How the Sale of Your Building Could Cost You Money

Jarvis
Howard Jarvis – Author of Prop 13

California’s Proposition 13 provides a statutory limit on annual increases to the assessed value of a property. Basically, the state general levy tax rate is limited to 1.0% of the property’s value and cannot increase more than 2.0% per year, unless the building is sold, more than 50% is transferred, or substantial new construction is completed.  (Note that the tax rate can and usually does exceed 1% because there is no limitation on municipal tax rates or special assessments).

So what does this mean to California’s office tenants?  If the building you occupy sells to a new owner during your tenancy, the building could be reassessed at a much higher value than when you initially moved in, and you could get stuck with a substantial increased tax bill passthrough.

Let’s assume that your company leases 10,000 square feet in a 100,000 square foot building (10% pro rata share)  and signs a 5-year lease in 2013.  Let’s also assume that the building hasn’t been sold in a while, and therefore has a low property tax assessment.  For our example, we’ll pretend that the building is currently valued at $200 per square foot, or, $20,000,000, and that in 2013 property taxes for the building were approximately $300,000 (at a rate of 1.5%).

Increases in operating expenses such as property taxes are passed through to tenants and collected according to the tenants’ pro rata share.  Therefore, when taxes are increased by 2.0% to $306,000 in 2014, you will have to pay your 10% share of the $6,000 increase, or $600.

However, let’s say that in 2014 the owner of your building decides to sell it to an investor for $50,000,000 ($500/SF), the property is reassessed and taxed on the new value, and the property taxes are increased to $750,000.  In this example, the increase in property taxes from 2013 to 2014 would be $444,000 and since your firm occupies 10% of the building, you’d get handed a bill for $44,000.  And the fun part? You’ll get to pay that bill every year until your term runs out.

So is there any way to avoid this?  Yes, but it’s highly unlikely.  If you’re a large tenant in a soft market, you may be successful in negotiating “Prop 13 Protection” into your lease, whereby any “Due On Sale” taxes cannot be passed through to you.  Building owners are extremely resistant to agreeing to this, however, as it adversely affects the selling price.  Another strategy, if you know a sale is imminent, is to try and get your Base Year set to the year of the anticipated sale which could be achieved in a new lease or upon a renewal.

For everyone else, it is crucial that you do your homework before signing a new lease or renewing your existing one.  Being well informed is the name of the game.  Assuming you do business in a market that continues to appreciate, the more time that has passed since a property’s last reassessment, the larger the increase will be upon a sale.  Think of it like a rubber band; the more you stretch it, the more it’s going to hurt when it snaps.

Knowing not only when the subject property was last reassessed but also the likelihood the ownership could change hands during your tenancy should be a top priority and can help you avoid egregious and unexpected pass through expenses that most all office tenants are exposed to.

The Evolution of the “Comp”

Remember the “telephone game” when you were a kid?

You’d whisper, “I had ham and eggs for breakfast this morning,” to the person to the right and by the time it made its way around the circle the last person would say, “Santa has ham for legs and just installed new flooring.”

telephone

Well the same thing happens when real estate comps are traded.

In commercial real estate brokerage the lease comparable or “comp” is a summary snapshot of a transaction that includes all the relevant deal points such as the rental rate, square footage, length of term and concessions. Simply put, it is one of the most accurate real-time indicators of what tenants are willing to pay to lease space in a market at a specific point in time.

Comps are traded predominantly amongst brokers, landlords, lenders and appraisers, however there is no central repository for this information.  Each party or their respective company or firm maintains their own proprietary database where this comparable information is kept; and this comes with its own challenges.

With such a fragmented method of assembling, compiling and maintaining this data it’s impossible to warrant its accuracy.  For example, I’ve received comps for the same transaction but from different brokerages, and they have all had conflicting information – inconsistencies in the lease expiration date, tenant improvement package, rental schedule,etc.

Also, there are severe limitations to only being able to search your own firm’s database.  What if the data you need existed somewhere out there but your firm didn’t have it?  Well then you’d just have to hunt around until you found it, which can be very time consuming.

