Supreme Court Case Has CRE Implications

NOTE: I am not providing legal advice with this article. Please consult with a lawyer to determine the actions you may wish to take.

This past week the Supreme Court of Canada heard arguments in what is called the Redwater case. It’s expected that the Court will render its decision over the summer. At the heart of the court case is the question of bankruptcy and creditor priority versus the environment and environmental clean up.

Redwater was an insolvent oil company with approximately 70 wells operating throughout the province of Alberta. The primary lender to the company, ATB Financial, and the trustee argued that under Federal bankruptcy law the trustee in bankruptcy could sell the profitable assets and disclaim the well leases that were unproductive. This left the unproductive wells to the Orphan Well Association (OWA), an association funded by the oil industry and charged with decommissioning and cleaning up abandoned wells in Alberta. Part of their argument was Federal bankruptcy laws trump provincial environmental regulations. The lower courts appeared to agree on that point.

On the other side of the table, the provincial government argued that Redwater must clean up environmental hazards and any monies derived from the sale of assets should first and foremost go to the underfunded OWA to expedite the decommissioning of the abandoned wells.

As background to the case it should be noted that these wells are located on third-party agricultural land and the oil company had the right to install these wells so long as they paid a royalty or rental fee to the landowner. In this complicated case the lower courts ruled in favour of the trustee in bankruptcy meaning they could to pay the primary creditor (ATB) first and leave the abandon wells to the OWA to clean up.

Unfortunately, in Alberta there are approximately 1600 abandon wells and another 1500 underperforming wells. This means it could be decades before all the abandoned Redwater wells are decommissioned. This, according to the province and affected farmers, poses environmental, financial and health risks.

There is the argument that the lower courts decisions would give oil companies an ability to organize their affairs so they do not have to take responsibility for their drilling.

It is believed that the Alberta Energy Regulator erred by not requiring oil companies to post bonds or insurance to cover the decommissioning of abandoned wells.

So what does this have to do with commercial real estate?

If the Supreme Court upholds the two Alberta provincial courts decisions then it could have implications beyond the oil patch, and affect any premises or land where pollutants could be deposited.

Therefore, I believe it would be prudent for landowners to ensure their tenants post a bond, or obtain insurance in some form, to pay for the clean up of their operations if the tenant becomes bankrupt. Otherwise, a trustee in bankruptcy could simply disclaim the lease and the landlord would face the costs of cleanup themselves.

All the leases I’ve personally seen assume the environmental obligations pertain to a tenant that is viable and ongoing. They do not foresee what happens if the tenant is bankrupt.

 

How to Handle the Recovery of Corporate Costs in Triple Net Leases

The generally accepted rule of thumb concerning the concept of Triple Net Operating Costs is that the landlord can and should recover all costs associated with operating the common facilities of the property. These costs would include all those costs to manage, operate, secure, repair and maintain the facilities, with the exception of structural costs in most instances.

Conversely, costs associated with the landlord generating income and profit should be borne out of the basic, or minimum, rent. For example, costs associated with the process of leasing space should not be recovered from the tenants.

While it may appear that this is a simple concept, it rarely is straightforward. As an example, some people feel that any costs borne by the landlord, at a level above costs incurred at the property itself, should not be included in Operating Cost Recoveries. But what if it is more efficient to have centralized services such as accounts payable, IT and HR or regionally based maintenance services? Should these be included as recoverable Operating Costs and borne by the tenants? If so, to what extent should they be included and does the market use any standardized guiding principles?

These were the questions I recently discussed with an experienced commercial real estate lawyer and an accountant who specializes in CRE at an international accountancy.

We had combined CRE experience of over 100 years between the three of us and we agreed there was no accepted single standard in answering this question, except one person’s apt response that it is whatever the landlord can do, and the market will bear. We all agreed that seems to be the sentiment. But let’s look at these questions in more detail.

