May 2020 — The organizational posture of the company interested in acquiring a property plays a key role in decision making. The company’s point of view, how much risk it is willing to take, and how it makes large-scale financial decisions greatly determine its financial priorities. A company can take one of four basic postures: owner/occupant, landlord renting space to others, tenant in space owned by others, and financial custodian.
Owner/Occupant
A company that intends to occupy a building it owns will most likely be there a long time. In this case, long-term interest loans and heavy front-end investments can be justified and may yield handsome returns. Financial decisions can include a consideration of long-term paybacks, lower internal rates of return (IRRs), and greater use of soft-cost and intangible items in justifications. Incentives exist for well-planned preventive maintenance and high levels of care and cleaning. The company may invest in long-term flexibility through the use of open-plan modular furniture, raised flooring, and demountable walls.
The viability of this owner/occupant posture depends on where a company is in its overall business cycle and the durability of its market presence. The essence of this approach is contained in one simple analogy: We tend to invest more in a house we plan to live in for a long time than in an apartment that will merely tide us over for a short period of time.
Landlord Renting Space to Others
As a landlord renting space to others, your priorities are vastly different from those of an owner/occupant, even if you intend to own the building for a long time. You are likely to invest heavily in base building systems, especially adequate HVAC, electrical, and communications capacities. You are also likely to try to minimize the investment of in-house cash, which may be needed to cover building operations when cost increases cannot be passed on to tenants. In this case, the property will probably be financed, resulting in tighter controls by the lender trying to preserve its investment and financing arrangements.
Although long building life may be desirable, your ability to attract and retain tenants may take priority over long-term investments, especially in depressed markets. Unlike an owner/occupant, who may set economic life cycles according to how long products and building components will last, a landlord will generally set life cycles according to depreciation schedules permitted by tax laws. Flexibility is achieved more by strategically planning a good tenant mix and staggering lease terms than by installing special building components, such as demountable partitions. In other words, business flexibility is more important than physical flexibility.
Tenant space flexibility is usually desirable, but it’s not critical, especially if tenant leases are short and turnover is high. In the final analysis, if your base building systems can handle the capacity and demand of tenants, the burden of achieving internal flexibility in the tenant space falls to the tenant, not the landlord.
Tenant in Space Owned by Others
Many tenants lease their space because they require more flexibility of location than owned space can provide. Owned space is relatively illiquid. For example, many communications companies, facing fierce competition in local markets, have opened several small sales offices in local market areas, deliberately delaying a space purchase until they can gauge how well their products penetrate and capture the market. If sales are disappointing, the company can pull out of any given regional market with minimal losses.
Tenants usually expend minimal outlays of capital. Their investment in flexibility is achieved by negotiating favorable lease terms, especially renewal options and future access to contiguous expansion space. Physical and spatial flexibility become more important as space holdings increase in size and as organizational churn rates increase. Under these conditions, tenants tend to invest more in a space to achieve this flexibility. The heavier this investment, the more likely tenants are to stay in the space. This becomes a serious disadvantage at lease renewal time. Tenants have very little leverage if they cannot afford to move to a new location.
Financial Custodian
Real estate owned (REO) property results when an owner defaults on a property loan. Clearly, this is a financial posture into which no one voluntarily enters. The bank or other financial institution becomes the recipient and custodian of the property because the bank held a mortgage on it—in other words, the lender provides foster care for the building. The financial custodian’s objective is usually to sell such properties as fast as possible. Efforts are directed at minimal investment, that is, turning over, selling, or disposing of the building. Older buildings are usually at a competitive disadvantage in the marketplace. They are harder to sell and, if kept for any length of time, can become subject to costly code-mandated upgrades. The main objective is to avoid losing money by minimizing losses. Many such properties are rented out to generate an income stream to cover expenses.
REO property is not a desirable situation for either the financial custodian or the tenants. Generally, lenders have no desire to be landlords, and neither party has any desire to invest in the building. Over time, it will deteriorate until a motivated, permanent owner can be found.
Changing from One Posture to Another
As leveraged buyouts, corporate downsizing, and mergers occur, businesses are required to reexamine previously unalterable assumptions. Such changes can create the need to sell long-occupied buildings, consolidate leases, or shift from occupying an owned building to renting it out. These adjustments can be difficult, because circumstances can force the affected party to perform a function for which it is not prepared. The following are some typical problems that arise when changing from one posture to another.
Entrepreneurial Naïveté
Some groups (especially some in-house facilities departments) lack experience in running self-supporting operations. That lack makes them vulnerable to pursuing bad deals because they have not had to operate at a profit, as commercial landlords must. Their management of in-house costs, especially for staff time, can easily get out of control.
Unresponsive Decision Making
Large organizations that are used to making space decisions in the open market may be incapable of making quick decisions. As a result, they may lose out on great deals because they cannot act fast enough or have not done enough strategic planning before entering the market.
Reeducating Corporate Legal and Accounting Groups
In-house corporate groups that customarily deal with leases may not appreciate the value of heavy front-end investments in owned space. Conversely, groups used to occupying space they own may resent the absence of amenities and creature comforts in “lean-and-mean” leased space. They may likewise resent and resist the influence of a new lender in determining tenant mix.
Reeducating Corporate Legal and Accounting Groups
In-house corporate groups that customarily deal with leases may not appreciate the value of heavy front-end investments in owned space. Conversely, groups used to occupying space they own may resent the absence of amenities and creature comforts in “lean-and-mean” leased space. They may likewise resent and resist the influence of a new lender in determining tenant mix.
Reeducating Procurement Groups
Contracting firms may make serious blunders by trying to buy leases or construction the way they buy standard services for their mainstream business units. The approaches, methods, and techniques of buying real-property-related services are almost always unlike those used elsewhere in a business, and many procurement groups seriously underestimate these differences. The results include faulty cost estimates, unrealistic time frames, contract disputes over scope of work, and nonconformance to contract stipulations.
Tenants Moving to Owned Space
These tenants are often unwilling to accept additional long-term consequences for decisions they make concerning their space. A large-scale exodus from leased space back to corporate-owned space may result as hoteling increases among field-based staff. Financial decisions, especially about tenant improvements, are likely to be given greater scrutiny, and greater financial performance will be expected.
Ultimately however, a company’s organizational posture will be subordinate to the objectives of the owner with the resources available to accomplish them.
This article is adapted from BOMI International’s Real Estate Investment and Finance course, part of the RPA and FMA designation programs. More information regarding this course or the BOMI-HP™ credential is available by calling 1-800-235-2664. Visit BOMI International’s website, www.bomi.org.