Watch Out! Current Hazards in Industrial Real Estate Transactions

As if finding available industrial real estate wasn’t challenging enough, we put together this list of concerns which could become hazards if they are not addressed in industrial real estate transactions. We encourage all principals and third party service providers to address these issues on the front end of transactions because they are much more costly after contractual relationships are created or other unfortunate events take place.

Delay in Possession

We encourage tenants to investigate whether there are any barriers to the landlord meeting a possession date under the LOI or lease. Barriers such as a current tenant’s ability to move out on time and a landlord’s tenant improvements can create major delays to possession. Although typically covered under a lease, delays in possession can create significant operational costs that may far exceed any legal rights under the lease. Often these legal rights are limited to the ability for a tenant to terminate the lease after a certain period of time, hardly a good solution if you still need the space!

With vacancy at historically low levels, today it is common for a tenant to execute a lease for a space that is occupied by another tenant. The new tenant’s expectation may be that the space will be delivered on or before the commencement date. However, we have seen a number of delay in possession scenarios where the current tenant goes into holdover, sometimes for months. This trend has created a domino effect in certain markets where the expected availability of spaces gets delayed for weeks, if not months.

It is therefore important that prospective tenants determine the likelihood of holdover by the current tenant if their desired new space is occupied. They should also expect their prospective landlords to work with them to understand any risks to occupancy prior to signing a lease.

Fire Sprinkler Systems

We encourage occupiers to investigate their sprinkler system requirements before looking at available spaces in order to save time and money. We also encourage landlords and tenant brokers to proactively ask prospective tenants whether they have satisfied their high pile permit requirements in reference to the subject building prior to drafting leases.

The National Fire Protection Association (NFPA) creates codes and standards which are incorporated into municipal fire department high pile permit codes. NFPA 13, Standard for the Installation of Sprinkler Systems and NFPA 30, Flammable and Combustible Liquids Code were updated in 2016 and 2018 respectively. A update to NFPA 13 is due out in September 2018.

The mistake we often see is an occupier relying on the sprinkler requirements from a previous high pile permit to guide sprinkler requirements for a new facility. As mentioned above, fire codes change and therefore sprinkler requirements change even for identical storage commodities and racking plans.

Accessibility

As part of the lease negotiations or, in the event of a purchase for a buyer, its due diligence, tenants/buyers and landlords should understand state and federal accessibility standards in place and how they may or may not affect their liabilities in the future. As with fire protection codes, accessibility standards and how they apply have changed over time and may vary by locale-especially in relation to potential liabilities for non-compliance.

The federal civil rights law underpinning most accessibility standards is The Americans with Disabilities Act of 1990 (ADA), which prohibits discrimination of individuals with disabilities and requires all facilities used by the public to be accessible to individuals with disabilities. ADA standards are based upon the age of the facility or date of renovations. To see more detail on this, feel free to visit this website.

We encourage tenants and landlords to work with their legal professionals to understand any future liabilities from ADA non-compliance under a lease. Although industrial properties are less likely than some other property types to be the subject of an ADA lawsuit, ADA liabilities can still be triggered by other ways such as tenant improvement permits. At the very least, leases should outline each parties liabilities should any ADA or other accessibility standard requirements be deficient. In addition, some tenant and landlords will hire a Certified Access Specialist (CASp) in order to evaluate any ADA or accessibility issues under a lease. Such inspections may also reduce liabilities such as statutory damages and provide confirmation that the parties have the intent to be compliant.

Entitlements

Finally, occupiers should always obtain a business license or make sure their use is approved prior to signing a lease or waiving any contingencies to purchase a property. As with fire codes, use codes can change and relying on industrial zoning does not ensure that an industrial use will be approved.

We always encourage occupiers to get written approval, via a business license or use verification letter, that their use is approved. Verbal conversations with City personnel or online searches of municipal codes should not be considered sufficient to sign legal obligations.

