Lease Options

Q:  Our company is negotiating a long-term lease for a new manufacturing facility. How important is an option to renew or purchase?

A:  The definition of an option is a provision in an agreement that gives one party the right, but not the obligation, to exercise a right of some kind. This is important to keep in mind when negotiating tenant options in a lease. A tenant option gives the tenant the right, but not the obligation, to renew, to purchase, to expand or to perform some other action. If and when a tenant exercises this right, the landlord must comply. Thus, all things being equal, it behooves the tenant to negotiate as many options as possible. It is to the landlord’s advantage to negotiate as few tenant options as possible. One ordinarily thinks of an option being a tenant’s prerogative, but in fact, landlords may also have options, such as the ability to terminate the lease or relocate a tenant. In any case, the advantage always goes to the party that may exercise the option.

From a tenant point of view then, the best strategy is to negotiate as many options as possible.  Here is a key point: Since an option is almost a future event, and no one has an accurate crystal ball, a tenant is always better off taking what seems to be a worthless option than no option. If negotiation with your landlord yields only an option to purchase at what seems a ridiculous price, take it. If the price is above market at the time that the option may be exercised, you will ignore it, and offer to negotiate with the landlord. But if it is below market, you may exercise it and the landlord has no recourse. Thus, options are sometimes labeled “a one-way street.”

So why would a landlord offer an option? Options are market driven. In a strong sellers’ or landlords’ market, options may be dear and expensive. In a high vacancy market, landlords will use options to create incentives to lease. Landlords are often very uncomfortable in providing options at a fixed cost, particularly many years into the future. Thus it is common to see “fair market value” options. These are options that allow a tenant to renew or purchase at a price that is supposedly at fair market value when the option is exercised. This, of course, requires some ingenuity on the part of the landlord and tenant in agreeing on the definition of fair market value.  You should also be aware as a tenant, that a landlord has considerable cost savings in renewing your lease as opposed to finding a new tenant. A new tenant may require costs that include additional brokerage and construction, not to mention vacancy and the associated lost rent. So it is common to see renewal options set at some percentage of fair market value, such as 90%.

Because you are negotiating a lease for a manufacturing facility, I would assume that there will be significant capital expenditures on your part that need to be protected with a long term lease or, perhaps, an eventual purchase. Landlords of such facilities are usually aware of your needs and would be unable to lease their buildings without providing their tenant the right to amortize heavy capital outlays. Thus, the negotiation of options is vitally important in your situation.

Now is the Time to Sell

Q:  Our company needs to expand out of a 20,000 square foot building we have owned for the last seven years. Do you have any recommendations on whether we should buy or lease larger quarters? Should we sell our present building? 

A:  Let me start by issuing a caveat: Your circumstances are individual and are probably best addressed by your CFO or accountant. In general, however, the commercial real estate market on Long Island today favors selling your existing real estate and leasing the replacement facility.

Why is this so? There is a wide disparity between the cost of purchasing and leasing commercial real estate on Long Island due to low-interest rates and an influx of purchasers relocating from Brooklyn and Queens. Many industrial buildings that have been sold recently had multiple buyers waiting in line to purchase. The demand for these building has far outstripped the supply.

For many years, we had a very stable relationship between purchasing and leasing, with the cost of purchasing approximately 10 times the cost of net leasing the same building.  As an example, if you could net lease a building in the past for $7.00 a square foot net, you could expect to pay $70.00 a square foot to purchase the same building.

Today, a lease price of $7.00 a square foot may have a corresponding sale price of $125.00 a square foot. The cost of purchasing is over 17 times the cost to lease! If you are fortunate enough to own your present facility, you have the opportunity to make this leverage work for you by selling your existing building and leasing a new one. You will be effectively winning on two ends – capitalizing on both a strong market to sell, and on a relatively softer market to lease new space.

