Mick Jagger, Net Present Value, and the new FASB IFRS Lease Accounting Rules

Mick Jagger, Net Present Value, and the new FASB/IFRS Lease Accounting Rules

I took this photo of Mick Jagger when I was a photojournalism major at the University of South Florida. It made the cover of a small time music magazine, and I had visions of eventually getting my work on the cover of Rolling Stone. Just like the song.

Around the same time, I took an elective real estate course and showed the photo to my professor. The unimpressed professor said, “If your photos are great, your photojournalism degree won’t matter. And if your photos are bad, your photojournalism degree won’t matter. Why don’t you change it to a finance degree in case the photos don’t work out?”

They didn’t, and fortunately, I did. The most fortunate part was that I developed a life-long obsession with discounted present value formulas, which is a bit odd, I know. Almost all NPV formulas built into spreadsheets and various analyses presume payments at the end of a period. This works fine for annuities, promissory notes or mortgage payments. Lease payments, however, are made at the beginning of a period, not the end. So if you use most standard NPV, PV, and IRR formulas the result is close, but not correct. Which absolutely drives me crazy.

The new FASB and IFRS Lease Accounting rules require that lease rent payments be shown as a liability on the Balance Sheet. The liability is calculated with a discounted NPV using the lessee’s incremental borrowing rate, excludes operating expenses and, in some but not all cases, taxes and insurance. If a termination right exists, you calculate based on the shortest likely term including any termination fee. This liability is offset on the Balance Sheet by a Right of Use Asset, which is generally the same value as the liability plus any “initial lease costs”. Not too complex, really.

I recently came across a “Big 5” commercial real estate brokerage firm’s online lease calculator that proposed to display the new FASB or IFRS balance sheet impact. The calculator uses an end of period assumption (wrong for leases!) and annual payments instead of monthly (again wrong for leases!). Almost all of the FASB/IFRS calculators that I’ve found online do exactly the same thing. Most also neglect to provide inputs for initial lease costs or termination fees. Making them, well, worthless.

So, while no online calculator can ever replace the experience of a competent CPA and the blessing of your auditors, I asked our team to create one. You can see it at FASBLeaseCalculator.com.

Don’t use it for your SEC filing, but it is a quick and convenient way to see an approximate balance sheet impact of existing or proposed real estate leases under consideration. Payments are calculated at the beginning of the term, and monthly. The way it should be.

Driving Business Growth using Smart Real Estate Strategy

Driving Business Growth using Smart Real Estate StrategyIf you have a growing service business, you probably used to shop for office space by comparing rental rates. The lowest cost space, of comparable class alternatives, was often the best choice. That’s no longer the case.

The cost of labor, including attracting, hiring, compensating and retaining staff is typically between 8 and 12 times the cost of the real estate that houses that staff. So while you certainly don’t want to overpay, in the grand scheme the cost of the real estate is just a fraction of the cost of labor, so perfect placement to attract and retain that talent is far more critical than rate.

Labor analytics are key. More specifically, it is a combination of labor availability, cost, demand, sustainability, and competition. Because labor drives growth.

Your VP of Human Resources understands this and, more frequently, HR will be the driver of real estate decisions. There are a number of dynamics in play here:

  • Near 4% unemployment
  • Increased urbanization (Live, Work, Play) demand
  • Competition for Millennial workers
  • Shrinking space footprints in favor of amenities

Here is some simple math that you can adjust to your market and staff salaries. Typical SQFT per employee varies by industry from perhaps 100 SQFT in a customer support center to 240 SQFT for a law firm (per staff member, not per attorney which is closer to 750 SQFT). The U.S. Average is currently about 160 SQFT per staff member.