CompStak is a new, crowd-sourced model that allows CRE professionals to contribute lease comps and then earn points for what they’ve submitted.  They can then trade the points that they’ve earned for details on other comps that are more relevant and important to them.

This is huge for a few reasons.  First, having a centralized database that everyone contributes to encourages data integrity and market transparency.  Simply put, verified, accurate data benefits everyone involved.  Second, being able to magnify the scope of a search by accessing a much larger, more robust database makes me a better-informed broker and ultimately, allows me to provide better service to my clients.

CompStak is currently available in San Francisco and Manhattan, with plans to eventually go national.  Personally, the service has already proven its worth in at least two recent transactions and I look forward to their continued success.

Hopefully now when I  say, “three months free with $25 per square foot in TI’s,” it doesn’t get translated into, “tree trunks free with $25 in bacon flavored toothpaste”.

Related news: Commercial Real Estate Tech Company CompStak Makes Bay Area Inroads

What I Learned While at 42Floors

Yesterday, I wrapped up a one-month consulting position with San Francisco-based 42Floors.com. As a tenant rep advisor that’s passionate about commercial real estate and technology, I jumped at the opportunity to join the team and get a feel for what it’s like to work within a fast paced startup in the midst of SoMa’s exciting technology boom.

The 42Floors Crew
The 42Floors Crew

In a nutshell, 42Floors is a free search engine for office listings in San Francisco and  New York, wrapped up in a gorgeous user interface.  The model itself isn’t exactly groundbreaking, except for the fact that their current focus is not on monetization, but on creating the absolute best user experience possible.

Here’s how it works.  The user searches active office space listings and when they find something they like, they submit their contact information and the handoff is made to the listing broker, who then follows up with them to schedule a tour of the space.  Nothing revolutionary there.  Where 42Floors really sets itself apart, however, is with their Concierge; a human being that uses a telephone to actually call you.  How many companies actually do that anymore, and for free?  Their only task is to make sure you’re happy, answer questions about the market and commercial real estate, and ultimately, that you’re successful in finding your new office space online through their website.

Don’t get me wrong, there are plenty of other great features that elevate the user experience, like robust filtering options, photo-intensive listings and rental estimates for properties that don’t publish their asking rents, but the Concierge addresses a gaping hole in the online listing arena: tenants not only need but deserve the advice of an expert that’s looking out for their interests.  This is something that gets lost when a tenant uses the internet to find an office space online and then cuts a direct deal with the landlord without being represented by an advisor.  With 42Floors Concierge, the tenant can receive guidance and assistance from a professional they can trust.

My big takeaway from my experience with helping 42Floors develop their concierge program, is that tenants will always need a human advocate, and 42Floors understands that.

Just like WebMD.com will never replace the role of the doctor, 42Floors.com will never replace the role of the tenant advisor – they exist to enhance and compliment the process, be it a trip to the hospital or signing a new office lease.

Help! My Landlord Wants to Double My Rent!

ScaredIf you’re an office tenant in San Francisco (or any other market where vacancy is plummeting), there’s no doubt you’ll probably face a substantial rent hike upon your upcoming lease expiration. Since 2010, rents in the City have risen 39% and in 2012 alone, 24%; representing the biggest gain of any market in the world.

Relocating your office can be expensive and disruptive to your business, so if your first choice is to stay and renew, here are a few strategies that can help mitigate the rental increase.  The days of passive negotiation are gone; you need to be proactive.

