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The Eight P&L Impacts of a Corporate Lease

The Eight P&L Impacts of a Corporate Lease

On many CFO and financial executive’s Urgent Issues or Focus List, real estate often doesn’t make the top ten. Why? I think in part it is because the impact of a real estate decision is spread over many categories of the Profit & Loss Statement. (I won’t get into FASB ASC 842 even though it is one of my favorite topics — for now anyway, keeping watching this space for future posts)

Often financial analysis of a lease decision is based on the rent and operating expense being paid now vs. the rent and operating expense on the new lease. If the impact is acceptable, the company moves forward. Simple enough, right? Perhaps too simple.

Why? Expenses related to a lease are generally as follows:

  1. Rent
  2. Operating Expenses (passed through by Landlord, usually inclusive of Property Tax and Insurance although often further broken out if paid direct by Tenant)
  3. Utilities (not included in charges above)
  4. Repairs and Maintenance (that are responsibility of the Tenant)
  5. Relocation Expense
  6. Furniture, Fixtures, & Equipment — Capital Expense and Depreciation
  7. Technology — Capital Expense and Depreciation
  8. Leasehold Improvements – Depreciation

There can be others of course based on specific uses, although the above are common across most operations.

Any comprehensive analysis needs to consider all of these costs. More importantly, you need to compare not just the current rental rates, but instead the rent amounts actually appearing on the P&L — typically a straight lined value. In today’s market, the SL rate of an old lease can be significantly below the SL rate of a new long term lease.

In addition, look closely at fully amortized leaseholds and other depreciation items that may be coming off of the books at the expiration of the current term. A renewal in an existing space may provide significant savings even when rent increases if the amortized numbers are significant.

The key to correct analysis is habit. Set up a template that works for your business. Many packaged real estate analysis solutions focus on making predictions based on future escalations. What the last roller coaster dip in the economy should have taught us is that projections are simply guesses — and often not good ones.

Instead focus on the certainties of a lease obligation and their impact on your business. You may be surprised after looking at the cumulative effect of all of the categories mentioned above and decide to set real estate priorities a bit higher on your Focus List.

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.

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.

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.