Playing Russian Roulette with Corporate Real Estate

When choosing professional services, there exists an old adage that the largest providers are the safe bets. “Nobody ever got fired for hiring IBM” was the well known saying implying that a large company offered at least the reasonable perception of reduced risk over smaller firms. In regards to technology consulting, those advantages may have been real or simply perceived. When choosing commercial real estate advisors however, often the risk increases significantly as the size of the provider firm increases.

What?

There is growing pressure for the commercial real estate industry to adopt the Model Rule of Professional Conduct adopted by the American Bar Association regarding Conflicts of Interest. This rule states specifically, “A concurrent conflict of interest exists if the representation of one client will be directly adverse to another client.” This prevents, for example, a law firm from representing a tenant in a real estate transaction and also representing the landlord.

An example of this adverse interest would be if a real estate firm represented both a landlord and a tenant in the same market. Doing so would put pressure on the firm to favor the interests of the most valuable client. In fact, the firm doesn’t have to even necessarily represent both parties for the conflict to exist. The other party might simply be a prospect for the firm. It is well known that institutional landlords often award lucrative listing agreements to the commercial real estate firm that brings the most traffic through their buildings. This would put pressure on the firm to steer tenants through those buildings most likely to award them such contracts. Worse, these firms that represent corporate tenants not only represent adversely motivated property owners, they may even have undisclosed ownership interests in the very properties being presented for consideration. Indeed, the two largest U.S. commercial brokerage firms were recently identified as also being in the Top 10 Largest U.S. Office Owners. Is their fiduciary to their tenant clients, or their shareholders?

Unfortunately, these exact scenarios are quite common in commercial real estate and there is no governing body similar to the American Bar Association to define and enforce professional ethical standards. While the real estate firms might contend that they “manage” the conflicts or construct a Chinese wall, why take the risk? The new FASB ASC 842 Lease accounting adds an additional layer of responsibility for a CFO to avoid such conflict as discussed in a recent article in the Huffington Post.

Fidelity recently learned this lesson the hard way when they were sued over their use of a Big 5 commercial brokerage firm with a potential conflict. In December 2016, the California Supreme Court upheld a ruling that CB violated the responsibilities of dual agency to provide undivided loyalty, confidentiality and counseling to both parties in a real estate transaction. Although the case was regarding a purchase transaction, the principles apply to commercial leasing as well and highlight the inherent obstacle to representing the interests of opposing parties, and the risk involved for those who put their faith in firms with potential conflicts. It is likely that this case will become the basis for similar suits whenever a tenant is adversely affected in a dual agency transaction.

There is a simple solution for a corporate office user to minimize this risk with their transactions: Get a No Conflict Assurance Statement from your real estate service provider that warrants that they do not and will not represent potential landlords within a 20 mile (or as appropriate) radius of any properties under consideration during their engagement or within one year after completion. Make sure that it applies to the entire company and not just a subsidiary or local branch, as most major firms are sophisticated enough to have independent entities acting as property owners or representing them. Hold them to the same standards as your corporate legal counsel. In the past, these conflicts were often ignored based on the “larger is better mentality” or personal relationships.

Don’t play Russian Roulette with your real estate advisor. It’s just not worth the risk.

Location, Location, Location

The City of London realized, shortly after WWII that they would need a new airport, now known as Heathrow.   The job of determining the location was entrusted to Alfred Critchley, a successful businessman.

Consider the many criteria that must be considered when choosing the location for a major airport: Transportation access, proximity to the population, geotechnical suitability, environmental impact, utility infrastructure, land acquisition costs, many others.

Do you know why Heathrow is now located precisely where it sits today?  Because that was the location exactly halfway between Alfred Critchley’s home and his office in London, and therefore the absolute most convenient place for him to catch flights.  And so you now have insight into how most site selection is determined when chosen by those who have a personal interest in the ultimate location.

Smart firms realize that each party involved in site selection will often have a bias toward a location that is in their own self-interest.   This does not necessarily mean that it is near their home or their child’s school, although that in fact is often the case.   We had one local manager who was insisting on a particular location that required a ten year lease, while we were under instructions from the CFO to limit the term to five years or less.   When the location became unsuitable for other reasons, he asked what other facilities would require ten year terms.   When we queried “Why is a ten year term important to you?”, he responded that he’d heard that the company planned to close several offices in the next year or so and, if they had a ten year obligation, then choosing his facility would become unfeasible.

Likewise, staff without financial accountability may want the nicest space for recruiting purposes, or the largest space to accommodate growth that is hoped for but not yet obtained, or even the easiest option simply because it takes a more complex project off their plate.

The point is this:  Corporate objectives need to be clearly defined for every location option, and then both quantitative and qualitative measures applied to each property under consideration.   Only then can you be assured that company goals are being met, and that they are not being driven by the goals of those who might have conflicting interests.

When it comes to Conflicts of Interest, then certainly Less is More.

Don’t Sign That Estoppel Until You Read This

Most commercial office leases contain a provision that requires the tenant to promptly return an estopple upon request.  What exactly does this bit of legal jargon mean?

It’s actually pretty simple: an estoppel is a common legal document that serves to 1) confirm various aspects of a lease agreement and to ensure that important documents and facts are accurate, 2) affirm that the landlord has met all of his or her obligations and 3) confirm that there are no additional addenda or other modifications to the terms.