  1. Renew your lease as early as you can.  The sooner you renew, the lower your rate will be.  Unfortunately, your landlord is also aware of this and typically will not renew your lease if too much term is remaining.  They’d much rather have you come back to negotiate at a later date, when rents are higher.  Every ownership is motivated by different things, however, so it doesn’t hurt to begin the dialogue early. 
  2. Explore options outside of your building.  Even if you fully intend to stay, you need to get out in the market and see what else is available.  You cannot expect to have any negotiating leverage with your landlord if their property is your ONLY option.
  3. Explore options within your current landlord’s portfolio.  If you’re getting priced out of your current office space, perhaps there’s a less expensive option elsewhere in the building on a lower floor, or even within another building your landlord owns.
  4. Reduce your square footage.  One of the most effective ways to reduce your monthly operating expenses is to simply lease less space.  Identify inefficiencies within your current space and consider consolidation or reconfiguration.  Are there employees in private offices that could be just as effective in a workstation?  Could employees who are out of the office regularly share a common workspace? There also might be an opportunity to “give back” some space upon your renewal whereby the landlord carves out a section of your office and builds a demising wall, thus reducing your rentable square footage.
  5. Hire a commercial real estate advisor.  Your broker is the best source of market information, and when you’re well-represented, your landlord knows you have access to valuable market information and may potentially relocate if they don’t offer you a fair deal.  But your broker also knows something your landlord does: renewing existing tenants is cheaper for the landlord than signing leases with new ones. Should you leave the building, the landlord will temporarily lose rent while the space is unoccupied. Also, brokerage commissions and tenant improvement allowances are typically higher on new leases.  Your broker will quantify these costs, translate them into real numbers your landlord can understand and then make a business case as to why your renewal rate should be lower than their current asking rate.

Rental increases are a natural part of the cycle and being prepared and proactive is the best way to mitigate an inevitable rental hike.  Ultimately, you’ll need to weigh out the two options of either staying in your space and softening the blow, or relocating to a less expensive building or submarket.

See also: When is the Best Time to Renew an Office Lease?

Is “Free Rent” Really Free?

Depending on what stage of the “cycle” the real estate market is currently in, landlords will sometimes offer tenants “Free Rent”; but what exactly is it and why do landlords use it?

Free Rent is a number of months that a tenant is allowed to occupy their space without having to make rental payments and is typically applied to the beginning of the lease term.

However, to really understand the concept of “Free Rent”, it’s important to look at it from the landlord’s perspective.  Offering a tenant free rent creates perceived value and is a compelling incentive when signing a new lease or renewal, therefore it serves as an effective strategy for luring tenants.  But it the tenant truly getting “free rent”?  Not exactly.

A landlord is focused on the “Net Present Value” of the lease when evaluating a transaction, or rather, the total dollar amount a tenant will pay in rent over time, after taking into consideration the time value of money and applying a “discount rate”.

What we’re really evaluating here is the “effective” or, average rent – which in both of the following cases is $24.00 per square foot, annually.  If a landlord offers a tenant 2 out of 12 months free with a $2.40 start rate, it’s essentially the same as offering another tenant 0 out of 12 months free with a $2.00 start rate.

This can be extremely beneficial to a tenant, since foregoing rental payments for a few months can help offset their relocation costs, or any of their own money they may have used to build out the premises.  Free rent at a new location can also help a tenant relocate from their current location in advance of their lease expiration date.

But for a landlord, it helps maintain a higher contract rent, which over time results in a more profitable building.  Take the previous two lease offers, for example.  The landlord would much prefer brokers trade a recent lease comparable with the higher $2.40 start rate, because they want rental expectations to be set as high as possible for their property.  And from the perspective of the lender or investor, this keeps them happy and in some cases there might even be a price per square foot threshold lease rates need to stay above in order to get their approval.  Factoring “free rent” into the overall economics of the transaction helps achieve this.

There are a few pitfalls a tenant needs to watch out for, however.  Before signing your new lease agreement or lease renewal, look out for a clause called “Inducement Recapture” and make sure your broker redlines it.  If you don’t and find yourself in default, you could be held liable to repay in arrears for any free rent you received at the beginning of your term – this could get expensive.

Also, make sure you’re not leaving any money on the table that could be applied to your transaction as free rent.  For example, if the landlord is offering a $10 per square foot tenant improvement allowance and you’re fine with taking occupancy “as is”, don’t just spend the money just to spend it, or walk away from it altogether.  Rather, negotiate to have that allowance converted into free rent.

The number of months in free rent a tenant receives depends on many factors such as a tenant’s current leverage in the market, the financial health of the landlord and the building’s vacancy rate.  Hiring an active tenant broker to represent you in your lease transaction will ensure that you receive the maximum benefit of incentives the market currently has to offer.

Why I Exclusively Represent Office Tenants, and NOT Landlords

As a commercial real estate advisor who has built an entire career upon advocating on behalf of tenants, exclusively, the million dollar question I’m always asked is, “Why did you stop representing landlords when the money is so good doing both?”.

