates.  Perhaps the company didn’t fully consider future expansion needs. Or above average parking requirements.  Or fibre optic accessibility.  In any case, the architect does his/her best, completes a set of drawings, and throws it over the wall to a contractor for bidding.

The contractor immediately calculates the impact fees of that particular site which were not anticipated.  He also calculates the cost of concrete, steel, and other resources that might be in short supply and therefore at premium prices to just a short while ago.  He then throws the drawings over the next wall to his subs, to give him pricing.

The subs complain that the design is not the way that they’d do it because the equipment and fixtures were specified from a catalogue/web site supplied to the architect and their engineers by various sales reps.  Some of those products have better, more efficient, and less expensive substitutes however the subs are required to bid per the specifications.

Not surprisingly, the final price is significantly above the original planned budget.  Perhaps worse, the owners had the opportunity to take advantage of the expertise of the real estate advisor, architect, contractor, and subs and instead severely limited their ability to add value.

So what is the Better Way?

Start with them all in the first room together.  Negotiate an open book arrangement and agree to reasonable fees up front for profit and overhead.  Now everyone is on the same team.

Perhaps the broker could have suggested a location just outside of the boundaries provided without the impact fees, and perhaps even with economic incentives.

Perhaps the company could have taken advantage of efficient design strategies and only needed 40K SQFT.

Perhaps the contractor could have suggested tilt wall or other construction methods that could save time and money.

Perhaps the subs could have suggested the latest technology in HVAC, lighting, and utility saving features.

Perhaps.  Unfortunately, using a 30 year old process, this company will never know.

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.

captive tenant syndrome

Captive Tenant Syndrome

In a recent post, Newtons First Law, we discussed how the “house odds” favor landlords since the overwhelming majority of tenants renew their leases.  Why?

Because:

  • It is a hassle to move
  • Evaluating options would require time and effort
  • A move would cause disruption to already stretched staff resources
  • It is expensive to move

OK, good points.  However, tenants who adopt the above mindset without actually quantifying or verifying those suspicions, are commonly said to be suffering from “Captive Tenant Syndrome” – the mistaken belief that they are being held hostage in their own space.
What if those issues could be minimized or mitigated entirely?  What if the design efficiency of the new office offset the effort required?  What if the improved morale of an exciting new workplace improved productivity?  What if the new landlord absorbed the cost of the move and paid to outsource the coordination the move?

And most importantly perhaps, what would a move cost the existing landlord?

Landlords know that every tenant considers the above bullet points when facing a lease expiration, and they typically count on it to achieve higher profits on renewal leases than they do on new leases.

Remember that, for an existing landlord, a vacating tenant means:

  • Vacancy expense in lost rent (often 6-12 months)
  • Free Rent to attract a new tenant
  • Operating expense carry for property tax, insurance, and non-variable expenses
  • Additional vacancy expense during design and construction for new tenant improvements
  • Tenant improvement costs (usually significantly in excess of a renewal refurbishment)

I’m not advocating that you put on the boxing gloves and get in the ring with the landlord, my point is simply that there are significant costs to both parties and any extension should be a collaborative effort that acknowledges that both parties might reasonably benefit from the renewal.

So how do you avoid leaving money on the table when your commercial lease expiration is approaching?  Here’s what you don’t do: Bluff.  A sophisticated landlord can sense a bluff the way a pitbull can sense fear.  It’s not that landlords are bad guys (or pitbulls – my apologies to offended landlords or pitbull owners), it’s just that it is their JOB to maximize return to their investors.  That means, getting the highest possible rents from tenants.  And the low hanging fruit is not in attracting new tenants, it is capitalizing on the ones in place.

So you have to make it real.  I know that you may think you want to stay.  I know that you may think your preference is a renewal.  Perhaps that really is the best option for you. However to get the best terms, you have to make a serious evaluation of relocation options.  Not just a check of the Business Journal to get an idea of market rates.  Search spaces, tour, meet with prospective landlords, do space plans, get construction estimates, issue formal Requests for Proposals, and prepare a fully loaded financial analysis.

Only then will you know the true cost of a relocation.  Only then can you weigh the true pros and cons.  And only then will you be able to either negotiate a fair market renewal or decide that the advantages to move may outweigh disadvantages.

