Why You Can't Afford to Ignore Vacancy When Buying Commercial Real Estate

Firstly, what is vacancy?

Vacancy is the estimate, usually based on historical data for a given property or property type within a given market, of the amount of space within a building that is typically vacant and is usually expressed as a dollar amount per foot or more commonly as a percentage of gross rent.

Vacancy is one of the most overlooked expenses, in my experience, when dealing with individual investors. For some reason, most people have a hard time believing that their building might not be 100% full 100% of the time.

Is this reasonable? Not even close. Especially in the current economic climate where vacancies are still climbing and businesses aren't expanding at the same rate that we've seen over the last decade.

As part of your due diligence when analysing a property you should always include a vacancy expense in your pro forma - even if the building is full at the time of the analysis. The building won't be full forever!

Don't misunderstand - some vacancy is good for the market. Shocking, but true. What happens when times are good, and growing businesses can't find vacant space to move into? They risk stagnation and missed opportunities. So a little vacancy is a good thing, but rampant vacancy is obviously harmful too.

How much vacancy is healthy? Well that really depends on the property type and the general market. Residential income properties generally use 5% as a normal vacancy rate (at least in my market), but storage properties typically run anywhere from 10-20% vacancy in healthy markets. The key is to do your research and try to find out the prevailing vacancy in your market and use that as a benchmark for comparison purposes.

Failing to factor in a normal vacancy rate in doing your financial forecasts can be deadly to your bottom line, especially when there's little room for error in a tight market.

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Adventures in Commenting. D'oh!

I owe anyone who has tried to post a comment to this blog an apology. Seems I tested just about everything but the commenting function. It never occured to me because I never thought about the need to comment on my own blog. But after 40-odd posts over the last little while and growing traffic, I was wondering why I wasn't getting any feedback at all from you. So I checked it out and it turns out it was an error on my part.

Sorry about that.

But it's all fixed up now, and I look forward to reading what you have to say in the very near future. For example, what kind of articles would you enjoy reading about on the topic of commercial real estate? If it's something that I know a little about, I'd be happy to give my take on any subjects you might suggest. Thanks!

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Tax Harmonization in Ontario - The Big Grab

Boy, have I got a bone to pick with the Ontario government this week! Several, actually. Yesterday was my rant about proposed energy audits. Today I'm going to write about Sales Tax Harmonization, or as I like to call it, The Big Grab.

The Ontario Government has put up a page explaining their position and the 'benefits' of making this move, you can read it here. Pure propaganda, if I've ever seen it. What really ticks me off is that they have the nerve to use terms like: transparency, fairness, job creation, and economic growth. Hogwash.

So what's it all about? They're proposing a change to sales taxes in Ontario a la the maritime provinces. No more separate PST and GST, both would be rolled into one tax, the HST. A 13% tax on just about everything you buy, including services that aren't currently taxable provincially - like real estate commissions. On the surface it doesn't look that bad as there are some exemptions that will be continued. Things like books, children’s clothing and footwear, children’s car seats and car booster seats, diapers and feminine hygiene products will still be exempt. What they don't offer, though, is the things that will now be taxable at a higher rate. Things like new homes and real estate commissions.

Firstly, new homes. Now I don't sell new homes and I have absolutely no desire to get into the market, but many of you do buy these properties or broker them on behalf of clients. Did you know that the sale of some new homes will cost tens of thousands of dollars more under this new tax scheme? I can hear the arguments already, "There's a rebate up to $400,000 and a reduced rebate for homes between $400,000 and $500,000. What about that? Doesn't that make up for it?"

Not really, no. According to the Ontario Home Builders Association (OHBA), in a recently released leaflet, fully 41% of new homes sold in centers with populations over 50,000 people will be subjected to tens of thousands of dollars in NEW taxes. That has the potential to, dare I say will certainly, impact new home sales and construction activity in this Province. At a time when the economy is suffering, should one of our main economic drivers be hamstrung in this manner?

Now you might be tempted to think, "That's just NEW homes though; there won't be any other negative effects on the housing market." How wrong you'd be! If your house sells for $300,000 and you negotiated a commission of 5.5% with your REALTOR®, then the fee would be $16,500 plus taxes. Today that tax amount is just 5% or $825 - after the HST comes into effect your new tax burden will be $2,145! That's an increase of $1,320 or a 160% increase! And just where is that money supposed to come from? I feel for you, dear consumer, but my kids still have to eat - I can't justify just dropping my fees because the government passed a new tax.

The McGuinty government claims that the impact to most families shouldn't be more than $70 per year in increased costs. But don't worry, they're going to give you your own money back in the form of a $1,000 pay off. The McGuinty government claims that businesses will benefit because they'll now be able to more affordably buy new equipment to keep people employed manufacturing goods. There might be some truth in this one, and I applaud them for thinking about how to keep Ontarians working.

Just a few questions though, and feel free to comment below - I'd like to hear what you have to say:

1. If sales tax harmonization (STH) will 'only' cost $70 per year in new taxes, why are they willing to 'give' families $1,000 each? Could it be to buy them off? Could it be a bit of a carrot so that people don't complain? Who couldn't use a little extra money right now? I could. Baaaa.
   
