CRUCIAL FACTORS TO CONSIDER BEFORE PURCHASING COMMERCIAL REAL ESTATE

Whether you are looking to start a new business venture, to move your corporate headquarters, to expand to an additional location or to move to a new factory choosing the ideal commercial real estate property can have a profound effect on the success of your business and your personal net worth/estate planning. This newsletter provides a list of considerations to contemplate and pitfalls to avoid searching for, evaluating and eventually obtaining ownership to commercial real estate.

  1. Choosing the proper location: The age old adage in real property is “location, location, location.”  In considering locations, it is very important to consider locations that are ideal for your business. Different types of businesses have different location needs. Retail chains not only need high traffic/exposure, but need exposure to its target market. A posh, high end retail chain needs to be in an affluent neighborhood like SoHo or Rittenhouse Square whereas a McDonalds or Wendy’s will thrive at a local truck stop or an inner-city location. A manufacturing plant or warehouse needs convenient logistical factors such as access to highways, rail,  shipping,  a central location to customers or suppliers plus the  potential of finding and applying for applying for federal and state real estate tax credits. Once you examine and evaluate your requirements, you can start selecting a subset of actual locations to review that fit your needs in the areas that  serve your needs.
  • Be realistic about space needs: In addition to the location, having real property properly sized with sufficient square footage for your current and future business activity is essential. Do not purchase a factory or warehouse too large if you do not plan to use the additional space during next five to ten years unless the excess space can be rented during the non-use. On the other hand, do not purchase a factory, warehouse or office building too small and spend substantial money on the new location only to find that you have outgrown the new property in two to five years. Then again, for a small startup where the prospects are still unknown it may be smart business planning not to spend large sums for bricks and mortars until the business is proven successful.
  • Decide whether to purchase or rent: Purchasing versus renting comes down to three simple variables:  1) whether market conditions makes one more cost effective than the other; 2) whether you need flexibility during the foreseeable future or can commit to a commercial real property for the next 15 to 20 years; and, 3) whether you need/desire control over the property.

In some real estate markets rents are out of line with fair market value or purchase price of the property or vice versa. It may cost $25,000/month to own the property (excluding principal amortization) versus $15,000/month to rent the same facility. In such an instance, renting may be the better option whereas on the other hand owning may be the better option if the monthly cash outlay is not substantially higher. This is a variable that must be examined.

However, renting is more appropriate if you need flexibility, do not have the capital or credit to own, or cannot commit to one location for the next 15 to 20 years. In such an instance, it is better business planning to rent to learn the market and expand the business before obligating millions of dollars of capital on purchasing a factory, warehouse or office building when such funds can be better used to grow sales.  Nevertheless, if you have a stable business and   understand and comprehend your current and future sales, growth and cash flow, it may be in your best interest to commit to purchase a desirable piece of commercial real estate for your business. Finally, if you need/desire control over your location owning may be the better option.  This is especially true if you are afraid of the landlord raising rents or not permitting you to make improvements to serve your business needs and expansion requirements.  However, if you have the option to move to another location if the landlord becomes difficult or obstinate or increases rents, then renting may be your option.