First, should regional and corporate costs incurred for the benefit of the common facilities be included as recoverable Operating Costs?

The feeling is yes, they should; if those costs are aligned to the benefit of the common facilities and not for the landlord generating profit. For example, it may be impractical from a cost and governance perspective to have all the accounts payable performed at each property in a portfolio.

Likewise, it may be more practical and cost beneficial to have roaming maintenance staff rather than staff dedicated to each property, particularly when dealing with skilled trades. Those costs – with certain caveats concerning competitive pricing – should rightly be recovered from each property served.

The second question of what extent should they be recovered can’t be answered until we tackle the issue of common guiding practices, as the two are intertwined.

Let’s look at accounts payable as an example. The invoice is received, reviewed, approved, entered into the accounting system, and a cheque is issued, in a typical accounts payable process. The cheque is then mailed and the bank reconciled once the vendor has cashed the cheque, and it is cancelled and returned.

Several people may ‘touch’ the process, from the person opening and sorting the mail to the person handling the bank reconciliation. Additionally, there are costs associated with the hardware & software used, IT support, space to house the staff, desks, communications equipment, stationary, mailing costs, etc.

Estimates to completely process one invoice range up to $21.00; while the average is $7.00 and as low as $3.41 if using a state of the art AP system, and depending on the number of invoices processed.

The question then becomes: “What method is acceptable to allocate the costs?”

In this case, is it on a per invoice basis? A proportionate share of the total costs? Some other method?

Again, we found there is no singular answer. So perhaps the pundit was correct when he said, “it is whatever the landlord can do, and the market will bear.”

We did agree that certain regional and corporate expenses should be considered for full or partial recovery. These include costs associated with:

-staffing relative to the management, operation, security and R&M of the property;

– technology costs including hardware, software and IT support staff;

– tools and equipment used for the maintenance and repair of the property;

– occupational health and safety expenses, including training;

– certain marketing costs, as permitted under the leases;

– insurance and risk management costs;

– daily banking costs pertaining to Operating Cost AP;

– services that support the above, such as HR, accounts payable, etc.; and

– costs to house and equip centralized and regional services noted above.

We also agreed that the extent of the recovery would be limited by what the market would bear. And that is a far more difficult question to answer because it is also subjective. The landlord may not optimize the recovery, or open themselves up to arguments from tenants (and their lease auditors) concerning the allocations depending on the formula used to calculate and allocate the costs.

For example, consider the issue of two same-sized buildings in different parts of the same market where the competitive operating costs recoveries in those submarkets are different. Think about the implications of attempting to come to a universal cost allocation across different asset classes. Industrial properties have lower operating costs than office buildings, and can’t bear the same per square foot allocation (if done that way), for example.

The combinations and permutations become mindboggling.

We also tackled the inevitable retort from tenant representatives and corporate real estate executives who would argue that the management fee is intended to cover the centralized costs.

Our feeling was that the management or administration fee is in addition to all the costs associated with operating the common facilities. As a result, it is not to replace any of those costs; which is the effective argument of the tenant representative.

Stated differently, the landlord is assuming the management of the common areas so the tenants don’t have to manage all those functions themselves, collectively; and the administration fee is akin to compensating the landlord for overhead costs not directly associated with the property operation.

Did we come to a definitive conclusion? Not really, but the discussion prompted further research, contemplation and discussion, I’m sure.

What are your thoughts?

© 2017 Peter D. Morris

www.GreensteadCG.com

The End of Commercial Real Estate Teams in British Columbia?

The Office of the Superintendent of Real Estate in British Columbia (OSRE BC) has issued several new regulations governing real estate transactions that will come into effect on March 15, 2018. These new regulations affect licensees trading in either residential or commercial transactions.

One change in particular will have a significant outcome on those involved in commercial real estate transactions including leasing and investment sales. That is the elimination of Limited Dual Agency, except in very remote areas of the province.

