You have reviewed everything about your current property and have a preliminary feel for the dynamics of the market. Now it is time to analyze the results, formulate your strategy, and turn your plan into action steps.
Your biggest question right now may be whether to extend your lease—which most companies end up doing—or move to another building. Let us review the options.
LEASE RENEWAL
Now that you have completed your preliminary assessment, you may feel differently than you did when you began this process. Many executives start off with the knee-jerk reaction to move, much like my auto parts distributor client did in the first chapter. But most of them realize it costs too much to pick up and move everything. Or they decide that moving is not worth the savings of a lower lease rate elsewhere. This is when it is time to negotiate a lease extension, also known as a lease renewal.
Most executives know they need to renew their lease up front.
Their business is status quo, and their facility works fine for their needs. However, I caution you to treat your renewal as a preference and not an absolute direction. Why?
Think about it from your landlord’s perspective. If the landlord is certain you are going to stay, or that relocating would be very expensive for you, the landlord will contemplate an increase of your lease rate. There is a limit to what a landlord can charge in the marketplace, but it is safe to say you will pay more than you would if the landlord were unsure of your next move. Once the landlord understands you have options and hears your broker speak about how your company potentially fits into those alternatives, it changes their nature. This is the tactic you want to take to drive home results. You will be more informed when taking this tactic as well.
This strategy can be summed up with the concept of “Always Be the Buyer.” The idea here is that instead of actively trying to stay in the building, you actively try to find superior alternatives. It is in the quest for alternatives that you become more articulate about the value of your current lease in the context of the market. This concept is courtesy of Strategic Coach®, the entrepreneurial business coaching program I have been a part of since 2014. If you would like to delve more into this concept, I recommend Dan Sullivan’s book Always Be the Buyer.
Because of the strategic need to create leverage, you will find that 80 percent of the steps in the process of leasing a new building are relevant to renewing the lease in your existing building. The only difference is that, at the end of the process, you will not have to move. While this strategy will take slightly more time and effort, it will result in a more advantageous new lease contract.
Most business leaders know that commercial real estate brokers list properties for lease and for sale, and find properties for tenants, landlords, and buyers. What most people do not realize is that lease extensions for corporate clients make up the majority of the work for many brokers. These tenant-focused brokers call themselves tenant advisors, or tenant reps. Lease renewals make up half of my own book of business each year. Once an executive has experienced great service from a tenant rep broker, the relationship often becomes long-term.
SUBLEASING
Subleasing is an integral part of the warehouse leasing business, as business growth often does not coincide with a lease expiration date. This is when subleasing can come into play.
So, why is subleasing so commonplace? If you started your own business, think back to when you were a startup. Remember when you were bootstrapping, trying to win every contract, worried about making payroll, and trying to save every penny possible? Many companies that start in this manner and work through organic growth will look for a sublease property because it is an opportunity to get a below-market lease rate, thanks to the motivation of the prior tenant to move in to their next space. It is also an opportunity to sign up for the shortest lease term possible, in the event your plans change.
For larger companies, subleasing may make sense if you have outgrown your building. Subleasing frees you up to move in to the new, larger facility before the expiration of your lease. When this is the case, executives often wonder about timing: should the company put its space up for sublease first or find its new building first? This can be a complicated question, and one your broker can help answer, because the answer depends largely on the current conditions of your specific market.
On one hand, you do not need to get rid of your old building until you have your new building. On the other hand, subleasing space does not happen overnight; it could take weeks or months. The 2020 COVID-19 pandemic increased the quantity and velocity of the sublease market, as many companies lost customer demand or were restricted from operating and needed to downsize. Others needed to expand, particularly food delivery companies and businesses that manufactured and distributed personal protective equipment, such as masks and face shields.
Subleasing your space can take a while because you have to find the right tenant, negotiate terms, review financials, draft and negotiate a sublease document, gain landlord approval, collect all monies due, receive and review the certificate of insurance, and fully execute all the documents. Subleases have more moving pieces than a regular lease because there are three parties involved: the sublessor (the company that is leasing the building and no longer needs it), the sublessee (the new company that wants to take over the building lease), and the master lessor (the landlord who owns the building).
The initial negotiations are between the sublessor and the sublessee. The sublease contract memorializes this negotiation. The sublease contract, however, does not supersede the original agreement between the sublessor and the master lessor. This means two documents need to be reviewed and approved by all three parties. But what if two parties agree to something that the third party rejects?
Every sublease negotiation involves new variables and nuance. Tenant improvements often play an outsized role. When a company offers their space for sublease, they usually do so with the expectation that whoever subleases the space will take it as is. Executives do not want to invest capital into a tenant improvement project for another company that is going to sublease their space. At best, the sublessor may offer a few months of free rent to offset the sublessee’s tenant improvement expenses and then leave the sublessee to spend their own time and effort building out the space.
