Why a promising commercial real estate deal may fall apart – Orange County Register
The commercial real estate market has a whole new feel these days. Gone are the days of buyer-fueled bidding wars caused by too few buildings driven out by too many occupants – the classic imbalance between supply and demand.
We were racing through the first five months of 2022 when bam! We hit a huge speed bump called the Federal Reserve.
You see, to rein in runaway inflation, the Fed raised interest rates – some would argue too aggressively. Buyers felt encouraged to behave, well, like buyers. Personally, our team felt the impact as we had three deals canceled at the altar. Abandoned indeed.
Our last divorce, a terminated transaction, involved a private investor in his search for a suitable purchase. He sold a property in June and now has to redeploy the proceeds to defer capital gains tax.
As we scoured the universe of available leased buildings, we settled on single-tenant, net-leased industrial buildings, ideally in Southern California. What we found in our search area are many sale-leasebacks. After all, net rented real estate is created by one, an investor believing the time is right to sell, or two, an occupier who needs equity from their owner-occupied establishment. The latter was the genesis of the implosion of our deal.
Therefore, I thought it would be interesting to review sale-leaseback and some things to consider when pursuing them. So this is it.
I have recently advised a number of my clients to consider selling their commercial real estate and entering into a three to ten year lease with the investor buying it. A few listened.
This structure, in our parlance, is known as a sale-leaseback. Different from a simple lease and not a short-term lease which allows for a purchase, a sale-leaseback allows an owner-occupier the opportunity to sell at today’s high prices and stay in the building – although than as a tenant – and avoid moving.
It’s a clever arrangement when the right motives are involved.
But let’s also talk about the disadvantages of a sale-leaseback.
The message it sends: When a sale-leaseback is listed and marketed for sale, the buyer’s questions range from “why is it selling?” to “is her business leaking gills and needing money to survive?”
Usually there is a story and it is essential to understand the story: why is the seller selling and how will the finances turn out? Our challenge recently has been the solvency of the occupier and the seas of red ink that we have been asked to navigate. At the end, we said “next” and moved on.
Lease: Value is determined by taking the rent a business is willing to pay and presenting that payment as a return on investment. Simply put, if the company pays $10,000 per month or $120,000 per year, and the return is 5%, the resulting value is $2.4 million. Easy, yes?
Now the fun begins. Where is $10,000 a month compared to what other comparable buildings are making in rent? It’s either above, below, or at par. If it’s over or under, you’re golden. Above and you get confused. You see, an investor is looking at the worst case scenario: if the occupier kicks out the hook after a year and can’t pay the rent – or worse goes bankrupt – then you’re stuck with a building that you can’t rent for the same amount she was paying. So was our conclusion in the failed affair.
The operating company is short of: One of the benefits of owned real estate is flexibility when times get tough.
For example, we own the office building that we occupy. We are the owner and the tenant. When our income dropped in 2009 and 2010, we simply reduced our monthly payments to ourselves. Once an independent investor enters the fray, you are simply a tenant and the flexibility evaporates.
In our canceled scenario above, the rent was inflated in order to make the most of the sale. The problem was that the rent was unsustainable.
The tax consequences: As we have discussed, the sale of appreciated commercial real estate comes with severe tax consequences, unless a tax-deferred exchange is used. Yes, equity is funded but at a significant cost, in some cases up to 35%. You may be wondering why this is important. Unless the seller has carefully considered these consequences, the transaction may come to a screeching halt.
Fortunately, we still have the commitment and are proceeding with the second possibility. This time, the seller is independent of the company. So we’ll see.
Allen C. Buchanan, SIOR, is a principal at Lee & Associates Commercial Real Estate Services in Orange. He can be reached at [email protected] or 714.564.7104.