 

Blend and Extend in a Landlord’s Market

The blend and extend lease renewal, often referred to as blending and extending, is a transaction where the cash flows from a currently leased space are combined with the cash flows derived from the current market value for the same space. Blend and extend transactions can consist of one space and one lease or multiple spaces and multiple leases, and typically will go into effect at least 12 months in advance of a lease expiration.

Negotiating a blend and extend transaction involves variables that are not a part of the typical lease renewal. For example, because blend and extend transactions are typically performed at least 12 months in advance of a lease expiration, assumptions must be made regarding future rent growth and market terms. A projected cash flow with an expected rent growth of 10% per annum is much different than one with 5% per annum. In addition, tenants and landlords may evaluate blend and extend transactions using different metrics. A tenant may focus on the straight-lined cash flow where the landlord might focus on its net present value or impact to an internal rate of return. The increased amount of variables and ways to evaluate transactions grows the complexity of the blend and extend renewal negotiation.

Both the tenant and the landlord must have incentive to perform a blend and extend lease renewal. In a marketplace favorable to the tenant, the tenant’s incentive is often to reduce their current rent spend by blending it with current market lease value, which can be significantly less. In exchange for a lower rent, the tenant will appeal to a landlord’s incentive which is often an extended lease term, which mitigates the potential for vacancy. Of course, these are not the only incentives possible.

Conversely, in a market where the landlord has an advantage the roles may be reversed. The landlord may have incentive to increase its cash flows by blending current below market rents with higher market lease values. In exchange for agreeing to a higher rent, the landlord will appeal to a tenant’s incentive which may be an extended lease term, allowing the tenant to project its real estate costs over a longer time period and mitigate the risk of real estate costs rising faster than expected.

Historically, blend and extend transactions have been performed primarily in a marketplace favorable to the tenant. Landlord’s concern over vacancy and credit risk have made them more receptive to reducing their near term cash flows in tenant-favorable marketplaces. However, we see potential for the blending and extending in landlord’s markets as well. This post examines the blend and extend lease renewal in a landlord’s market by analyzing realistic scenarios and identifying the upsides and downsides for both parties.

Blend and Extend Scenario 1-No Transaction Costs

In this scenario, a lease is in place for two more years at a base rent of $100,000 per month with base rent escalations of 3% per annum, which is the current market base rent escalation. Market rent is $125,000 per month with an expectation that it will increase by 10% over the next year and 9% over the final year of the lease. There are no transaction costs involved with this blend and extend. Using the aforementioned information, the current rent and market monthly cash flows would be as follows:

Months Current Rent Market Rent
1-12 $100,000 $125,000
13-24 $103,000 $136,250

 

The landlord, who is looking for ways to boost its short term cash flow, approaches the tenant about blending and extending its lease for another five additional years. In order to figure out what terms to propose to the tenant, the landlord creates a blended cash flow that will allow the landlord to increase its short term cash flow and align with current market base rent escalations over the seven year lease term.

To the current rent and market monthly cash flows above, the landlord adds a combined cash flow column and a blended cash flow column. In the combined rent column, the landlord inserts the current monthly rent for the first two years and then the market rent for the remainder of the seven year lease to provide a baseline cash flow. The landlord defines the baseline cash flow as the assumed cash flow if the lease was renewed at the end of the lease term at market rents and terms. Using the total baseline cash flow as a target, the landlord then financially engineers the blended rent to align with current market base rent escalations over the term. The resultant cash flow is as follows:

 

Months Current Rent Market Rent Combined Rent Blended Rent
1-12 $100,000 $125,000 $100,000 $130,338
13-24 $103,000 $136,250 $103,000 $134,248
25-36 $148,513 $148,513 $138,275
37-48 $152,968 $152,968 $142,423
49-60 $157,557 $157,557 $146,696
61-72 $162,284 $162,284 $151,097
73-84 $167,152 $167,152 $155,630
Cash Flows $2,436,000 $12,968,481 $11,984,481 $11,984,481
NPV @ 6% $2,289,118 $10,234,408 $9,566,389 $9,697,595

 

The blended rent cash flow above provides advantages for both the landlord and tenant. The landlord is able to receive a higher rent sooner and also mitigate the downside risk of rents dropping prior to the expiration of the lease. Furthermore, the net present value of the blended rent cash flow is higher than the net present value of the combined rent cash flow at a discount rate of 6%, which further helps support the blend and extend lease renewal for the landlord under this scenario assuming 6% is an appropriate discount rate for the transaction.