There are some added bonuses to this maneuver as well. A sale of your current facility frees up capital tied up in “bricks and mortar” and allows it to be spent on the core business activity of your firm. Leasing has become the preferred method of occupying real estate by Fortune 500 companies, as they intensify their efforts to concentrate on core business and outsource non-core functions. In addition, leasing provides your firm with an easy and known exit strategy. In a fast changing business environment, flexible real estate terms are often the key to managing real estate costs. For these reasons, most of America’s largest companies have divested themselves of their real estate holdings and prefer to lease.

The very best way to analyze the objective side of the decision is a discounted cash-flow analysis of a sale vs. lease for both the disposition of your old facility and acquisition of the new one. This will give you the present-value cost of each alternative, allowing relatively easy financial comparisons. There may be other factors at work as well, some of them subjective, but this is a good place to start.

I recommend hiring a real estate professional to provide you with comparable numbers for selling your facility and leasing a new one, as well as assisting you with the financial analysis. There is a really good chance a windfall awaits you!

Contingencies in a Contract of Sale

Q: We are negotiating the sale of our industrial building, and the buyer is insisting on a long list of contingencies in the contract. What is normal?

A: There is no “normal” set of contingencies to a contract of sale, in the same way there is no “normal” real estate deal. Contingencies are simply another set of business terms that are agreed to by a buyer and seller. I have negotiated contracts that permit the buyer to cancel within a specified period of time for “any reason or no reason,” as well as contracts that took three or four years to close because of rezoning contingencies. And I have also negotiated a contract with absolutely no contingencies, in which the buyer conducted a title search and environmental research without the benefit of a contract (very unusual!)

What is a contingency? It is basically an option given to the buyer to cancel the contract under a set of specified conditions. As an example, a buyer with a financing contingency may generally cancel his contract without obligation (and receive a full refund of his down payment), if he is unable to secure financing upon terms stated in the contract. Generally speaking, the objective of the seller is to negotiate a contract with as few contingencies as possible. The buyer, on the other hand, desires to maximize the number of contingencies to allowing him maximum flexibility if he discovers problems during the contract period.

The two most common contingencies in a commercial contract of sale are a marketable title and an environmental review. Even if a buyer would be willing to waive these contingencies, his lender (if he has one) will insist upon a title search and a Phase I Environmental Assessment. There is no “standard” language for these contingencies. The language that is drafted can be either quite generous to the buyer, extremely limited, or somewhere in-between. For example, if an environmental problem is found, the buyer may not have an unfettered right to cancel the contract. It is not unusual for the seller to have the right to cure the problem up to a specified limit, $50,000 – $75,000 being common.

In the end, you have to evaluate the contingencies that have been presented to you in light of your relative bargaining position. If you have multiple parties interested in the property, then you are in a position to be more demanding of a short list of tightly worded contingencies. If you have relatively little other interest in your property, then you may be forced to acquiesce to a more liberal set of contingencies.

If you have to agree to a longer list, try to limit the contingencies as much as you can. As an example, if you are willing to make the closing subject to financing, try to specify the amount and rate at which the contingency is valid. If you specify a loan-to-value ratio of 65%, instead of 75%, you increase the likelihood that your buyer will receive a financing package.

I highly recommend that you seek the benefit of legal counsel before agreeing to any contingencies. Your attorney will not only have suggestions on what contingencies should be included in your particular situation but will also give you some ideas on limiting those contingencies.

How to Slash Commercial Construction Costs

Q: I nearly fell off my chair when I received a quote from a general contractor to renovate and enlarge our office space.  I had no idea that costs had climbed so high. Any suggestions?

A: Yes, there is a way to slash 10% or more from your commercial construction project. It is a method of running construction projects called Construction Management. It is not the same as General Contracting, in which a general contractor quotes one price to complete the entire project. It is common for a general contractor to total his costs (both his subcontractors as well as other costs) and then add 20% for overhead and profit.

