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.

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.

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.

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.

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

amazon prime logistics

Amazon Prime’s Logistics Strategy

A few months ago, I joined Amazon Prime.  That’s a $79/year program that Amazon developed that gives members free 2 day shipping on Amazon-stocked products (which is most of the stuff that they sell).  For me, having nearly anything I want conveniently delivered anywhere I want in two days is fantastic.  However, the second time I bought from them, I was given a choice:  Free 2 Day Shipping, as I had signed up for, or Free No Rush (5-7 day) Shipping with a $1 credit to their Amazon MP3 Music Store (with most songs priced $1 or less).

Now the offer isn’t a huge incentive, but you have to appreciate the strategy behind it:  Many times customers just don’t need things as fast as we’re able to deliver them.  By effectively “polling” my needs, Amazon just created an amazingly flexible logistics model.  Can you imagine having a pool of pending deliveries that you can pick and choose when to fill and when to ship based upon your labor and transportation capacities?  That’s what Amazon has accomplished.

The strategy is absolutely brilliant:

  1. They’ve got customers to pay a premium for shipping (most orders over $25 ship free 3-5 day anyway).
  2. They’ve created a membership organization which builds loyalty – if you’re in the Prime program, you’re likely to buy from Amazon or at least check there first.
  3. They are determining customer’s true time requirements, and thanking them for the flexibility with a token MP3 song – a near universal currency in today’s world.
  4. By having up to 7 days to select orders based on size, weight, or delivery area,they are able to optimize shipping strategy to lower costs.

Now, based around the requirements of their 2 day must-deliver products, they can fill trucks and planes based on available capacity.  They can have geographically revolving flights (Pittsburgh on Mondays, Cleveland on Tuesdays, for example).  They can lower inventory based on order time.  If their suppliers can supply them with inventory in just a few days, perhaps they don’t carry the inventory at all!

If your business delivers products, think about how you might apply this to your business:  A brand loyalty program, rush delivery when your customers need it, flexibility when they don’t, a small reward to thank them for both the information and permission to be flexible.

It happened that, as I was placing my order I was about to leave town for a week so certainly didn’t need it in a rush.  I took the credit.  A handful of times since then, I was in less of a hurry so received more credits.  Less = More.  I recently used $6 in credits to buy a $5.99 MP3 download of the Rolling Stones’ Sticky Fingers.  Thanks Amazon.

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.

commercial lease demising

Commercial Lease Provisions: Tape on the Floor

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

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

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

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

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

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

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

key performance metrics

Corporate Real Estate Best Practices: Key Performance Metrics

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

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

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

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

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

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

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

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

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

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.

Step 7 – Space Planning

Step 11 – Letter of Intent