 

For the tenant, under this scenario the main benefit of the blend and extend lease renewal would be the predictability of its rent in years 3-7. As in this scenario, tenants may prefer to base the blended rent on the combined rent NPV versus the cash flows-however this is largely dependent on the discount rate they choose to use.

Blend and Extend Scenario 2-Landlord has Transaction Costs

Scenario 1 provides a simple and straightforward example of how to arrive at a blended rent cash flow under a blend and extend lease renewal. However, in reality the Landlord typically incurs transaction costs in a blend and extend lease renewal. Such transaction costs can include brokerage commissions and tenant improvements-whether by allowance or turnkey improvements.

In Scenario 2 the landlord agrees to pay a brokerage fee of $100,000, to be paid ½ upon execution of the lease amendment and ½ following the 24th Month of the new lease term. In addition, the landlord also agrees to provide a one-time tenant improvement allowance of $100,000 prior to the start of the new lease term. The landlord typically applies a straight-line amortization to its transaction costs.

Prior to submitting a proposal to the tenant, the landlord creates a blended rent cash flow that will recapture its transaction costs over the lease term on a cash flow basis. Using the combined rent and blended rent cash flows generated in Scenario 1 as a template, the landlord creates the cash flow below to address the landlord’s request:

 

Months Blended Rent +Transaction Costs +Recapture Amort =Blend + Recapture
0 ($100,000) ($100,000)
1-12 $130,338 $0 $2,381 $132,719
13-24 $134,248 $0 $2,381 $136,629
25-36 $138,275 ($100,000) $2,381 *$140,656
37-48 $142,423 $0 $2,381 $144,804
49-60 $146,696 $0 $2,381 $149,804
61-72 $151,097 $0 $2,381 $153,478
73-84 $155,630 $0 $2,381 $158,011
Cash Flows $11,984,481 ($579,380) $200,000 $11,984,481
NPV @ 6% $9,697,595 ($548,539) $162,983 $9,666,440

*One month @ $90,656 to account for the second half commission payment

Advantages and Disadvantages

As exemplified by the Scenarios above, a blend and extend lease renewal in a landlord favorable market can have certain advantages and disadvantages for both the landlord and tenant. The following table illustrates some of the possible positive and negative aspects for the landlord and tenant.

  Positive Negative
Landlord · Higher cash flow now vs. later

· Mitigate vacancy risk

· Improve value of property

· Possible higher NPV of future cash flows

· Removed re-leasing costs in 2 years

· Transaction in a favorable marketplace

· Lower potential cash flows after Y2

· Lost opportunity to lease to “better” tenant

· Prevents expansion potential by neighboring tenants

· Potential un-budgeted transaction costs

· Possible loss of book value in Y3-Y7

Tenant · Predictable cash flow over 7 years vs. 2 years

· Possible access to tenant improvement dollars

· Stable occupancy rights for 7 years

· Mitigate significant rent increase after lease expiration

·  Rent is higher for next two years than current obligation

·  Transaction in an unfavorable marketplace

·  Possible higher NPV of future cash flows

·  Possible impact to financial statements

Summary

The blend and extend lease renewal can be an advantageous transaction for both the Landlord and Tenant in markets favorable to the landlord or tenant. In either case, it is important for each party to quantify the positive and negative aspects of a proposed blend and extend transaction, especially its financial impact to each respective organization.