Construction Management is completely different. In this model, you hire a construction manager to manage the project for you. The construction manager is paid a fee, usually a percentage of the project cost. This fee is usually less than 10%. Thus the cost of a project utilizing Construction Management can easily slash 10% or more from the cost of your project. Let’s take a look at the advantages of Construction Management.

One of the reasons that I am a big proponent of construction management is the complete transparency provided to the client, and the elimination of inherent conflicts. In general contracting, it is in the financial interest of the general contractor to buy the cheapest products and services, since by doing so, he will increase his profit. The construction manager, on the other hand, has nothing to gain by doing so. Each product or service is put out to multiple bidders (including any that may be introduced by you.) You and your construction manager can then make the best cost/benefit decision from multiple bids. The entire process is open and transparent.

You will also have complete control of the project and choose what decisions to make yourself, and what to delegate to your construction manager. In essence, the construction manager is assisting you as you act as your own general contractor. Since the construction manager is your agent, you will have complete control over the building process, including negotiating with suppliers and subcontractors. You can be as involved as you wish – every day or seldom. Either way, you have a professional managing your construction with a fiduciary responsibility to protect your interests.

Another advantage of Construction Management is that if there are potential savings to be achieved during construction (perhaps a special buy, or discounted services from a subcontractor), the savings are yours. This is not the case with General Contracting, in which the contractor will pocket the savings as additional profit. And finally, it is not uncommon for a general contractor to charge exorbitant costs for change orders. In essence, you are almost forced to pay what he demands for changes during construction. This is not the case in Construction Management, where once again, there is complete transparency and change orders are submitted out for bid.

So, Construction Management is the way to substantially reduce the cost of your construction, usually by 10% or more.

Contingencies in a Contract of Sale

Q: We are negotiating the sale of our industrial building, and the buyer is insisting on a long list of contingencies in the contract. What is normal?

A: There is no “normal” set of contingencies to a contract of sale, in the same way there is no “normal” real estate deal. Contingencies are simply another set of business terms that are agreed to by a buyer and seller. I have negotiated contracts that permit the buyer to cancel within a specified period of time for “any reason or no reason,” as well as contracts that took three or four years to close because of rezoning contingencies. And I have also negotiated a contract with absolutely no contingencies, in which the buyer conducted a title search and environmental research without the benefit of a contract (very unusual!)

What is a contingency? It is basically an option given to the buyer to cancel the contract under a set of specified conditions. As an example, a buyer with a financing contingency may generally cancel his contract without obligation (and receive a full refund of his down payment), if he is unable to secure financing upon terms stated in the contract. Generally speaking, the objective of the seller is to negotiate a contract with as few contingencies as possible. The buyer, on the other hand, desires to maximize the number of contingencies to allow himself maximum flexibility if he discovers problems during the contract period.

The two most common contingencies in a commercial contract of sale are a marketable title and an environmental review. Even if a buyer would be willing to waive these contingencies, his lender (if he has one) will insist upon a title search and a Phase I Environmental Assessment. There is no “standard” language for these contingencies. The language that is drafted can be either quite generous to the buyer, extremely limited, or somewhere in-between. For example, if an environmental problem is found, the buyer may not have an unfettered right to cancel the contract. It is not unusual for the seller to have the right to cure the problem up to a specified limit, $50,000 to $75,000 being common.

In the end, you have to evaluate the contingencies that have been presented to you in light of your relative bargaining position. If you have multiple parties interested in the property, then you are in a position to be more demanding of a short list of tightly worded contingencies. If you have relatively little other interest in your property, then you may be forced to acquiesce to a more liberal set of contingencies.

If you have to agree to a longer list, try to limit the contingencies as much as you can. As an example, if you are willing to make the closing subject to financing, try to specify the amount and rate at which the contingency is valid. If you specify a loan-to-value ratio of 65%, instead of 75%, you increase the likelihood that your buyer will receive a financing package.

I highly recommend that you seek the benefit of legal counsel before agreeing to any contingencies. Your attorney will not only have suggestions on what contingencies should be included in your particular situation but will also give you some ideas on limited those contingencies.

