In this second instalment of this our two-part article I outline eight more reasons why leases are of the utmost importance in a commercial real estate transaction.
Read the first part by clicking here
When you purchase a residential property you can undertake an exhaustive due diligence and investigation of the property and on settlement date collect a clean certificate of title from the seller.
The clear title deed is the government’s guarantee that you have unchallengeable title to the property and this is everything with residential property.
However, with commercial properties, the terms of the lease document itself are everything.
Read on to continue your path of self-education but this does require some energy though.
As tempting as it is to leave these issues to others and to flick-pass the problems to your solicitors, accountants and town planners, I’d encourage you not to do so.
The reason is that the easy road eventually becomes the hard road.
Put the effort into your own instruction now and the path ahead will eventually become simpler.
Commercial Lease Checklist
1. Term of the lease
The norm is for a commercial tenant to pay a bond or rental guarantee of two or three months’ rent.
However, there’s no cap on the amount of bond with commercial leases, unlike with residential leases, and this is another benefit of buying commercial property.
The biggest bond I’ve seen is six months’ rent and that was in the case of a design/construct where the landlord funded the development of a specialised building, tailor-made for their tenant.
Make sure too that the bond allows you as the landlord the right to draw down on it and all that you have to do is just give notice of draw down in the case of default by tenant.
There should be no other requirement other than just giving notice.
However, not all tenants will pay bonds and major tenants just refuse to do so.
It’s also desirable to couple a requirement for a bond with another common requirement, in the case of a company lessee, that the directors of that company provide personal guarantees then ask for a higher bond.
You can sweeten the arrangement by offering to given them the interest on the bond that you invest during the term that you hold it.
Finally, make sure that on the settlement of the purchase your solicitor collects the original of the bank guarantee or bond.
Financial institutions that provide these products won’t allow you to draw down upon them if you only have a photocopy of the bond.
You must have the original document.
This is as important as collecting the title deed.
So put this pearl of wisdom into your kit as a commercial property investor and don’t wait to learn it the hard way when you live through the next economic crisis.
Put this lesson into your grab bag of learning now.
There’s a lot of unapproved signage around.
You might take a casual approach on this on the basis that the sign is not a big improvement to the land, but if it’s to, say, a pylon that costs $40,000, check that the local authority has approved this.
Firstly, Councils make big fees with applications for approvals for signage and then yearly licence fees.
If they find there’s unapproved signage they will usually jump on you.
With a $40,000 pylon, if this is revealed later to be a non-approved use, then you could lose your tenant.
Understand that all signs on site have to be approved by council and if there’s a community title scheme operating in the building, body corporate approval is needed as well.
Also appreciate that additional rent is usually paid for a sign on the premises if the sign is used to advertise other businesses or products other than those of the tenant.
If the commercial property you’re looking at has good road frontage then it’s worth considering obtaining development approval from the local council to add a sign to the site.
You can then lease that sign out to one of the big billboard companies to generate additional income form the site.
When you go to sell the property with such a sign however, understand that the rental generated from the sign is usually not sold on the same yield as was paid for a building, as it’s different Weighted Average Lease Expiry.
For example, if the yield on the lease of a building for commercial use is sold in your area at a yield of say 10 per cent, then the yield payable for the rental of the sign would perhaps be 15 per cent.
“Wind is a big factor and an issue with signs on roofs as you need to attach them with concrete and girders etc. So while you might get $30,000 per annum rent for a sign, it may cost you $100,000-plus to put it up because of the need to control any potential wind problems,” John Potter, author of A Property Investor’s Guide to Negotiating, says.
So when you buy commercial property you must be a voracious reader of the lease documentation.
This is a time when you’ll learn that with commercial real estate it isn’t just a case of throwing money at a property and he who throws the most money, gets it.
You must be educated and understand what you’re doing, so read on.
The GFC revealed a weakness in the value that’s been given for a long time now to the personal guarantees under leases.
What it revealed is that, if you as the landlord are calling upon a person who’s personally guaranteed a tenant’s obligations under a lease (where the company has defaulted), you’d usually find there are other people out there also calling upon personal guarantees that the same directors have given them e.g. bankers.
And so you’ll find yourself in a queue claiming reimbursement from these people personally.
Therefore, personal guarantees are nowhere near as valuable as bonds or bank guarantees.
With this in mind, whenever you have the chance to trade off personal guarantees for cash bonds or guarantees, you’re usually best advised to do so.
In the case of default, then you’ll simply draw down on the bond rather than have to instigate expensive and protracted litigation, along with other people, against a guarantor under a lease.
4. Release of guarantor obligations
Be aware of this issue.
Under retail leases, provided the protocol under legislation is followed, guarantors can usually be released on a transfer of the lease to a new tenant.
But with most industrial and commercial leases, the leases specifically provide that the old lessee and guarantors aren’t released, making this a big incentive for the outgoing lessee and guarantors to sell their business and to transfer the business to a financially sound new tenant.
I’ve seen a number of examples where landlords have been able to recover unpaid rent from past tenants and past guarantors, who were the lessees years earlier, because the lease document provides they’re not released on a transfer or assignment of the lease.
This is even where possession of the premises has passed to new lessees three or four times in more than 10 years.
