The following two articles were recently printed in the Small Business BC publication.
The following two articles were recently printed in the Small Business BC publication.
More 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.
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.
Many people believe that a negotiation must arrive at a Win/Win conclusion. The concept of attempting to reach that position is misplaced and can actually hurt the process. Let me explain as it applies to real estate leasing, without meaning to simplify the process in attempting to address this in just a few words.
After the basic financial terms have been agreed the lease negotiation is all about the transfer of the business risk from either the landlord to the occupier or vice versa. One party wants the other to assume some portion – or all – the risk associated with the lease. The negotiation concludes only when both parties have become comfortable with the amount of risk they are willing to assume. This involves compromise and a certain amount of ‘betting’ that the risks assumed don’t play out or outweigh the potential benefits. In short, to reach agreement each side has to give something.
Giving something up isn’t synonymous with a WIN, as both parties to the negotiation start with their ideal position of wanting the other party to assume the risk. In essence, both leave the negotiating table in a position less than their ideal. Hardly a “Win/Win” concept.
However, here is the real “Win/Win” in a lease negotiation. It isn’t the conclusion that should be the “Win/Win” – because it can’t be as we’ve just learned. It is in the negotiating process itself that the two sides should strive for a “Win/Win”.
In our lease training programs for landlords and occupiers, we note that every successful lease negotiation has to have 5 criteria. The first is a positive experience. Both parties will remember the negotiating experience long after they have forgotten the financial fine points of the deal. They will remember the feeling that it was fair, or pleasant, or that they were taken advantage of, bullied or generally negative.
As a case in point, many car dealers have switched to a no-haggle pricing strategy. Why? Because car buyers typically felt mistreated in the price negotiating process and that left such a bad taste in their mouth that it may affect where they buy their next car.
A person who is having a positive negotiating experience will tend to be more open to sharing information and really listening to counter points to a discussion. Conversely, a person who is having a more negative experience may tend to dig in their heals, be closed to offering information for fear it will further erode their position, etc.
The impact will be a longer more adversarial negotiation as well as the potential of the lease only lasting the one term, if it is completed at all.
As a person seeking the best outcome in the lease negotiation, you need to mitigate risk. How you accomplish that through the experience will determine how successful you are.
To learn more about how to create a positive negotiating experience while still controlling the negotiation, or the other four essential criteria needed for a successful lease negotiation, contact me at firstname.lastname@example.org
They say when a business person makes a mistake or loses money they gain experience. I can attest to that during my 30+ years in commercial real estate. Fortunately, most of my experience has come from being a keen observer of other’s mistakes; although I’ve had some hands-on ‘experience makers’ too.
In our MasterguideTM lease negotiation training program we talk about a fairly common error built into leases. We call these Trap Door TM clauses/issues. That said, Trap Door issues are not confined to leases, as you’ll see.
A Trap Door issue occurs because of one or more of the following:
The last one is related to the first. It happens when a material evolution has occurred but common practice lags behind. Here is a perfect example contained in many commercial mortgage documents.
I became involved in a property comprised of a number of separate buildings with an existing, long-standing mortgage. Unfortunately, one of the buildings was completely destroyed by an arson fire. Financially, the building represented about 16% of the property income.
Although the owner had both replacement insurance on the building and income interruption insurance – effectively replacing the lost rent from the one building , a Trap Door issue arose due to the wording in the mortgage documents. The lender was an additional payee on the insurance. In the mortgage document, the lender could apply all insurance proceeds against the outstanding balance of the mortgage.
The mortgage wording seems reasonable when dealing with a total loss and by all accounts, that boilerplate wording hadn’t been reviewed for many years. It shouldn’t apply with the rise of the number multiple building projects, because it can cause a Catch 22 situation.
In this case, the debt service and the mortgage covenants were fully covered by the rental income from the property before the fire and could be sustained by the remaining income after the fire. The income interruption insurance further covered the payments until the planned rebuilding was complete. Notwithstanding this, the lender wanted to lay claim to all the insurance proceeds from both the income interruption insurance and the replacement value proceeds to pay down the mortgage principle; effectively, creating a double dip.
The money the owner was expecting to receive to rebuild was going to the lender instead and the income interruption proceeds would also go to the lender, pursuant to the mortgage wording. The lender’s solution to the issue was to offer to lend the amount needed to rebuild the affected building. This was not a good situation as the insurance proceeds would be interest free, whereas a new loan would increase the overall cost of debt on the investment. And the new loan was at a higher interest rate than the existing mortgage.
Additionally, the income interruption proceeds included the amount of the affected tenants’ prepayment contributions to operating expenses. Having all that go to pay down the mortgage would result in one of two things:
While we eventually resolved the issues with the lender, this was an experience builder.
Here are some take-aways:
Negotiate mortgage documents to mitigate similar issues in the future recognizing issues around partial destruction, multiple buildings and income replacement insurance.
Recognize that just because ‘it has always been thus’, doesn’t mean that the world is static. Build in as much future-proofing as possible into all contracts, documents and leases.
Issue resolution, such as this, is one of the services we provide. In addition we provide extensive lease and asset management training based on global best practices. Use the Contact Us form to learn more.
Harvard death n. a death which occurs despite all symptoms being treated successfully or all medical test results appearing normal. Editorial Note: This term is often explained to mean “the operation was successful but the patient died.” (source: Double-Tongued Dictionary)
Most real estate leasing is borne of experience rather than preemptive learning. There are no university courses specifically dedicated to distilling the knowledge that is gained from the leasing experience.
Let me qualify that. There are courses that outline the financial analysis of a lease transaction, how space is measured and tenant retention, etc. But none have been found to date that explains how to maximize the outcome for the landlord or tenant, depending on the perspective.
The operation or mechanics of leasing can be perceived as successful, but the opportunity for value can die. The difference between a successfully completed lease transaction and a successful lease being completed is based on the experience and understanding of the process and the nuances of the transaction.
There are 5 required components to a successful negotiation. Those are:
To be successful, every lease negotiation must contain all five. However, because each component is interrelated to the others, the successful negotiator needs to master all five aspects and intuitively balance each during the leasing process.
In addition, the mutual understanding and final documentation must be precise, concise, and clear.
These aspects of real estate leasing are rarely taught or understood; partially because of the lack of formalized learning in this area. As a result, additional value is often missed.
If your organization would like to learn how to implement the five components in order to drive value, please contact me.