Limited Dual Agency permitted the licensee to represent both the seller and buyer or multiple buyers in a transaction, with the consent of the parties. The same applies when acting for both lessors and lessees.

As of March 15, 2018 the licensee will only be able to act on behalf of either the seller/lessor or buyer/lessee and not multiple parties. The licensee will be the Designated Agent for the party they represent. The OSRE BC has placed the onus on the brokerage to ensure that their licensees do not act as Limited Dual Agents.

According to the official summary of the OSRE BC public outreach for comments, the OSRE BC has also taken the following position: “A team will not be able to engage in dual agency to represent both a buyer and a seller, or multiple competing buyers, in a transaction as the team is considered collectively to be the designated agent of a client [NB: the bold emphasis is mine]. While teams may be a convenient business model to facilitate a real estate transaction, a licensee’s responsibility to fulfill their fiduciary duties takes precedence over the ease and timeliness of completing a transaction. Teams wishing to represent both buyers and sellers in a single transaction could consider licensing as a brokerage in order to continue to provide this service.”

Therefore, a team may not have both a buyer’s representative and a seller’s representative, for example. The OSRE BC’s proposed solution would be to create separate brokerages, which may not be feasible or desired.

In speaking with a Realtor® about this, he said his managing broker said that to ensure the licensees representing one party are independent of the other party in an instance where the brokerage represents both the seller/lessor and the buyer/lessee he believed there would need to be a physical separation at a bare minimum, such as walls. Keep in mind, that the new regulation is intended to avoid potential conflicts of interest and reinforce the fiduciary duties of agency. Therefore, my point of view is that the separation would also include information about the other party, their motivations, data, CRM information, and computer files, etc.

What does this mean to full service teams, or teams that work in a specialized niche market that is so small, or the team’s expertise is widely known and accepted by the industry players? Those teams will surely need to break up.

Additionally, brokerages will incur extra expense creating all the separation required.

I’d be interested in knowing your thoughts on this topic. I’ll also be providing information and my point of view on some of the other new regulations in other posts.

 

 

 

 

Peter D. Morris comments on the closing of Sears in Canada

Principle Consultant for the Greenstead Consulting Group, Peter D. Morris, comments on the closing of all the Sears stores in Canada in this article in Retail-Insider.com

https://www.retail-insider.com/retail-insider/2017/10/sears-canada?utm_source=Retail+Insider+Newsletter&utm_campaign=bcf3861251-EMAIL_CAMPAIGN_2017_10_11&utm_medium=email&utm_term=0_659c2a0c20-bcf3861251-113728729

 

A Retail Merchandising Mishap

I wrote about the importance of carefully crafting a retail use clause recently. Today, I read that greeting card and stationary company Paperchase has entered into wholesaling arrangements with Staples, an office supply company. This marks an expansion of the Staples use from office necessities to appealing to the general public by introducing greeting cards into their mix.

Paperchase also announced shop in shop concessions in the Hudson Bay stores in Canada and a desire to do the same in the USA.

Other uses such as grocery stores, pharmacies and many others are expanding their merchandising concepts as consumer’s tastes change and they grapple with omnichannel competition.

All this points to the need for carefully crafted restrictive use wording. Admittedly, I hate restrictive use clauses in leases when working for landlords; and attempt to get them in tenant leases when working with occupiers.

When working for tenants I start with getting an exclusivity clause that says something along the line of the following: “The Landlord won’t suffer or permit any other tenant to sell or permit to be sold any product, service or merchandise that conflicts with the Tenant’s use.” Please understand that I am not a lawyer and I’m not offering legal advice by providing this wording so please discuss this article with your lawyer and obtain the best wording for your circumstance.

But why do I start with that type of wording? The concept I want to get across in the negotiation is a true broad exclusivity within the property. Going back to the Staples/ Paperchase situation, let’s assume my client operated a card store. When my ficticous client entered into the lease, Staples was not in the greeting card business. Now they are a direct and large competitor.