  • Do not solely rely on public listings: Properties on public listings are third or fourth pickings after other real estate professionals have passed on the opportunity. Many properties are offered to friends, business partners, family members, private clients, private developer lists, private listings through private brokers, before they get to the public market. While you may not be a real estate developer requiring an ear on every possible opportunity, the use of private brokerage firms or networking with developer friends/associates will help tremendously.
  • Failing to fully perform due diligence: Due diligence before closing is important to ensure what you are actually purchasing or renting is what you intended it to be.  You do not want to get blindsided after the fact. This includes profitability analysis, cost analysis, environmental studies, if applicable, traffic/population studies, title insurance/searches, physical inspections, and appropriate zoning for your use. Below is a non-exhaustive list of considerations and factors  during due diligence:
  1. Avoid relying on the broker too much: Realize that brokers only get paid if a real estate transaction closes. They receive no extra compensation if you are able to close on an excellent real estate transaction, unless they anticipate future work from you or your referrals. That is to say, absent being an active real estate investor, you may not purchase another   property for another 10 to 20 years. Therefore, take their information, oral promises and assurances with a grain of salt.  Confirm it!
  • Underestimating improvement/upfront/ongoing costs and the time involved: Many individuals look at the purchase price and the ongoing operating costs of a property, but fail to give a full weight to certain upfront costs and accurate improvement assessments. Major upfront costs including transfer taxes, title insurance, business permit fees, professional fees to draft agreements, surveys,  brokerage fees,  bank fees and expenses, relocation expenses plus lost personnel time  can be substantial and,  if properly evaluated, affect your decision. Additionally, it is important to not underestimate improvement costs, the time it will take, and potential overages that may occur for both of them. If anything, it may be best to overestimate them where any slack will be a bonus. This helps ensure you do not purchase a property for $3,000,000, expect to finance the purchase price  over 30 years and have the new factory, warehouse or offices fully operable in 12 months, but suddenly you find the total purchase and improvement budget is now $5,000,000 and it will take a full 27 months to completely relocate.
  • Title search/insurance: This may seem like a basic pitfall, but some people try to save a dollar. Always get title insurance by the title clerk you choose, not the real estate agent or seller. Even if the property is inexpensive where, for instance, the purchase price is $250,000 it is still good to obtain title insurance as you never know what liabilities are attached with the property. There could be $100,000 of back property taxes or a $200,000 judgment on the property. It is always better to have the title searched and insured by the title clerk chosen by you.
  • Local zoning/ordinances: Make sure the existing zoning/ordinances do not interfere with your current or future use of the property such as lot size, height, density, sidewalks and street lights.  If you intend to put a bar in the location, makes sure there is not any restriction because it is located within 500 feet of a school or church. If you intend to use certain hazardous materials within the property, make sure there are no restrictions. If there are, it is mandatory there is a zoning contingency requiring a variance included within the Agreement of Sale.
  • Environmental issues: While environmental issues are less prevalent for residential properties, for commercial and industrial properties environmental due diligence is necessary to avoid any potential Superfund liability, especially if the property has oil tanks, or had prior uses that may indicate the use of environmentally hazardous materials on the property like gas stations, printing plants, dry cleaning plant, car washes, auto repair/maintenance facilities, industrial facilities, commercial properties with Leach Fields or drywells, etc.  The Superfund Law imposes liability on parties responsible for, in whole or in part, the presence of hazardous substances on the site.   The due diligence  starts with a Phase I Environmental report which  identifies any potential significant environmental risks in the subsurface due to previous  uses at the subject property  or from nearby properties.  If there are risks present a Phase II Environmental Site Assessment must be performed by highly-qualified professional engineers to reliably assess contamination risks including the testing of soil, soil gases and/or groundwater for possible contamination.  That is to say, a Phase I or II report can help save your company substantial monetary fines before you purchase a property due to a Superfund cleanup! 
  • Avoid making purely emotional decisions: Avoid making purely emotional decisions such as letting your ego get in the way or simply relying on a gut feeling without any further analysis.  It is important to perform a proper objective analysis including a cost analysis; a business needs analysis, environmental, title, structural, and area survey. This avoids making a suboptimal decision that may be fine at closing, but could really hurt you and your company in the future.
  • Failing to take into account the correct entity structure: Many owners try to purchase the property in their individual name or in the name of the active business entity you intend to operate at the location. It is better to create a separate limited liability entity for the purchase of business real property. This helps to insulate the liabilities of the underlying business from the real estate and vice versa. This also creates flexibility in the future if you either want to sell the business but retain and rent  the real estate, or sell/rent the real estate but sell or transfer the business. Just as important, titling heavily financed real property in a separate legal entity is an excellent estate planning tool and technique to transfer wealth to your children without the use of your federal unified estate tax credit.

While this is not an exhaustive list, this newsletter raises many important issues business owners who intend to purchase office buildings, factories or warehouses must fully assess and evaluate before a bad purchase puts a major strain on the current and future cash flow and profitable operation of your business. If you are looking for a new facility/location, it is extremely important to get your advisors in the process early so we can help you avoid making some of these pitfalls and help ensure you make the best decision for your business and personal wealth/estate planning.