Suppose that your firm averages 160 SQFT/staff and you’re considering Class A office space at $35/SQFT. Your annual cost/seat would be $35 x 160 or $5,600. You could move to a trendy urban site that is $40/SQFT. The $5/SQFT delta equates to $5 x 160 = $800 per seat. I’m sure that you can understand that if you can improve your firm’s ability to attract and retain even just one additional staff member, you will very quickly recover that $800 difference. If cost is an issue with your CFO, you could probably just find a way to get 20 SQFT per staff member more efficient and save the $40 x 20 = $800 if necessary.

We use advanced analytics software to aggregate data to evaluate the large number of elements that come into play. While this is certainly not necessary for all businesses, having a good plan like the one outlined here certainly is advisable. The greatest challenge is often the rigid and long term nature of an office lease. Business growth, and results can vary significantly based on the economy, technology, competition and occasionally government regulations. So how do firms make smart decisions? First you determine your own ideal profile of workforce characteristics and then compare them to your target or sample locations. Here are 10 key data points that should be considered:

  1. Labor Supply — What is the Standard Occupational Classification (SOC) count for the specific positions that you need to fill in the target city?
  2. Total Jobs Needed to Hire — How many positions do you need to fill over next 3–5 years?
  3. Underemployment Rate — What is the overall unemployment rate in this area?
  4. Labor Supply & Demand Gap — What is the supply and demand gap by industry?
  5. Target Occupations Median Wage — What are median wages for your required entry, median, and experienced workers?
  6. Population Growth Rate — How will population growth affect your future labor supply?
  7. Aging Labor Rate — In 2015, those aged 55 years and older represented 23 percent of the U.S. labor force, the highest since 1945.
  8. Potential Candidates to Job Posting Ratio — How many competitor jobs are posted relative to the candidate base?
  9. Median HH Income Growth Rate — How will growth rates put pressure on future wages?
  10. Cost of Living Index — How do cities under consideration compare?

In addition, there are other forces that are perhaps not quite as statistically obvious: The impact of organized labor, political trends of various states, and gaps in educational output and specialized skill sets.

Many times it is possible to discover a labor shed (an area within a metro that has the ideal profile and minimal competitive employers). That’s the location, location, location that you want. There is a war for talent. Use your real estate strategy to win the war.

How to Screw Up an Acquisition

How to Screw Up an Acquisition

Acquisitions often focus on just a handful of items: synergy, talent, perhaps geographic coverage and/or technology, and revenue of course. The investment bankers and attorneys that orchestrate the deal generally do a great job of ferreting out the business issues that need resolved. Except for the real estate.

In the grand scheme, real estate is probably not the top issue, or even in the top five for that matter. However, it can represent a huge financial liability. Especially if your firm will take over a lease(s) and the acquired principals are the building owners, there is significant risk. That risk can be eliminated or at least minimized. You just need to take action before the merger is complete, not after.

There are three primary risks associated with the real estate in a merger:

  1. Utility
  2. Marketability
  3. Unfavorable Terms

The first is easy enough to to determine with inspection, and more easily mitigated after the fact. Most companies will identify and plan for disposition or elimination of the location(s) as part of the acquisition negotiations.

Ditto for marketability, or determining fair market value, although we sometimes see acquirers look the other way on above market valuations or lease terms because they’re more focused on the operational terms of the deal. Sometimes this is because it is either a special use facility or in a very small market where market comparables are non-existent.

This often results in money left on the table, rather than a disastrous financial situation.

The greatest risk, and surprisingly the most common when a lease-back from a principle is involved, is the Unfavorable Terms risk. Here’s why: Closely held private firms frequently enter situations where the principal(s) purchase and own a building and lease it back to the company. This type of arrangement, which is generally presumed to be at arm’s length, may only actually be fair market terms on the surface. They are almost never memorialized with a lease document that would be found between an open-market sophisticated landlord and tenant, so the business terms and potential liability can also be far from typical.