Basically, it states that all aspects of the lease are in effect as contemplated and “stops out” a tenant or landlord from claiming a different set of facts as true. Some of the most frequent elements of an estoppel include: 1) the lease term, 2) the rent payable, 3) the date up to which rent has been paid, 4) options for renewal and 5) defaults under the lease. This might not seem too scary; after all, an estoppel grants you certain protections.

Since most lease agreements require you to sign one, you just do it, right?  Well, not so fast.

The one most important consideration:  Do not let the estopple modify or add any additional terms!

We’ve seen estopples that waive renewal rights, affirm that the landlord had completed work that they actually had not, and even provide a personal guarantee.  Often this may be unintentional or at least not malicious.  A closing agent may be attempting to get estopples from dozens of tenants to close a new loan, so neglects to read the fine points of a lease agreement and uses a boilerplate form.  Or an ambitious attorney may be trying to protect his purchaser client by bolstering language that he’s not satisfied with in the original document.

The document your landlord sends you is not the one that you need to sign: you have the right to correct any inaccurate information, delete anything that would change or add new terms to prior agreements, and add reasonable clarification before submitting it back to your landlord.

For this reason, it is advised that you have a legal professional read over the proposed estoppel to prevent any hazardous points from trickling down to you in the future. Here are some tips for signing an estoppel:

  • Respond promptly. A landlord is often either attempting a refinance or sale, so your cooperation will likely be appreciated.  You’re probably contractually obligated to sign an estopple, just not necessarily the exact form as it was presented to you.
  • Don’t try and renegotiate your lease through an estoppel, although you can certainly use an estoppel to clarify issues or clear up any confusion.
  • Be careful! A poorly-worded estoppel can come back to haunt you in the future. Take time to fact-check, and don’t be afraid to change the language or correct any errors. This is a document that needs to be perfect.
  • Definitely object to any provisions that change the original lease agreement, limit your rights, or add to your obligations. This is a document meant to confirm what is already known, not alter your existing agreement.

A red flag for us is often a multi-page form, as length often indicates excess baggage.  Simpler is better.  Estopples are another example where Less is More.

FASB-3-1

Tenant Strategy for the New FASB Lease Accounting (or “How to Make Your CFO Happy”)

It seems like every accounting, real estate, and asset tracking software firm has published an article on the new FASB Lease Accounting Standards.  I’ve noticed that they all tend to talk in generalities about the actual mechanics, and none that I’ve found seem to offer suggestions from a corporate user perspective aside from “Get ready!”.

The reason this is a big concern is that operating leases, likely such as the one for your company’s existing office or warehouse spaces, will soon have to be shown on the balance sheet.  They will appear as both a “right-of-use” asset and a corresponding liability.  So if you have both a liability and an off-setting asset, it is a wash, right?  Well, yes but from a credit standpoint it is still less favorable. Here’s an example of how a balance sheet might look for a company with $1M of assets and a $1M operating lease both before and after:    

BEFORE:  Assets:  $1,000,000    Liabilities:  $0

AFTER:    Assets:  $2,000,000    Liabilities:  $1,000,000

The net equity remains the same, but in the Before scenario the user has no debt and in the After scenario the user has 50% debt.  Less desirable.

So the objective will be to minimize the impact.  Because this is a complex issue, and there are many parts that are open for liberal interpretation, please do not underestimate the value of good legal and accounting advice and I hereby recommend that you seek an opinion from your own advisor.  That disclosure out of the way, here are my observations:

  • Term:  Shorter is better.  You can try to hedge your risk with options, but if it is “likely” that you will exercise the option (meaning that you have strong financial incentive to do so), you’ll need to capitalize the option period(s).  Making a large investment in improvements or having a below market renewal option would trigger this “likely” opinion.
  • WACC the Discount Rate:  Both the asset and the liability are determined using a discounted Net Present Value (NPV).  You can use your incremental borrowing rate or the “risk free” rate.  Of course, you want the highest possible discount rate, because this will reduce both the asset and liability values.  Intuitively, you might expect to use your incremental debt borrowing rate (for a like term), although consider instead your Weighted Average Cost of Capital (Google it if you need the formula) which will likely boost the rate by factoring in a higher return on equity.
  • Float the Taxes:  If a Base Year is used for Property Taxes (including if bundled in a full service lease as is currently common practice), then the taxes must be capitalized.  But if the tenant is responsible for their proportionate share of property tax whatever those taxes may be (as in a NNN lease for example) then they are not capitalized.  This can make a very significant difference, and a smart real estate advisor can install some protections that limit or eliminate the risk of negative surprises.
  • Parking Optional:  Designated parking spaces included in the lease are capitalized.  Instead, negotiate the option but not the obligation to take reserved parking.
  • Track Direct Costs:  Tenants can add the value of related direct costs paid to 3rd parties to the asset value such as legal fees, brokerage or consulting fees, and related travel costs.  Track these costs by project as they can be added to the asset and straight-lined over the lease term separately from the lease present value.

The new guidelines are “principles” and not “rules”, so there is much room for interpretation and, while it must be reasonable, it can also be structured favorably.  Because when it comes to balance sheet impact, Less is More.

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

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.

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.

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.

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