Investing In Commercial Properties
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Invest Web Homepage Buying, managing, and selling commercial real estate is, in general, somewhat different than residential. Advantages
A generalized truth is that commercial real estate activity is less regulated than residential. While consumer protection laws strongly favor the tenant of residential properties, commercial tenants are assumed to be more sophisticated. Even if this is a false assumption for many commercial tenants, it is a fact that the government is considerably less interested in protecting them from their ignorance compared to residential tenants. And, on average, the commercial tenant probably is more sophisticated regarding business than the average residential tenant.
The commercial landlord has much more flexibility as to the terms and conditions that may be included in a lease. Although there are statutes and case law that govern certain aspects of commercial leases, in general, the Courts will enforce almost any terms and conditions contracted between the landlord and tenant.
Procedures for dealing with problem tenants, including getting rid of them, are simpler for the commercial tenant. For example, so long as allowed under terms of the lease, a landlord may, following the procedures of the specific state, lock-out a commercial tenant for failure to pay rent or for certain other lease defaults and impound the personal property left on the premises.
Commercial properties are, in general, not covered by fair housing law or lead paint regulations.
Leases for commercial properties are usually much longer than for residential, often 3, 5 10, 15 years, or even longer. Accordingly, there is less turnover of tenants.
Commercial property has little danger of future rent control. Disadvantages - How To Eliminate or Minimize Them
In spite of the above advantages of commercial rental property, there are, as might be expected, also characteristics that represent potential disadvantages. These potential disadvantages can be avoided or at least significantly reduced with proper knowledge. This necessary knowledge can be found on our site, including in the following paragraphs.
Economy
One potential disadvantage of commercial property is that it tends to be more easily impacted by a bad economy. It is much more likely that a tenant will walk away from a lease for a failing business than from his place of residence. When times are bad a person still needs a place to live even though he might not need a place to run a business. In an economy where new business formation and expansion are actually contracting, lowering the rent will not have the same benefit for a commercial unit as it might for a residential unit.
The best protection against a bad economy is (1) proper tenant selection in the first place, (2) use of strong leases with adequate periodic increases, (3) use of personal guarantors for limited liability entity tenants, and (4) maintaining the property so that it remains attractive to tenants and their customers compared to competitive properties.
Lease Documentation
Although the allowed terms and conditions of commercial leases are more flexible than residential, and partly because of that, the lease documents themselves are generally much more complex. Residential leases are governed by the state's landlord tenant statutes, and, in many states the statutes are automatically made part of the residential lease.
The flexibility of the commercial lease means that every detail of a many-year relationship must be explicitly covered in the lease document. It is not unusual for a commercial lease to be 20 or many more pages of single-spaced typing. Different categories of commercial properties require different lease clauses and even for the same property specific tenants may require customized leases due to the nature of those tenants' businesses. However, this factor is not a disadvantage once the leasing documentation has been developed for a specific property. Length of Leases
The fact that commercial leases are relatively long was listed above as an advantage, but this same fact can sometimes become a disadvantage. Since rent increases are usually defined for the term of the lease, and sometimes even for subsequent renewal, means that the owner may not be able to keep up with rapidly escalating market rents. Of course, in a bad market, the automatic increases work to the owner's advantage.
In order to avoid the long-term lease being a disadvantage, the owner must simply make sure the leases provide for periodic increases that are reasonably certain to keep his rent up to expected future market rents.
One fact to be remembered when negotiating new leases is that tenants are usually more concerned about increases in the early years of the lease rather than the later years. While they usually realize that it may take a couple of years to build up business, they almost always expect that the business will be very successful within tw0 or three years. Accordingly, one can usually negotiate a long-term lease having increases over the entire lease term totaling significantly more than the average expected market increase, if one is willing to give the tenant some slack up front. Tenant Improvements
Spaces in commercial properties are often remodeled or completely rebuilt when new tenants take over. Because this can be a costly project, the lease should be very clear regarding how the cost of these improvements are allocated between lessor and lessee. Not only must the new construction be considered, but it must clear who is responsible for any basic structure or utility service defects that were not an issue for the previous tenant. For example, who pays to correct an old code violation that the owner and several previous tenants had no knowledge of, but is discovered by an inspector in the course of the new tenant's improvement build-out. The owner must also protect himself against mechanics liens by a tenant's contractors by posting Notices of Non-Responsibility.
Example clauses dealing with these issues can be found in some of the lease examples found in our members-only Forms Web, as can a Notice of Non-Responsibility sample. Recourse
The tenant of a commercial property is often a corporation or other entity having limited liability. If a failing corporate tenant defaults, there will likely be no recourse in collection of rents or damages. This problem is avoided by requiring that financially qualified person or persons, whether principals of the entity or third parties, become personal guarantors of the lease. Having guarantors is of benefit not only during the period of ownership, but also when seeking financing or selling the property as the values of the existing leases are enhanced. Purchasing, Financing, Selling
The purchase and sale of commercial property often requires more documentation and more investigation than residential. Items more often required for commercial than for residential properties include Environmental Reports and Estoppel Certificates.