While it is reasonable for legitimate costs of operation to be passed through, many closely held properties provide for much more liberal applications. For example, we have seen net leases which allow for all costs of ownership including financing costs. This could obligate the lessee to pay for refinancing expenses, and perhaps even allow the property owner to withdraw equity and require the increased payments to be absorbed by the lessee. They may also require capital replacements and/or improvements, remediation of environmental issues, or require return of the property at the end of the term in original condition (and not subject to “reasonable wear and tear”). This can add hundreds of thousands or even millions dollars of unplanned expense.

By including a corporate real estate professional as part of the acquisition team, a firm can 1) confirm that no unfavorable market lease terms exist and 2) renegotiate any terms on facilities where a principal of the target may have an interest in the property.

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.

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.

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.
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.

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.

captive tenant syndrome

Captive Tenant Syndrome

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

Because:

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

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

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

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

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

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

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

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

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

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

Interview with Eric Berson – Avocat Group CEO

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

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

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

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

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

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

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

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

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

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

Two ways to protect yourself on operating expense pass-throughs

I’m not crazy about condominiums.  Here’s why:

Other people (the condo association – which is often controlled by a very small group of individuals) get to vote on how to spend your money.  Some of those choices may not add value for you or to your property.

Operating expenses on leased commercial property work the same way. The management company, which is the property ownership or someone under their direct control, gets to decide what expenses get passed through to the property tenants.

So what expenses do they pass through?  Every single one that they can possibly get away with.  There are only two methods of protection for tenants, and I’d estimate that more than half of all leases don’t fully take advantage of them.

Protection #1:  Operating Expense Exclusions
Most commercial leases say something to the effect that the landlord may pass through all expenses (or the expenses over a base year) related to the ownership, maintenance, and operation of the project.  As long as these expenses are market competitive, that’s fair or at least customary, right?  Wrong.

The landlord should only be passing through the costs of maintenance and operation, not ownership.  Ownership could include costs of refinancing, marketing the property for sale or lease, legal costs related to the ownership structure, accounting fees for ownership tax returns – even income tax.  Taxes are a cost of ownership.

My point is, you need to exclude those costs and any other costs with specific language because the landlord’s thirty or fifty page document (or more, I’ve completed leases of more than a hundred pages and the landlord’s attorney didn’t have a single word in there by mistake) allows everything including their Christmas party, executive meetings in Las Vegas, and hiring family members to provide management or lawn service.  You need to have a long list of what is NOT allowable, and argue to get them into every lease.  You won’t always succeed on every item, though you should always try.

Protection #2: Auditing
You need to audit the Operating Expense Reconciliation that you receive from your landlord annually.  Why?  Because if you have used Protection #1 to modify your lease in any way, you can bet that whomever actually does the bookkeeping has never bothered to read the changes that you made to the provision.

My firm has seen landlords ignore negotiated caps or limits included in the lease and include capital improvement costs, expenses directly for the benefit of a another tenant, costs related to code issues that existed before the tenant’s lease commenced, and costs for services that were not competitively bid and significantly out of line with the market.

If you don’t have the time, expertise, or resources to audit the reconciliations yourself, hire an outside firm on a contingent basis. Most importantly, do it in the first year of your lease, so that you:

  1. Put the landlord on notice that you are the “auditing type” – most tenants are not – and will nail them on any inappropriate charges.
  2. Identify any issues early in the relationship, since most leases prevent you from challenging expenses or auditing prior years after a certain period – some as short as 30 days after receipt of the reconciliation.

A recent trend that we’re seeing is the inclusion of six-figure executive salaries (with titles such as Asset Manager or Director of Properties) usually split between several properties.  As the economy puts the pinch on commercial landlords, they are allocating as much of their overhead as possible to their portfolio’s operating expenses.

If you are lucky, you’ll have inserted language into the original lease that prohibits salaries above a property manager.  And if you’re smart, you’ll audit the operating expense reconciliation to enforce your rights.  When it comes to pass-through expenses, Less is most certainly More.

Market Rate Audits for commercial leases

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

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

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

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

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

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

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

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.