While a prudent landlord would exclude large box stores, multi-department stores and anchors from any exclusivity restrictions; I’ve seen many leases that don’t exclude them.

From the landlord’s perspective, this type of wording is very dangerous. It is very difficult to manage a property with this type of wording, particularly when it is tied to poorly structured use clauses. For example, how would the landlord tell Staples, a national tenant, that they couldn’t sell greeting cards in this one specific location? If the landlord did nothing and my example greeting card tenant raised the exclusivity issue, then the Landlord has problems with this tenant. It creates an untenable situation.

The answer to the landlord’s conundrum is a well crafted use clause for each and every tenant, an exclusion to any restrictive covenants as noted above and wording in any granted exclusivities that is limited to the landlord leasing space to a competitor.

To learn more about this topic and how I can benefit your investments contact the author to arrange a 30-minute, no-obligation consultation.

Peter D. Morris is the principal consultant at Greenstead Consulting Group and an acknowledged expert of income-producing real estate.

He has a unique perspective gained from multiple roles in real estate including consulting, training, acquisition/disposition, leasing, asset management, development and property/facilities management as well as being the Chief Operating Officer of a publicly traded real estate company. He has a depth of knowledge in most real estate asset classes including multi-unit residential, mixed-use, retail, office, industrial and hospitality. Peter has worked with top companies such as Cadillac Fairview, Brookfield Properties, Marathon Realty, Grosvenor Americas and Colliers International. He also brings a global perspective having worked in 8 different countries including Canada, the USA, as well as countries in Asia, South America and the Middle East.

pdmorris@greensteadcg.com 

CNL Lifestyle Properties, Inc. Engages Us to Reposition Whistler Creekside Village

Creekside Village, Whistler, BC

Creekside Village, Whistler, BC

The owner of Whistler Creekside Village has engaged BC based Greenstead Consulting Group to assist in developing a repositioning and remerchandising plan for the property to better address the needs of both residents and visitors to Whistler.

“The opportunity arose to make significant and, we believe, positive changes to the offering we present at Creekside Village”, said Ryan Bell, the Director of Asset Management for the owner, CNL Lifestyle Properties, Inc. “A number of leases expired and we made the conscious decision to develop a scheme to replace those uses to better compliment our existing tenants such as Creekside Market, BC Liquor, Scotiabank and Starbucks, to name a few.

After an internal planning session, Greenstead Consulting Group was hired to refine a repositioning and merchandising plan for the property.

According to Greenstead founder, Peter Morris, Creekside Village is ideally suited to provide a different experience to the common brand name retailers found elsewhere in Whistler. He suggested that Creekside Village will be seeking tenants that are unique and/or offer something quintessentially Canadian, resulting in a ‘must visit’ reason at Creekside Village.

“The better quality hotel accommodations adjacent the property cater to an affluent, luxury family clientele who appreciate the opportunity to uncover something new and different as compared to the mass chain stores”, said Morris.

Morris stated that the preferred merchandise mix includes a signature restaurant; a salon/spa; unique art and gift gallery; quick service food outlets, with either a healthy food option or a menu of wide appeal; resort or adventure wear and a lounge, craft brew pub, wine bar or speak-easy atmosphere location to cater to those wanting somewhere to go in the evening.

According to the recently produced Whistler Chamber of Commerce Commercial Lease Report that provides a snapshot of current rates and operating costs rents in the Creekside Village area are less than in the Village Square, where they can be as high as $125 per square foot according to the report. Morris believes this is one reason his client will be able to find the right tenants.

“Even with the high rents demanded in Village Square, tenants still have to advertise to attract customers and the combined costs compound the risks of doing business in Whistler. Alternatively, if you locate your ‘must visit’ type of concept in a property with less rent, you can still spend on advertising to attract customers and the overall risk is reduced,” Morris said.