5. Right of tenant to remove fixtures
This can be an expensive issue to deal with if you’re left with the cost of de-fitting premises after a tenant leaves.
Make sure you’re fully aware of what the lease provides about this issue before you sign off on your due diligence on the purchase.
For example, on the exit of a tenant who operates a hardware store in a building that has a mezzanine level, you could be left with a bill for tens of thousands of dollars to reinstate these premises if the outgoing tenant has no obligation to do so.
Now that you’ve read this far you can see that commercial property is not complex and the issues behind it are simple, although there are many of them.
There’s no complicated analysis behind them however.
So, with commercial property, you should devour every bit of information about the financial and legal aspects of the property in the same way that some people fall in love with their football team or their kid’s school.
Don’t take the minimalist approach about your education and discard anything that you don’t need to know on the basis that you engage experts to do it for you.
You’re on your own journey as a commercial property investor and it’ll serve you best if you have a good general understanding about all financial and legal aspects of the property you’re considering.
6. Demolition causes and redevelopment potential
If you’re acquiring a commercial premises that has the potential for redevelopment, it would be valuable to know if the lease contains a clause that allows you to move the tenant on, and demolish the premises for redevelopment.
In new leases that you negotiate with tenants you can attempt to include such a clause, however understand they will usually resist it very strongly.
The reality is that on most occasions, a commercial investor looking to develop a site, which is subject to a lease, will just have to come to terms with the fact that you have to pay the tenant out if you want to redevelop.
7. Due diligence
A well advised commercial investor will ensure their contract to purchase includes a due diligence clause allowing them to undertake whatever enquiries and investigations, including a check of the terms of the lease, they need to ensure the property is in order.
According to John Potter, the importance of due diligence is paramount and should include:
- Always get a town planning report to check that all uses are allowable under the planning scheme.
- It’s a must to get a survey to particularly check there are no encroachments onto a neighbouring property by the property you’re buying. Encroachments are very common with buildings with a bit of age on them.
- Get a report from the letting agent (this is critical) about what actual rent had been paid. Look for rent concessions and rent holidays, which are evidence the tenant is going bad and the lease might not be as strong as you otherwise thought.
- Easements are a real negative. Easement documents are generally poorly drawn and don’t deal with some basic matters or are unclear about simple issues such as the height the easement extends to e.g. can you cantilever over the path of an easement to extend the floor of a building above the ground floor? Easement documents still talk about “horses and carriages” and often no mention is even made of cars. It goes further as you can often have issues about who has to clean up an easement and maintain it, and how you deal with illegal parking. Illegal parking often occurs, not just by the person who has the benefit of the easement, but other adjoining properties.
While I often suggest meeting the tenants, John rarely speaks to tenants himself as almost all of the information you need is gained from looking at a proper report from the letting agent.
This advice will also include the terms of the lease and the material disclosed to you as part of the marketing of the sale of the property.
8. Market trends
Think about what the market’s doing and how it’s changing.
Many lawyers and accountants now contract out a lot of their work to India and Asia, so you shouldn’t assume that an accountant and lawyer who’s been the tenant at the premises you’re buying will stay for another 20 years.
They might do, but they might not take as much space because they’re contracting out a lot of their work.
An Amex office in a capital city would once have been approximately 5000 square metres of space.
In recent years it’s dropped back to a few hundred square metres.
Many more people work at home.
“Captain Snooze is a classic example. In years gone by, you’d walk into a Captain Snooze retail showroom and it would be thousands of square metres in area,” Tony Lenan, principal of Firestar Developments and a veteran commercial investor, says.
“Now it might only be hundreds of square metres because a lot of people go online to look at the displays of bedding and furniture available, and then only go into the store to see some samples. The full range will no longer be on display in the retail showroom, but will be found instead online and so this tenant will take less space.”
Think too about what uses will survive the change in trends the best. Probably purpose-built car dealerships, car washes, fast food outlets, stores such as Bunnings, and banks will likely endure the longest.
It will all be okay, at the end of the day, if once against he position is right and the property is in a prime spot, and can be re-let for another use any way.
Think too about Coles and Woolworths, which just seem to be rolling out new stores everywhere across the nation.
But the trend more and more is for people to do this shopping online and it’s then home delivered.
Therefore this does seem to be a contradiction with Coles and Woolworths.
With retail banking you should understand that the areas being taken by banks are just getting smaller and smaller as so many people are doing their banking online.
“Understand too the demographic shifts, for example with companies such as Harvey Norman,” Potter says.
“Some years ago if you bought a clothes dryer from Harvey Norman you’d take delivery of the one on the floor and take it with you. Now you just can’t do that. The one on the floor stays there and Harvey Norman will usually offer, for no fee or a modest fee, to deliver it to your home. This is because the clothes dryer that you’re buying is not housed in the store where Harvey Norman are paying $300 per square metre rent. It’s stored instead in a warehouse down the road where they’re paying say, $1000 per square metre rent.
The smart commercial investor tries to let the trend do the work for them. And that’s the challenge – to get in front of the wave.
If this article has tweaked your interest in commercial property, go back and read Part 1 again by clicking here so its tips and traps are embedded in your psyche as a commercial buyer.
Do this and you’ll build up your investing muscles and grow strong as a commercial real estate investor.