Commercial properties are also, in general, harder to finance or refinance, in that larger down payments are required and interest rates are higher. This may be partly due to lender perception that the risk is higher for commercial compared to residential, but just as likely, it is because there is significantly less interest by the government in promoting commercial property ownership through loan guarantee programs and fewer secondary mortgage markets. Accordingly, most commercial properties are financed with conventional loans and/or seller financing.
Any difficulties in purchasing, financing, and selling commercial properties will be minimized by having complete documentation and records available.
Special Concerns
Although the government has less interest in many aspects of commercial properties, there are several areas where that does not hold.
First, environmental issues can be a concern. Past use of chemicals on the premises of certain types of commercial properties, even if occurring under ownerships many transfers back, can be a serious liability for a new owner. The owner must also be sure that his leases deal with the subject so that new pollution does not occur during his ownership.
Second, commercial property can be impacted by the Americans with Disability Act (ADA), possibly requiring expensive renovations.
Accordingly, much more investigation is usually required for purchase of a commercial property compared to residential. This is not a reason to avoid commercial property, however. It simply means the buyer and manager must exercise reasonable care.
Types of Commercial Properties
Each type or category of commercial property has its own specific peculiarities.
Retail: The retail category includes any space leased to any business that sells anything (e.g., grocery store, restaurant, bookstore). For retail space, location is the most important consideration. Desirable location factors include easy access (including public transportation), adequate parking, and proximity to other retail.
Retail leases tend to be relatively long-term because of the importance of walk-in traffic and customer loyalty. A retail business will usually lose a substantial part of its customer base if it moves significant distance from its previous location.
Retail leases will usually be Triple Net (NNN) and often tend to be quite complex, particularly if the total rent includes a percentage of gross or net profit as is sometimes the case for retail. Non-competition clauses are often found in leases for retail centers.
Office: Tenants in this category usually operate service businesses (e.g., real estate, insurance, accountants, attorneys). Office space is usually located with attention to accessibility and neighborhood. However, location is not usually as important for an office business as for a retail business because walk-in traffic is not usually as important.
Office leases are generally not as long as retail because the customer base will usually follow to new location. Also, it is generally not as physically difficult to move a business from one location to another as it would be for retail. Office lease formats can range from full-gross to NNN, with every variation in between.
Office buildings do not often have environmental problems unless the office building was constructed on a site that once had a polluting use. Accordingly, when purchasing, some care should be taken to eliminate this possibility as a concern.
Industrial: Industrial space is usually suitable for manufacturing use. Accordingly, it usually offers services and/or amenities not found with either retail or office space. Included are such things as high voltage/amperage electrical service, truck loading docks, and/or a rail spur. Industrial space is often located without attention to customer traffic or neighborhood condition.
While industrial leases tend to be shorter than retail, they are usually longer than office because of the equipment involved. Lease formats are often triple net, but can range from full- gross to NNN, with every variation in between.
As would be expected, environmental issues are usually more important for industrial properties than for any other category and it would usually be highly advisable to insist on a Phase 1 report.
Warehouse: Warehouse property is used for storage of items. A property might simply be a shell containing one large space or it might be divided into separate spaces.
Storage Units: Although storage units space is more often rented to non-business persons for personal use, we consider it to be a commercial category because, since no one usually lives on the premises except perhaps a manager, it is not residential. Storage unit leasing is considerably different than other commercial categories. The laws are different with regard to what the landlord can do if the tenant fails to pay rent.
Leases are usually month-to-month and the documentation is relatively simple compared to other commercial leases. On-site management is usually required during the hours that the units are open to the tenants. For security purposes, the management often lives on the premises.
Mixed Use: Mixed use covers any property where spaces in the complex are not all one of the categories discussed above. The most common would be a combination of various types of commercial such as Retail/Office or Office/Industrial. However, one sometimes finds a combination of Residential space mixed with spaces in one or more commercial categories. Mixing residential with commercial can sometimes also impose certain residential requirements on the commercial space.
Of course, many businesses require a mixed use space. For example, a manufacturing facility also needs office space at the same location. Also, some older retail properties include living quarters above a store.
There are several potential problems with mixed use properties. The different types of use (1) require different types of documentation, (2) may be subject to different laws, and (3) have different kinds of purchase, management, and sale problems. This is especially true when residential is mixed with any type of commercial space, but it is sometimes a concern when different categories of commercial space are mixed.
One should also be sure that all the uses are allowed under the zoning and that any that are not are protected by a variance or are grand-fathered in.
Although one could theoretically generate an integrated lease document to use for multiple categories of commercial use, it is unlikely that a reasonable size document would adequately cover each type of use and such a document would be very complicated. Separate documentation applies not only to the lease itself, but maybe also to subsidiary documentation such as applications, checklists, and form letters. Of course, for residential/commercial mixed use, the residential space certainly requires its own documentation. |