I Do This So I Don’t Get a Sinking Feeling When Acquiring Commercial Real Estate

life-jacketMore landlords are adopting reserve funds, also known as Sinking Funds, in their management practices to attend to future capital expenses and major repairs. These may be established for items such as Heating, Ventilation, Air Conditioning (HVAC) system replacements and major roof, envelope or parking lot repairs. Effectively the sinking or reserve fund is money collected from the tenants and set aside for these future requirements so the landlord is not out of pocket in the funding of those at that time. This is separate and distinct from a capital fund an investor may fund from the property profit.

However, unwary investors often miss the transfer of these sinking or reserve funds from the vendor to the purchaser as part of the property sale transaction and the closing adjustments. It is certainly incumbent on the purchaser to determine if the vendor has these types of funds during the due diligence process and to ensure that they are including in the closing adjustments.

Several issues can arise if the transfer of these funds is missed. The most important one is the financial risk assumed by the purchaser when it comes time to complete the replacement or repair. Many times the lease will exclude the amortization of items covered by the sinking fund, since the fund represents a form of prepayment toward those costs. This will mean the new landlord may not be able to recover these costs, directly affecting the property Net Operating Income and the overall property value. Failing this type of exclusion wording in the lease, tenants would still object to any form of amortization or recapture of the expense without accounting for their past contributions to the reserve fund. Aside from the financial impact, the landlord may be faced with a tenant relation problem too.

A second issue is that the missed transfer may become a legacy problem when the purchaser subsequently sells the property. The new purchaser will not want to inherit the issues we are discussing in this article.

The purchaser must determine what fund, or funds, exist and the current balance of each fund (at closing) to be transferred. This, in itself, can seem like a job for Sherlock Holmes, depending on how the funds were collected and accounted for in the landlord’s books. To compound the issue, many purchase and sale agreements are negotiated to limit the time frame of the financial statements to be provided by the vendor (such as three or five years). It is for this reason we counsel clients to have a separate line item in the list of due diligence production documents for sinking and reserve funds that is not time limited. It calls out the need to disclose all of these funds.

In addition, purchasers should be aware of the many different types of reserve funds another landlord may establish. For example, the landlord may have created a reserve fund for a pending insurance claim deductible or litigation expectation. It pays to seek out all potential funds by inquiring with the vendor and scouring the lease for any wording that could allow the landlord to establish these funds.

It is also important when examining the leases in due diligence to note if and when the funds may have started or ended. In some (albeit rare) cases, a landlord may have stopped using a sinking fund and now excludes fund payments in their current leases. But, if a tenant has been in the property over a number of terms and lease editions, you may uncover a dormant fund contribution. It is important to determine what became of a dormant fund; otherwise, at the very least, the purchaser could have a tenant relation issue on their hands in the future.

We use our collective expertise at the Greenstead Consulting Group to assist landlords improve the value of their commercial real estate investments. We can help you. Contact us today.

Simple Ways to Improve Operating Returns for Retail Property Owners

Graph  It doesn’t take a business degree to know that to improve operating return at the corporate or property level means revenues must increase, expenses must decrease or a combination of the two. Aside from the obvious question of occupancy, we’ll explore some other aspects to improving returns.

At the company/enterprise level removing waste, eliminating redundancy and cost containment are all common sense ways to add value. As is a serious review of the debt structure and financing options. Another avenue to explore is to examine the company’s sacred cows – policies and processes that have been implemented over time. Some may no longer be needed or the methodology may be outdated. Challenging the status quo may reveal hidden opportunities. For example, I’ve long advocated that the way property management services are delivered to both the owners of property and their tenants is completely outdated and is actually hurting tenant renewal rates and property returns. Moreover, by realigning staff duties in the manner I have suggested, management companies can reduce their overall costs of service delivery by as much as 15%.