General Contacting or Construction Management?

Q:  We will be closing on an industrial building shortly, and will need to reconstruct approximately 12,000 square feet of office space. I have heard that Construction Management is a better way to build. Is it, and how does it work?

A:  There are two major ways to hire a contracting company to work for you. The first and most traditional method is called General Contracting. In this model, you and an architect produce plans and specifications for the work to be done. Most often, a bidding process between several reputable general contractors would then be orchestrated by your architect. It is important that the plans and specifications be as detailed as possible, specifying quality, and in many cases, brands or equivalents. This is the only way that you will achieve an “apples vs. apples” comparison between several general contractors.

The chief advantage of General Contracting is that your work is being performed at a fixed cost, established through competitive bidding and that the contractor is assuming a certain amount of risk in fixing the price. If the work takes longer, or he runs into unforeseen difficulties, it is his financial burden, not yours. Typically his bid will be broken down into several categories:  labor, material, subcontractors, fieldwork, general administrative expense, contingencies, and profit.

Construction Management is a newer model of performing the same type of work. A construction manager acts as the agent of his client, hiring subcontractors and authorizing payments to them directly from the client. A construction manager is typically paid a percentage of the project cost. The advantage of this delivery system is that you, as the client, have complete control over the process. In essence, the construction manager is assisting you as you act as your own general contractor.  Since the construction manager is your agent, you will have complete control over the building process, including negotiating with suppliers and subcontractors.

Another advantage of Construction Management is that if there are potential savings to be achieved during construction (perhaps a special buy, or discounted services from a subcontractor), the savings are yours. If a General Contractor were to have the same opportunity, he could pocket the difference as additional profit.

The downside to Construction Management is that you have no peace of mind with regard to the final cost and you are also assuming all the risk of unforeseen issues.  Since Construction Management has the more financial risk, the cost of hiring a construction manager is generally going to be less than hiring a general contractor.

So there really is no “one size fits all” answer to your question as to which is the best method. It is a personal decision that takes into account your risk-tolerance and pocketbook!

Evaluating the Buyer

Q:  We are selling an industrial building and have multiple offers that are very close.  Besides price, how else would you evaluate the offers in making a final decision? 

A: This has been a common occurrence on Long Island in the last few years (and frustrating for buyers) as increasing demand has chased a dwindling supply of commercial properties. While price is certainly important, it is not the only criterion.  If two prices are relatively equal, I would be more concerned about which offer is more likely to close, and how quickly it will close. So let’s look at some of the items that may contribute to a fast and successful closing.

The Purchaser: This is usually a subjective decision.  As an example, a large public company may be a desirable buyer because it is financially strong, but undesirable because there are layers of management involved in the approval process. Or a company that needs to occupy the building in five months because of an expiring lease may have more motivation to close than an investor who is hoping to find a tenant. So take a close look at the buyers and their motivations, and ask yourself who needs the deal the most.

Financing: If the contract is to be subject to financing, you must have reasonable assurance that the purchaser can achieve the financing. I ask for a full set of financial statements. After I evaluate them, I ask a mortgage professional to do the same. If the purchaser is looking for a high loan-to-value ratio (LTV), will it be reasonably granted? If the purchaser has identified his lending institution, I like to pick up the phone and chat with the lending officers. Of course, an all-cash deal with no financing contingency is much more desirable, all other things being equal.

Other Contingencies: The two other major contingency items are a title and environmental. The first is rarely an issue in comparing buyers, but the second can be huge. There is no commercial property that is being sold today without an environmental report and a contingency associated with it. The important item to be negotiated is what happens when an environmental report is positive and remediation will be necessary. I cannot discuss all of the possible alternatives in this column, only point out that two different purchasers may consider different alternatives, one of which may be more advantageous to you.  (And, of course, the purchaser with the fewest contingencies is usually to be preferred.)