Interview with Eric Berson – Avocat Group CEO

You’ve negotiated commercial leases from New York and Washington D.C. to Beijing and Moscow. What has that taught you?

EB – Negotiating an office lease is like playing chess for money. Very significant amounts of money. However, unlike chess, you cannot study and learn the moves from the masters in a book or from a computer. Certainly laws vary between municipalities, although so do customs and customary lease terms. Something learned in Abu Dhabi might spark an idea for a transaction in Chicago, or vice versa. The only way to learn is through personal experience and direct involvement, and this cumulative global experience expands the solutions available.

Are there mistakes that you commonly see being made by firms leasing space?

EB – Of course. Real estate is a relationship business, primarily because it is business that requires a very high level of trust. People tend to trust the people that they know, and they should of course, but that can also cause them to be blind to recognizing competency and seeking out the highest level of expertise. For example, we often see law firms that will choose a real estate representative based on that firm sending business to the firm. So in exchange for some nominal amount of legal work that primarily benefits a few real estate partners, the entire firm might suffer six or seven figure missteps in their lease strategy.

Well, yes, that certainly could be painful. Anything else?

EB – Most firms generally do not allow enough time for planning and wait for an event, such as an expiration or need to expand, before developing a strategic plan. The real estate strategic plan should be ongoing. It should start at the beginning of a lease term, so that it can be tweaked and refined over time, and the tenant can properly position themselves with the landlord and in the market. The best time to start is not a year before the expiration.

Your website has a “Canon of Ethics” that discusses conflicts of interest. Should that be a concern?

EB – There are only two types of representation: No Conflict and Not Quite No Conflict. Which do you think is best? I’m an attorney, and each state Bar where I’m admitted has a set of rules of professional conduct that says to effect, that “a firm will not represent a client if their responsibilities to that client might be adversely affected by their responsibilities to another client”. Unfortunately, the commercial real estate industry does not hold itself to such standards and client firms tend to therefore overlook the issue. The simple fact is, a real estate company cannot represent both tenants and landlords, because the other party represents prospective business to their firm, and that can cause unfavorable judgement or pressure on the part of the representing firm. The full service firms try to explain this away by saying that they manage it, but they cannot manage both the interests of individuals in their firms and of their stockholders to maximize profit.

Your client list includes some of the largest law firms in the world and presumably some of the smartest attorneys. Does that make it more difficult for you to represent them?

EB – On the contrary, the smartest attorneys are the easiest to work with because they understand that it takes intelligence combined with experience focused in a very specialized area to create excellence. Whether hiring an attorney or a real estate advisor, or both, you have to decide whose brain power and personal experience you want working for you.

Two ways to protect yourself on operating expense pass-throughs

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.
  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 expenses, 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.

7 Red flags that may indicate the need for a lease compliance review

By Ed Harris
(Editors Note:  Ed Harris is VP of Commercial Tenant Services, a NYC-based auditing firm that specializes in corporate lease review. We hope you enjoy this guest article.)

Few areas hold as much impact on capital outlay as real estate and leasehold expenses. Ensuring that your company is not overpaying is integral to fiscal management.