The way leases are structured and the mechanics of them can also improve value. In the early 1980’s Cadillac Fairview, a leading mall developer and owner, instituted an across the board HVAC basic charge. It was a sinking fund established to pay for the replacement of roof top units, air handlers, central plant equipment, etc. The concept was drafted into the company’s standard lease form and used for all future new leases. There are many other items in the way a lease is structured that can have a positive impact on returns; such as how renewal options are treated, how the space is used and measured, and how amortization and depreciation costs are handled.

For example, many landlords provide for a recovery of amortization in their leases, but few also specifically note that the landlord should also recover an interest cost on the amortization. When explaining why the landlord should receive an interest component to the amortization, I liken the capitalized (and then amortized expense) to a loan to the common area to the benefit of the tenants. If a tenant pushes back I provide this example.

“Lets assume the landlord will need to replace the roof membrane, the cost of which is, say, $250,000. This is a recoverable expense, but the tenant doesn’t want to be charged with their portion of a $250,000 expense in one year; so the expense is repaid through amortization of, say 10 years. The landlord is out of pocket the initial expense and won’t recover that expense for 10 years. Effectively, the landlord is lending the tenants the $250,000, and just as with any loan the tenants should compensate the landlord for that through interest.”

These are just a few areas of more than a dozen lease refinements I’ve developed for companies I’ve worked with over the years.

One of the biggest lifts in return and value is to change the way lease rates are determined. Many owners and leasing agents for shopping centers still rely on comparable analysis to be the sole determiner of the basic rent. This is a mistake. Rent should be a function of sales – not to be confused with the concept of percentage rent. Using sales as the method for determining base or minimum rent it is possible to create a rent structure that is as much as 35% above comparable rents, based on my personal experience. There is a specific methodology to achieve this. It starts by understanding the market potential in the trade area served and relies on obtaining sales information from each tenant, even if they do not pay percentage rent.

There are a number of opportunities at the property level too. For example, the Greenstead Consulting Group has developed and implemented over 20 different ancillary income streams at the property level. Some produced significant revenues while others did not; but collectively the effect was the same as adding two or three rentable store spaces to the property– without the infrastructure costs.

Another area of additional income from retail properties is through creative densification. The land-mass for retail properties is very large compared to the vertical nature of office buildings. Much of this is dictated by parking ratios mandated in zoning requirements. The typical 5 stalls per thousand square feet of leasable area has been in use for more than 30 years, yet the nature of retail has changed dramatically over the same time. In the 1970’s evening shopping was usually confined to one or two nights a week and virtually no one shopped on Sundays. That parking ratio may have made sense then but does it make sense with the expanded shopping patterns and channels of today?

We convinced a municipal council to adopt a new micro stall designation to accommodate the new ultra small cars, such as the Smart car, and to include designated motorcycle parking as part of the overall parking ratio. Decreasing the average stall size allows for more stalls on the same piece of land. Even with the existing stall ratio, the increase in the number of stalls permits further development on the site. In another densification program increased the site densification that resulted in an $8 Million lift in the property value because the site development could be easily intensified. This improvement came with no additional infrastructure cost, such as a parking structure.

On the expense side of the ledger there are many opportunities to reduce expenses. One that is not widely practiced but that can pay significant dividends is lean maintenance, a concept borrowed from lean manufacturing practices. In lean maintenance there is an understanding that some common maintenance practices have diminished value through the lifecycle of the physical plant. Correcting this is the same as reducing the waste that was inherent in older manufacturing processes.

Repositioning and remodelling can have a positive impact on the revenue and expense of a property. Curb appeal determines customer attraction and what tenants perceive as a desirable location. So we never advocate trimming expenses to the point of harming the impression of the property. This includes capital expenses. However, the timing of the program is critical to obtain the best returns. It is also important to conduct a complete cost benefit analysis and judicious value engineering. Sometimes, just as in theatrical staging, some inexpensive changes can have a dramatic impact on the look and perception of a property.

Improving returns and value is what we do best. Contact us to learn how to transform your investment returns in retail real estate.