Timing and Cash Down: You will naturally favor the buyer who can close more quickly, all other things being equal. And from your point of view, the fewer rights the purchaser has to delay the closing, the better. Also look for a substantial down payment. Avoid purchasers who are offering down payments that are little more than “option” payments that permit them to walk away.

Representation and Legal Counsel: And finally, I am more likely to have a “warm and fuzzy” feeling with a purchaser who is well represented, by both broker and attorney. The likelihood of closing is much stronger if both are well respected in the industry, as well as professional in their conduct.

There may be other issues or concerns that arise, but a review of these items is a great start in comparing multiple offerings, making a decision, and quickly achieving a successful closing.

Negotiation Tactics for the Seller

Q:  We have received an offer on our 16,000 square foot industrial building. What are our next negotiating steps?

A:   Fundamental to any successful negotiation is thorough preparation – this is the work that needs to be done before a counter-offer is made. Entire books have been written about the art of negotiating, and you have not shared any of the details of your situation, so I can share only a few of the strategies that have helped me negotiate advantageous transactions for our clients.

First, any real estate negotiation has to be kept in the context of the market. Hopefully, your agent has given you a thorough background on the market in your geographical area and size range. As an example, the sale of a 50,000 square foot industrial building in your area has little relevance to your building, since it is only 16,000 square feet. Market data might tell you that buildings in your area, size range and condition are currently selling between $110 and $125 a square foot, which gives you a starting point in evaluating the offer you have received.

Having occupied the building, you should be well aware of any costs that the buyer might have to incur to repair or renovate. From the buyer’s point of view, renovation or repair costs are simply adding to his acquisition cost, whether it is roof repair, HVAC replacement, office modernization. So be realistic in anticipating the true market value of your building.

Next, I always look to the needs of the other side. It often seems like price is the only or major component of a real estate transaction, but I often find that the opposite is true.  Perhaps timing, terms, or some other issue is more important to the buyer. Representing the seller, I recently sold a building at what was perceived as a discounted price to the buyer.  In reality, we were able to negotiate a short-term leaseback for the seller that was substantially below market, and more than made up for the “discount” in the sale price.

I always like to look at the marketplace to see what other buildings might be available to the buyer as a BATNA (“Best Alternative to a Negotiated Settlement” in negotiation parlance.) If I have a lot of competition, then I will have to be aggressive to make the deal.  If I am the only game in town, I have a more likely chance of negotiating a deal close to my asking price.

In the end, the seller always has to weigh the offer in hand against the probability of a higher offer, and when that offer will come in.  Several years ago, I was responsible for the sale of my parents’ house on Long Island. I calculated the cost to carry the house, e.g. taxes, utilities, etc. Then I added the lost investment revenue that the house proceeds would earn if properly invested. Every month the house remained on the market would cost my parents over $5,000 a month! In the sluggish market I was experiencing, it was an easy decision to take an offer that was $10,000 below the market.

Probably nothing is more predictive of a successful negotiation than preparation, knowledge, and analysis. The time required in this phase of negotiations will be well spent and is always the place to start.

Lease Abstracts – As Essential as Signing the Lease

Q: We have just signed a lease for our business. Aside from important dates, such as the lease expiration, what else should be included in a lease abstract?

Probably the last thing on a tenant or landlord’s mind at the successful completion and execution of lease negotiation is additional paperwork. But there is one last item on the checklist that should be done at the completion of every successful lease – the lease abstract. A lease abstract is a detailed summary of the salient facts of the deal, usually on a single sheet or two. It will provide the essential details of a transaction long after the terms are forgotten by the parties who negotiated them.

A lease abstract is not a frivolous paperwork chore. It is a powerful tool to help administrate and audit a lease during its term. Today’s commercial lease can easily number 50 pages or more. Even with an index, tracking down essential information and critical red-letter dates can be a time-consuming chore that is often the victim of procrastination. What are the essentials of a lease abstract? Whether you administer one lease or hundreds, the elements of good lease abstracts are the same:

Identification of the transaction: The premises, the parties, counsel for both sides, brokers, and/or legal notification recipients, and addresses, as necessary.