LEASE TERMINATION
The idea of terminating a lease that you no longer need may seem straightforward. That might be the case if we were talking about an apartment lease you had when you were in college: you could just pay $500 and walk away. However, commercial contracts are much more complex and have much more money at stake. You could have $60,000 per month left on your commitment over the next three years. That means that the landlord would forgo $2,160,000 if they allowed you to terminate.
Termination fees represent the cost of ending your lease early and fluctuate based on supply and demand dynamics, as well as ownerships. Some landlords will work with you because the market works in your favor, whereas others will look for fifty cents on the dollar for every outstanding dollar you have left on your contract—and that might only be if you also find a replacement tenant. Your security deposit usually is not something you can use as a termination fee. If your landlord has an outstanding loan, a lease termination might affect his ability to refinance the property. Additionally, if the landlord contributed toward your tenant improvements, they will want to be repaid at the time of lease termination.
In practice, it is a rare occurrence for a company to sign a long-term lease and obtain the right to terminate within their original lease contract. In most cases, the ability to terminate may be allowed after the initial three to five years, at the cost of three to six months’ rent, paid at the time of termination. Any unamortized expenses, the expenses that the landlord paid up front at lease signing, usually need to be paid back as well. For instance, if a ten-year lease is terminated at the end of year five, the tenant would have to pay back 50 percent of the outstanding tenant improvement costs, leasing commission, and expenses, such as demolition, permitting, and signage. All of this can play a big role in your real estate decision.
The termination clause in leases usually spells out how far in advance a tenant must give notice to the landlord. It generally ranges between six and twelve months, but is negotiable, and gives the landlord a reasonable amount of time to market the building and find a replacement tenant.
Landlords rarely consider terminations on leases that are shorter than seven years because of the amount of time, effort, expense, and vacancy that takes place with each lease. Lease-up times can be long enough for older industrial buildings, ultra- specialized buildings, or buildings in tertiary markets where the downtime can be months or years. In addition, the break-even period for many landlords is several months. It can even be up to one or two years in larger deals, due to the significant tenant improvement costs, leasing commissions, and renovation costs involved.
One of my favorite ways to add value for clients is to try and turn a sublease into a lease termination. My perfect-world goal here is to market a client’s buildings for sublease and find a new tenant who wants to lease the building for a longer term than my client has left on their original lease, at the same rent or higher. Then, instead of taking on a sublessee, my client and I can take this tenant to the landlord and help the landlord work out a new deal in exchange for terminating my client’s lease.
Why would a landlord do this? They do not have to. But if we can provide enough value to the landlord, they may find the opportunity worth the time and effort to sign the new tenant and terminate the lease.
The last thing you want is to sublease your space to a company, only to have that sublessee run into problems and vacate the property. Nobody wants to pay rent for two buildings, and some companies just cannot afford to do it. This potential risk is why turning a sublease into a lease termination is so valuable.
INSTITUTIONAL LANDLORDS
Institutional landlords are becoming increasingly common. If you have one, your broker should contact them if you think you may need to expand. In most cases, your landlord will be happy to hear you are thinking of expanding and will give you the first look at any new building in the portfolio. And if the landlord knows you have a broker, they will know you are aware of all opportunities in the market—not just theirs.
Another benefit to this approach is that your lease expiration date may become flexible because many larger landlords will let you out of your current lease if you sign a new one on a larger building owned by the same company. Also, if you move to another building within your landlord’s portfolio, but that new building will not be ready until months after your current lease expires, the landlord can extend your lease at the same rate to bridge the time gap.
I am proud to have worked for two of three generations of a family-operated private food production company in Los Angeles. A few years back, we worked on a five-year extension of their 60,000-square-foot warehouse near the Port of Los Angeles with one of the largest industrial landlords, who is among the most experienced and sophisticated in the country. The client’s excellent relationship with this landlord became beneficial when the company considered consolidating this facility with their second 35,000-square-foot warehouse.
After some careful considerations and initial space planning, we figured out the company could consolidate their total of 95,000square feet into one modern and efficient 80,000-square-foot food production plant. After we shared these plans with our landlord, the landlord provided us with advance notice of several building options that were not on the market yet. At the time, the South Bay market had only 1.2 percent vacancy, so this communication saved months, possibly years, of trying to find the right building.
I recommend doing this only if a broker is involved. While it may seem obvious, it is worth repeating: while your landlord can be a trusted partner, they still have a fiduciary responsibility to their shareholders to charge you the highest rent possible. Your landlord will prevail unless you have a skilled broker working for you, digging up competitive lease comps and creating leverage. While the upside of an institutional landlord is having a portfolio of property to choose from, the downside is that they have more information and experience than you do, and in most cases by an order of magnitude or two. Bringing your broker to the party will level this playing field.
OWNED INDUSTRIAL BUILDINGS
If you own your property and want to move, you need to think through a few additional considerations when it is time to sell. Owners of industrial buildings sometimes have outstanding mortgages, which means they need to sell their existing property in order to buy their next property and will likely need a new loan.