  1. Significant Jumps in Operating Expenses / Additional Rent
    Performing a simple trend analysis of your year-to-year operating expense obligation is a must. And while inflationary and market forces generally create an escalating building operating expense profile, when you see a marked jump in expenses issued to you, a red flag should rise. Causes of significant jumps might include new and potentially lease impermissible capital projects, new expense categories not reflected in your base year, new contracts or vendor changes and/or related party issues, and newly increased or above standard services which are not reflected in your base year.
  2. Change in Property Ownership / Property Manager
    A change in property ownership or property management should always trigger a lease audit. Property management changes create a very real risk of affecting accounting category integrity which is integral to an apples-to-apples comparison to your base year level. Management fee levels and composition, related party vendors, and changing service levels are also common building operating expense issues when a building changing ownership or management. Another potential trap fall in a building transaction is the tenant estoppel which, if not carefully worded, has the potential to sign away rights or leverage. Finally, once a building changes hand, future audit finds and recoveries may become complicated should overcharges be identified in years under previous ownership.
  3. Building Undergoing Capital Improvements or Renovations
    If you are walking into your building and notice construction – audit your landlord. Renovations and capital projects may be subject to your lease operating expenses exclusions, and every project should be audited for permissibility under your lease. And while you are most likely obligated to reimburse the landlord for a true building operating cost, you probably are not obligated to reimburse your landlord for increasing the value of his/her building if it does not reduce building operating costs in the future. And if your building had undergone renovations and/or capital improvements in past and unaudited years, it may not be too late. Those costs were most likely amortized across future years, and there may still be an opportunity for avoid ongoing expenses if they prove to be impermissible per your lease exclusions.
  4. Your Lease is Commencing / Expiring
    Perhaps the most valuable times to have a lease audit performed are at the commencement and expiration of your lease. If you occupy under a base year lease, the valuation of your base year will have material impact on your leasehold expenses throughout the term of the lease. It is in your direct interest to both validate all charges in Year One, and to validate expense levels so as to not undervalue your base year. Likewise, lease audits should always be performed as a standard practice at any lease expiration. Not only might you lose rights to recoup any overcharges after vacating the premises (audit windows), you may lose significant leverages after your move. Lease audits and the potential uncovering of over- or mischarges may also have a material impact on any lease renewal negotiations and construction of lease amendment/renewal language.
  5. Sizable Shifts in Building Occupancy Levels
    Accounting for accurate building occupancy levels is integral to an accurate gross up methodology and can have enormous implications to your operating expenses obligation. This can be significantly magnified vis-à-vis fixed versus variable occupancy-level driven expenses should the vacancy rate in your building be sizable. And of course it directly benefits the fiscally conscious tenant to ensure that occupancy shifts are accurately reflected within a given expense period.
  6. No or Limited Backup Supplied to Annual Reconciliation Statements
    Just as you would not accept your credit card statements if they did not itemize your charges, accepting an annual reconciliation on face value is fiscally unwise. Yearend reconciliations can carry significant and lease term long financial impact – particularly if your lease terms include caps or index-driven escalators. And any failure to timely challenge a landlord’s computations and/or inclusions may forfeit your rights thereafter per potential audit windows as discussed above. Accepting a rudimentary reconciliation, even one broken down to expenses per billing category is to trust your company’s finances to an outside party with a vested interest in maximizing its profits. Whenever an annual reconciliation crosses your real estate department’s desk without sufficient back up to verify expenses and calculations, a lease audit should automatically be triggered.
  7. Building or Landlord is in Financial Straits
    While it might not always be obvious, it is in a tenant’s best interests to periodically inquire into a building and its owner’s financial wellbeing. These are difficult financial times, and few sectors have been hit as hard as commercial real estate. Commercial Tenant Services (CTS) has uncovered multiple examples of landlords in difficult financial straits materially overcharging their tenants. And while we would never suggest that such a situation directly underlies the overcharge in any specific example, the coinciding of the two – a landlord in financial distress and overcharges to its tenants – can be a recurring theme.

It is important to remember that auditing your landlord issued expenses is your right. It is sound fiscal practice and required compliance protocol in many of the most efficiently run companies in the North American markets. Lease audit has become commonplace, and chances are your landlord has been audited by its tenants many times before your inquiry. Nowadays, landlords expect to be lease audited and have generally already prepared for your call.

Edward Harris is the co-founder of Commercial Tenant Services and has over twenty-five years of real estate finance and lease audit experience. Mr. Harris holds degrees in physics and engineering from Columbia University, and an MBA joint degree in Real Estate Finance and Operations Research from the Graduate School of Business at Columbia University.

Newton’s first law

Newton’s First Law of Inertia:  An object at rest tends to stay at rest.

A Landlord’s First Law of Inertia:  A tenant in place is likely to renew.

How likely?  It is hard to find precise data although many Real Estate Investment Trusts report that in excess of 80% of their commercial portfolios renew.  With those kind of odds, most landlords will presume a low risk of vacancy at renewal time and in-place tenants will be offered less favorable rental terms than a new tenant coming in off the street.