Dates:  Dates are so important that it is a good idea to put them at the top of the page, perhaps in a highlighted box. One date that is often overlooked is the commencement date. On the surface, this date would seem to be an obvious one, but in many leases this date is dependent on completion of work by the landlord, and not so obvious five years later.

A red-letter date is a critical date that if ignored, could lead to dire circumstances to the leasing party. The most obvious is an option date or a lease expiration date. It is a good idea to have several reminder dates of an upcoming red-letter date. You do not want to be reminded of an option date one week before the last day it can be exercised. So decide how much lead time you need to make an intelligent decision.

Your dates are only as good as your tickler system. Make sure yours is reliable. As a backup, it is a good idea to make sure your attorney and broker are also tickling these dates as a backup.

The size of the premises: Rentable and useable square footage, loss factor, the percentage of the building occupied.

Rent and Additional Rent: A rent schedule should be prepared as well as a clear description of how lease escalations and additional rent will be calculated. What does the rent include? What is considered additional rent? Security deposits should also be detailed.

Obligations: Any obligations by either party should be succinctly summarized. This can be anything from maintenance obligations to rent escalation calculations.

You should also include any other details that may be important to you and your financial interests in the premises. And with all entries in a lease abstract, it is important that any narrative language is free of “legalese” and reasonably understandable to the lay reader. You probably spent well over a month negotiating and executing a lease. Spending another hour or two to create a lease abstract is a powerful way to preserve your work!

Choosing a Real Estate Agent

Q:   How do you choose a real estate agent?

A:   Probably the very best way to answer this question is to tell you how we choose a real estate agent when an assignment takes us off Long Island. In that case, we may need the expertise of a local agent to assist me with properties, zoning, economic development opportunities and the like.

First, we will only work with one agent exclusively. The primary reason is that we want that agent to legally represent our client’s interests. In New York State, a real estate agent has a fiduciary responsibility to protect the seller or landlord’s interests, unless there is a written document to the contrary. So we make sure that we have a contract. And because we are working with only one agent, we take care to select that agent carefully.

We usually start with one of the professional organizations that I belong to, depending on the nature of the project. The Society of Industrial and Office Realtors (SIOR) is a division of the National Association of Realtors. A broker who has an SIOR designation is in the top 4% of commercial agents nationwide, and must not only pass a rigorous educational and testing program but must also demonstrate transaction volume that is significant for his market. You can locate an SIOR broker in the marketplace of your choice at www.sior.com. A similar designation, with the same rigorous requirements, is the Certified Commercial Investment Member (CCIM). A CCIM is more focused on investment real estate and can be found in your area at www.ccim.com.

We find that personal recommendations are very helpful, but not so easy to obtain out of the area. But if you are considering real estate locally, I would reach out to your network of business owners, perhaps a trade group, and ask for recommendations. Personal experience with a broker tends to cut through the fluff and promises of a great presentation but poor follow through.

Next, we want to make sure that the agent and the office that we have selected, has the inventory and tools to help us. We would like to see sample reports, spreadsheets, and the work that they have done for other clients. Have they worked on similar projects?  Is this their area of expertise? We do not want my project to be a learning curve for the broker! I also want to make sure that my day-to-day contact is a senior level broker. All too often a senior level broker makes the initial presentation, but 90% of the project is handled by junior salesmen with limited experience. Obviously, I want to avoid this.

And finally, we make sure that we are working with someone we like! Life is too short to be working with someone who is difficult or annoying. There are usually a number of really qualified agents in any marketplace, and there is no reason you cannot locate someone that fits your personality.

So there you have it. This is a process that has worked well for us, and I am sure will lead you to a more than satisfactory real estate experience with the commercial real estate agent that you choose.