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.

Buying for Resale Value

Q: We are in the market to purchase a 30,000 square foot industrial building suitable for light manufacturing and warehousing. What criteria should we consider in our purchase that will maximize the appreciation of the real estate in the future?

A: I have five criteria for you to consider that will help boost the future value of your real estate. But first and foremost, the building must suit your own needs today. Don’t get so caught up in the investment side of the acquisition that you ignore your company’s business. Future appreciation is dependent on your new acquisition being desirable to a large population of buyers in the future. It is, therefore, likely to be more expensive than other alternatives today. Only you can make that subjective decision as to the value achieved and the associated cost.

Given that caveat, the number one criteria for future resale value is, of course, location. Why is this at the top of everyone’s list?  It is the one criteria that cannot be changed. We can renovate offices, we can add power, and we can even raise a roof, but we cannot move an industrial building.  Location controls transportation, shipping and employment costs. On Long Island, buildings that are close to limited access highways, primarily the Long Island Expressway, will appreciate the fastest. And those buildings further west will sell for more than their eastern counterparts, all other things being equal. Restrictive zoning and planned industrial parks add further value to industrial real estate.

The second criteria is parking. Generous parking allows flexible use of the building for a wide variety of users.  This is because zoning codes limit the amount of finished area to the number of parking spaces provided. To be flexible for future use, I would recommend a parking ratio of three cars per thousand square feet of building area, if possible.

Next, I would be concerned about ceiling height. On Long Island, an industrial building today that would appeal to a wide section of businesses has a ceiling height of 18 feet, under steel. This is a height that will allow racking of 3 standard pallets, yet not be exorbitantly expensive to heat.  Specialized warehouses may have higher ceilings, but the number of potential users drops dramatically as the ceiling heights increase (or decrease.)

The fourth criteria is the quality of the construction. You may need an engineer to help evaluate your alternatives, but clearly a well-constructed building is a much better investment. I am less concerned with cosmetic appearance than structural problems. We can paint and carpet easily, but a cracking floor, shifting foundation, or poorly constructed roof is another matter entirely.

And finally, environmental considerations, whether on site, or in the general area, can have a massive effect on the desirability of real estate. Most buyers have a very limited tolerance for the possibility of environmental action or clean-up, so I would stay away from anything questionable.

Take these five items into account as you work through your decision-making process, and you can significantly boost the resale value years from now.

Maintaining Your Property Like a Professional

Q:  Our firm is not large enough to employ a full-time property manager for the building we own. Do you have guideline or checklists that one of our senior managers could use to make sure everything is completed in a timely manner?

A:  You do not have to have a full-time property manager to maintain your property, but you, or whoever will be responsible for day-to-day maintenance, should think like one.  Since you will not have an in-house maintenance staff, you will be depending on outsourced work. Your maintenance manager must have sufficient knowledge of maintenance operations to effectively oversee contracted work and make sure it is done in a competent and timely manner.

The first step is a maintenance policy and procedures manual. This will ultimately be a collection of everything that could or should be done to maintain the property. You can start with any documents that you may have inherited when you purchased the building.  You probably had an engineering inspection before closing, and you may have had subcontractor inspections as well. These reports and recommendations can be the start of on-going checklists.

Each of the major systems of your building should have their own calendared checklist.  They include:

  1. Roof and structure
  2. Heating, Ventilation and Air-Conditioning (HVAC)
  3. Plumbing – including storm water drainage and sanitary systems
  4. Electrical
  5. Fire Safety – including fire sprinklers, fire extinguishers, and fire alarms
  6. Security
  7. Paving
  8. Landscaping

Your building may have other requirements as well, such as elevator maintenance and inspection. The most important goal is to fully understand the systems of your building and develop a plan for handling the short term and long term maintenance requirements.  Do not hesitate to ask your contractors for their recommendations on maintenance.  However, use that information to develop your own checklist. And make sure that all your contractors are licensed, insured and qualified.

My other two major recommendations are to make safety an absolute priority, and concentrate on fixing problems right the first time. You will actually lower your maintenance costs over the long term by establishing and maintaining optimal conditions from the first day. As an example, a major cause of expensive HVAC repairs is not replacing filters on a regular basis. I also suggest that you know, and prominently post, the location of all water and gas shut-off valves, as well as the main electrical circuit breakers. Plans for the building should also be accessible.

These are the basic steps a professional property manager would take to manage the risk and lower the long-term operating costs of an office building. If you would rather concentrate your energies elsewhere, professional property management and maintenance firms, can do all of this for you.  At Hunt Construction Services, Inc., our maintenance department acts as out-sourced property manager for our clients in exactly this manner.