The easy answer is that I always felt like I was somehow representing the “bad guy” by representing landlords, and that I get much more satisfaction out of helping out the underdog, who is almost always the tenant.  Now, that’s not to say that all landlords are bad, but tenants are often the “Little Guy” at the negotiation table and need a strong ally in the ring with them.  While a commercial office tenant may only address their real estate needs once every 3 to 10 years, a landlord will conduct many, many more transactions in that same time and is tasked with maximizing shareholder/investor value – naturally, this typically runs counter to the economic goals of the tenant.

The second and longer answer, is that try and spin it as you might, there is an enormous amount of conflict when dual-agency exists – whereby the broker simultaneously represents both the landlord AND the tenant.  The only way to truly offer my clients the very best in service is to choose a side, and completely remove that bias altogether.

I think the best way to get my point across here is with a few examples:

Let’s say I’ve been hired by “ABC Tenant” to locate and negotiate terms for their new office relocation, however I also just happen to represent quite a few key landlords downtown.  Now consider this:  there is pressure from the landlord to tour the tenant through the buildings they own and to try and make a deal, even if it’s not the best fit for my client.  If the buildings I list don’t make the tour, I can forget about holding on to that listing for too long.

There’s also pressure from within the broker’s own firm, as the firm (and the broker) will earn a larger commission if the deal stays “in house”.  Again, the needs of the brokerage and broker are being placed above that of the clients’.  If the real estate broker is going to make more money if you lease space in a building that they list, rather than sign a deal at a competitor’s building, do you think that might affect the advice they give you?

Another valid scenario is explained in the following.  Let’s say I tour ABC Tenant through a building I do not currently list, but would like to win that landlord assignment in the future.  Well, I’ll probably do one transaction in the next 3-5 years with the tenant, but if I win the landlord assignment I could easily increase my volume twenty-fold.   How hard do you think I’m going to negotiate against that landlord and am I really going to go to bat for my tenant if I’m trying to create favor with the landlord?

There are plenty of hardworking, honest real estate brokers who offer dual representation and I am sure they outnumber the bad apples, however I firmly believe that the only way to truly offer conflict-free tenant representation is to completely remove any opportunity for bias from the equation; and the only way to do that is to simply NOT represent landlords, and focus solely on fighting hard for tenants.

How much office space should I REALLY lease?

Leasing too much (or too little) office space can be a costly mistake, however determining exactly how much space you require is one component of the leasing process that is often rushed or inaccurate.

Unfortunately, our industry is partially to blame for this.  Tenants often think they need more space than they actually do, and since a broker earns more when you lease more, they may be the last person to tell you that you could scale back.

Taking the time to identify the size, configuration and quantity of each element of your new office will not only save you time and money down the road, but chances are you’ll find that you require less space than you originally thought you did.

Old rules of thumb such as, “tech tenants require 150 square feet per employee, and law firms require 350” is an unreliable measure and nothing more than an insightful metric for spotting a gross irregularity; there are far too many variables involved in determining your space requirement to simplify it in this way.

A better and more accurate solution is to take an analytical approach by using a tried and true Excel spreadsheet.

First, calculate the quantity and size of all your desired offices, cubes, conference rooms and supporting spaces such as kitchens, server rooms, storage closets, reception area so as to arrive at your Net Square Footage.

Then factor the following into your spreadsheet as they’ll substantially affect your true space requirement.

  • Circulation Factor – this is simply “the space between” and takes into account all the interior space that hasn’t yet been accounted for such as hallways and walkways between cubes.
  • Load Factor – Buildings add a percentage on top of the actual square footage of your office to account for common areas such as lobbies, restrooms and hallways.  This is the difference between the Useable Square Footage (USF) and Rentable Square Footage (RSF). Properties can vary greatly in how efficient they are, and a good broker will not overlook this important factor.

Finally, this exercise will yield an accurate square footage of what you require today, but what about in the future?  Take time to consider factors that will affect your space requirement throughout the term of your lease such as hiring or consolidation, planned mergers and acquisitions and changing in funding schedules.