You will want to factor into your analysis the cost of paying off your existing loan and how you will approach your new loan. For example, if your current mortgage is assumable and your loan terms are more favorable than what is available in the marketplace, you might be at an advantage if you can offer your buyer the ability to take over your loan. If your current mortgage is less than three years old, you will probably have a prepayment penalty due upon sale of the property. Check this amount so you can get a feel for how much you will net after expenses.
A few key financing questions to start with are:
- What is your outstanding mortgage amount?
- When does your existing loan mature?
- Is your loan assumable?
- Does your loan have a prepayment penalty, and how much is it?
All of the same preliminary assessment items we have already discussed in the context of renting also apply to owned buildings. However, you will view the findings of these assessments through a different lens. When you sell a property, you will be held accountable by the prospective buyer, not the landlord. Some sellers do renovations in advance of offering their property for sale. For instance, they repair or replace specific building systems that are failing or take care of deferred maintenance. Others take a hands-off approach and price the building in its current condition. Talk to your broker about what will work best for your company.
Most owners are too focused on their company’s operations to invest in extensive renovations. There are two primary schools of thought on how to approach property sales:
- Make sure you deliver everything in proper working order.
- Offer the property “as is, where is, with all faults.”
One would think that “as is” includes having everything in good working order, but that is not true in reality. For example, let us say you operate your business out of a 100,000-square-foot building, which includes 9,000 square feet of office space. After the advent of e-commerce, you shifted your business model to online sales and no longer have a large inside sales team. As a result, you demolished half of that office space to make room for more racking and inventory, and in the process, you removed the HVAC ducting and left the unit on the roof in case you needed it. Now what should you do? Should you have your HVAC guy go up there and see if the unit is working before you sell the building? What if the unit needs a $2,000 repair? What if the unit needs to be replaced, even though you are not using it? Being aware of items like this in advance is helpful.
Now that you have a good idea of the current condition of the property and how you will deliver it to the market, it is time to assess its market value. You might have a recent appraisal from your bank if you have refinanced recently. Reach out to your broker for an “opinion of value.” This will include properties currently on the market that directly compete with yours and comparable properties that have recently sold, and may include new developments that will be on the market at the same time as your property.
A high-level broker opinion of value is not a data dump. It should be an executive summary of the valuation, full of insight into how value can be maximized, and include potential disposition strategies.
Most clients calculate their net proceeds using these broker opinions of value, along with “net sheets” from an escrow officer. Net sheets are worksheets that calculate the total proceeds from a prospective property sale minus all of the costs of the sale. Costs can include the payoff of an existing mortgage, title and escrow fees, brokerage fees, security deposits if a tenant is in place, and property tax prorations. Net proceed calculations give you a forecast of how much cash you need to finance your next property.
As a broker, my job is to think about how to position a property for sale. I do this by identifying specific market players that could utilize the property and then positioning the property for maximum positive exposure to those segments. I then provide insights as to how these potential suitors can maximize the utility of that property. Sometimes this takes the form of hypothetical racking layouts, possible truck turning radiuses, or prospective furniture layouts for the office space.
When bringing an industrial property to market, it is crucial to accurately forecast specific demand. For example, a few feet difference in ceiling clearance changes the entire market for an industrial building, as does column spacing, yard size, power, parking, and so on. This property nuance is where the value of an early property assessment pays dividends. However, not all buildings are comparable: in the industrial asset class, each building has 80 percent unique attributes.
Once you know your current mortgage terms, principal balance, condition of the property, and its probable value in the market, it is time to size up your hypothetical purchase amount. We will want to make sure the new property you are looking for exists in today’s market and that you can afford to purchase it.
SCENARIO PLANNING
When going through this strategic planning process, it can be helpful to build a quick side-by-side comparison. Each scenario should be specific to the company’s objective, and this type of comparison will help you make value judgments and informed decisions.
I work for a global multinational company that is in the infectious disease blood-testing business. This business is capital intensive to set up, operate, and decommission. The company owns the majority of their industrial facilities outside of the United States and had just acquired a new business line, including a leased research and development facility. We had to assemble several different scenarios in California for local and global executives to use for discussion. They had to decide whether to renew the lease on their current facility, or if it was best to lease, buy, or build a facility elsewhere.
We evaluated the markets within the Bay Area, Los Angeles, Orange County, and San Diego. We identified the industry pioneering research universities within each market and examined which nearby buildings were available for lease or purchase. By comparing each scenario, we realized it made the most sense for the company to operate within Orange County.
Once we decided on Orange County, we could get down to more specific opportunities. We put together pro formas for purchasing land and hiring a general contractor to build a facility. We prepared purchase alternatives, along with general renovation pro formas. Finally, we looked at other leasing alternatives closer to top research facilities. In the end, we decided our existing facility was optimal and renewed the lease for another thirteen years. This demonstrates that only when you come from a place of knowledge can you have the confidence to press ahead.
NEXT STEPS
Now that we have discussed high-level real estate strategies, we can start to translate these strategies into determining what you will need in your next building.
In this next chapter, you will uncover and overcome stumbling blocks before obstacles have the chance to derail your best-laid plans.