Negotiating with Your Existing Landlord

Q:  My lease is coming due within a year.  I intend to renew.  I don’t need a broker, right?

A:  The reasonable assumption goes something like this:  “I have a good and long-established relationship with my landlord.  I know what I can afford to pay and will negotiate a fair renewal with my landlord.  Besides, if I introduce a broker, it’s just another cost item that will be charged back to me in higher rent.” 

Your landlord is in business to make a profit, to increase the value of his real estate.  If you or your landlord seek each other out to renew your lease, what leverage are you bringing to the table, especially if you say you’re interested in renewing? 

What will make your landlord give you the best deal possible?  The best possible deal will be obtained when you can demonstrate to your landlord that you are ready to move.

Put yourself, for a moment, in your landlord’s shoes.  What’s the worst possible scenario? – An empty suite, unit or building.  When space is vacant, the Landlord faces an unknown quantity of time to re-lease the space, an investment of capital to modify the space for a new tenant (architectural & construction), legal fees in drawing up and negotiating a new lease, brokerage fees, and in competitive times such as these, free rent that is given as an incentive to lure a new tenant.

During all this time and capital outlay, the landlord has been, at minimum, paying real estate taxes, maintenance to upkeep the property and mortgage payments.  After all this time and outlay of capital, a new tenant is still an unknown entity!

The best way to impress upon your Landlord that you are serious about moving is to hire a broker.  The broker must prepare a complete list of comparable properties.  You should visit with your broker the best candidates, “as if” you had to move.  After this, your broker should prepare RFPs (Requests for Proposal) for your existing landlord and several of the best available options.  When the responses are in and analyzed, you are finally in a position, through your broker, to arrange a meeting with the Landlord.  Prior to the meeting you and your broker should review the objectives:  Rent structure, free time, renovations and other criteria should all be clearly established.  At the meeting, the complete list of comparable properties can be strategically displayed, and smart, leveraged negotiation can begin.

Remember that your best negotiation will occur when you have the ability to walk away from the table.  During this process, you may find an alternative with significant enough savings and other attractive benefits to make it worth your while to move.  At minimum however, you will put your current landlord in an equal position as landlords with vacant space and hungry to attract you as a tenant.  You will lose this leverage by trying to negotiate directly and not hiring a broker.

Fortune 500 companies follow this system to achieve the best market-driven deals possible.  This same resource is available to you by selecting the right broker. 

Net, Gross and Full-Service Leases

Q: Looking on the internet, I see that rental prices have different labels. What are the differences between a net lease, a gross lease, and a full-service lease?

A: These are all terms used to describe the manner in which services and expenses are paid in a landlord-tenant relationship. While the terms are used freely in commercial real estate transactions, there are actually no agreed-upon exact definitions of each. You should be concerned with the total cost of occupancy, so it is crucial to sort out what services are included in the rent, and incorporating the cost of those that are not. The following are the generally accepted definitions of these terms:

A net lease refers to a base rent that is being paid solely for the real estate and does not include payments for real estate taxes, utilities, insurance, and any other operating expenses. A good way to remember the basis of a net lease is to equate it with the mortgage payment of an owned property. If you own a property, your mortgage payment is generally due once a month, just a like net rent, but you are also responsible for tax payments, insurance, all operating costs and even the landscaping! A net lease is similar. The rent paid to the landlord is simply compensation for his investment and risk in the real estate, and no more. The so-called triple net lease (usually encountered with single-occupant buildings) puts the entire burden of these expenses upon the tenant, in addition to the net rent that is paid.

A gross lease, on the other hand, usually incorporates some of the operating expenses (almost always real estate taxes) in the rent that is paid to the landlord. The gross lease may or may not include building insurance or common area maintenance (CAM). The tenant must take it upon himself to inquire as to exactly what is included in the gross rent that is being quoted. On Long Island, for example, CAM and building insurance can easily add an additional $0.80 a square foot to the quoted price if they are not included in the gross rent.

Full-service leases are almost exclusively encountered in office buildings. They have, as the name implies, a rent that supposedly incorporates all of the tenant’s cost of occupancy. A typical full-service rent will include the base rent, real estate taxes, insurance, CAM, heating, air-conditioning, cleaning, and rubbish removal. A “full service plus electric” adds an additional charge to the tenant rent for tenant electric use (lights and outlets).

The definitions for these terms are hazy, and by no means universal. It is, therefore incumbent for you to compare alternative properties and their prices with a full understanding of the total cost of occupancy. It is important that you ask the necessary questions and dig as deep as necessary to fully itemize the expenses. This is the only way a true economic understanding of the real estate alternatives or pricing can be made.