Does a renewing tenant often pay more?  Absolutely. These tenants justify it with a number of flawed justifications:

Reason:  “We’re still paying less than the Landlord’s “asking” price.”
Flaw:  Nobody will end up paying the “asking” price.  The only amount that matters is the true market rate, adjusted for concessions such as free rent and improvement allowances.

Reason:  “It would cost a lot to move.”
Flaw:  It’s probably less than you think, and many firms never actually do the homework to determine the real cost.  Further, many prospective landlords will either provide a move allowance and/or a free rent period equal to or greater than these costs.

Reason:  “It is a hassle to move and a bad time due to limited staff resources.”
Flaw:  The productivity gains that are typically accomplished by improved workspace and layout often reduce facility costs 15-20% or more, and most tasks can be outsourced to relocation firms that specialize in corporate relocations thereby requiring very little staff involvement.

There is a term for this flawed mindset, Captive Tenant Syndrome, which I’ll cover in my next post.  Until then, don’t be caught sitting on your hands.

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.

Project Management Rule #1: No surprises

We have a rule for our real estate project management process:  No Surprises.

Typically our clients are either doing a major construction project to build out or expand their business space, relocating to another facility, or both.  Usually these are operations critical to providing their products or services to their customers.

So what happens when a freak storm like Hurricane Sandy arises well after the usual season, misses the tropical coast, and heads for New Jersey & New York?  Isn’t that a surprise to everyone?  Well, no.

Here’s why:  Stuff Happens.

Of course we could not predict that particular storm, but you don’t need to anticipate every possible scenario. You simply need to realize that Stuff Happens and have a contingency plan in place in case something occurs that will prevent you from executing on your plan.

Perhaps it’s a labor strike, bankruptcy of a contractor, fire, failure of a piece of equipment, unanticipated code or licensing violation, even death of a key team member.  All undesirable and unfortunate, but, from your customer’s perspective the show must go on.

Have a plan in place to deal with how you will handle unavoidable delays.  We’ve found that there are three key components to keeping your project moving forwardas anticipated, or at least with the absolute minimum disruption possible:

  1. Be Proactive – If even a hint of trouble is brewing, communicate with staff, property owners, contractors and other team members to discuss how to handle and respond immediately as problems occur.  Know operational alternatives: Can product ship from another location or staff lease temporary office space in another property?
  2. Establish Relationships in Advance – The time to look for a roofer is not after the hurricane has passed through town.  Know who you can use, talk to them in advance, and assemble your back-up response team before your project starts.
  3. Experience Counts – Staff the project with people that have experience commensurate to the importance of the project.  If you deliver mission-critical products or services, or a delay of the project puts a multi-million dollar contract at risk, don’t put a relocation/construction newbie in charge no matter how competent they are at running your [Fill in Blank] division.  Get someone who has been through many of the same situations before.  They may not anticipate a Hurricane Sandy, but they will know how to deal with seemingly insurmountable issues. A couple of those seem to happen on every major project, don’t they? No surprise there.

Month-to-Month Could Be 15-Days to the Curb

We are working with a multi-location user with several leases in an unnecessarily precarious state of month-to-month lease term. As they are finding, this situation leaves them extremely vulnerable…more so than they imagined.

In Florida this month-to-month tenancy is a tenancy at will which is cancelable by giving “—not less than fifteen (15) days notice prior to the end of any monthly period.”  So rather than requiring a notice period equal to the rental period, that is, one month, as little as fifteen (15) days notice is all that is necessary.

Consider a month-to-month holdover with rent paid in advance for the month of January. The landlord could terminate this tenancy at will in Florida with a notice delivered on January 16th. (See Florida Statutes Sections 83.02-83.03).

In the case of our client, they require unique tenant improvements and industry  permitting prior to occupancy in a new location. With only weeks to vacate and occupy a new location, they would need to close their doors for up to 3 months.

The good news is that this situation is easily avoidable. Have a real estate expert take a look at any leases expiring within the next 12-24 months to fully understand your timing and requirements should you decide to vacate your space. At minimum, a single page addendum should be permissible requiring either party to provide at least 90 or 180 days notice in a month-to-month or holdover situation.

As originally posted by Casey Bourque on LinkedIn