2. If STH will benefit business so much, why are they providing $4.5B in tax relief to businesses to offset the cost of new taxes? Could it be to buy them off? Could it be to provide the illusion of doing more for our manufacturers?
3. They claim that consumer prices dropped in the maritime provinces by something just short of 2% after STH was introduced. Why then, do they estimate that it will cost consumers an extra $70 per year?
4. What extra benefit does the hard working Ontarian get from this extra $70 per year in increased taxes? And don't tell me it's the $1,000 pay off! That's already your money! You just gave it to them in April when you did your taxes!

When has this government EVER given us something with one hand without taking more back with the other? EVER?

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Yet More Mistakes When Selling Commercial Real Estate

Not using net leases.
One of the most common mistakes I see with landlords who own smaller properties or who ‘like to do things the old way’, is failing to use net leases and to enforce them when they exist.I guess we need to back up a little.

What is a net lease? Well that depends on who you talk to. The terminology changes from region to region, but what I mean by a ‘net lease’ is this: the tenant pays you a base rental amount out of which you pay yourself and your mortgage company. All of the other expenses, and I mean ALL of the other expenses, are paid by the tenant either directly by being billed by the utilities and tax office or through you in the form of ‘additional rent’ out of which you pay the expenses on the tenant’s behalf.(Don’t forget to factor in a management fee if you are administering the expenses! For a list of common expenses that you should be charging to your tenants, please email me.)

What do net leases do for you and why are they important when you decide to sell the property? Net leases provide you with tremendous security versus gross leases (where all expenses are included) by providing a natural buffer to variable expenses like gas, water, electricity, and even realty taxes which can vary wildly from year to year. In a net lease you know exactly what your bottom line will be in each year of the lease because the expenses are dealt with separately. When you finally decide to sell the property, it becomes much easier for the prospective buyer to analyze the cash flow and hence the suitability of the asset in meeting their investment goals.

But aren’t gross leases easier to explain to tenants? Isn’t it easier to lease space at a flat rate and on a handshake? Maybe. But is the risk worth this small savings in time? Wouldn’t you rather have a tenant that truly understands the cost of operating the building? Would you rather not have your income eroded every year by skyrocketing energy costs and ramped up tax bills?

A gross lease might be easier to explain, but in the end you only hurt your bottom line. At the time of sale this can result in a markedly lower sale price. Risk is commensurate with reward, right? Well if I’m going to take on the risk of gross leases and a variable bottom line, shouldn’t I get a better return on my investment? Of course! How do I get a better return? By paying you less for your property!

As your gross leases expire, you really should consider moving to net leases. Once you do, enforce them! If costs go up this year, do a reconciliation at year-end and charge your tenant for them and allow for those increased expenses in your estimate of the additional rent you’ll need to charge next year. Your cash flow will improve, your stress level will go down and your equity will go up!

Failing to use a Commercial REALTOR®
I’m going to tread carefully here, because, under no uncertain terms would I ever say that your REALTOR® can’t help you with your commercial real estate transactions. Your REALTOR® has worked hard to earn your trust and wouldn’t do anything to intentionally harm you or your business. They’ve worked hard, they’ve trained hard, and they’ve gained experience in their field.

Nice things said. Time to move on.

Would you go to your dentist if you needed to see someone about a sudden bout of chest pains? Of course not, you’d ask to see a cardiovascular specialist at the earliest possible time. While I maintain that there is no such thing as a real estate emergency, the principle is the same; you should see a Commercial REALTOR® when you want advice about commercial real estate and a REALTOR® who specializes in farms when you want to buy a dairy farm and a waterfront REALTOR® when you want to sell the family cottage. When you need to sell your home you naturally seek out the best residential REALTOR® you can find. If they all happen to be the same person, and that person has the training and experience to see you through all of these processes, great! There are a lot of generalists in this business who do an excellent job for their clients.

If you want truly specialized service however, be sure to speak with a number of REALTOR®s. Ask them a few questions: Have you ever done this kind of business before? What additional training have you taken? How long have you been practicing commercial real estate? Do you belong to any commercial real estate associations like the Canadian Commercial Council? Could I speak with some of your past clients? What exactly will you do to market my property differently?

Most REALTOR®s want to do a good job for you, and most will work hard for you. Just be sure you find the one that you can work with and who can demonstrate the expertise you need.

Just don’t be surprised to find that it’s you who’s being interviewed!

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Still More Mistakes Made When Selling Commercial Property

Underestimating the time needed to fully expose the property to the market.


I know what you’re thinking, “You REALTOR®s are a crafty bunch! I just know that you can get this property sold quickly, but you want it to sit around to generate calls so that you can go off and sell someone else’s property so you can make more money! Greedy so-and-so’s....grrrr."

No. We don’t.

What often gets forgotten here is that we don’t get paid until the property is sold and the commission cheque is cut. Until that point, we’re out of pocket and want to get paid sooner rather than later. That isn’t a problem for us, that’s the way it’s done, and we wouldn’t be doing this if we felt that the system was unfair or not equitable for all parties. Please don’t think that, because your property doesn’t sell quickly, your agent isn’t working hard on getting it sold.

Using a short listing period as some sort of cattle prod to try to get your agent moving more quickly is just a recipe for reduced effort on the part of your agent. Yes, you read that correctly; it takes a great deal of effort and time to get a successful marketing campaign off the ground. This is especially true if your commercial REALTOR® uses targeted marketing and develops new databases specifically to sell your unique property. It might take a few weeks to start hitting the right segment of buyers and several more before they start looking at it seriously and several more before they consider making offers. If there isn’t an expectation that your agent will have time to actually go through this process before the listing expires, then who’s to say that the effort will really be there? I’m not saying that there would be any insincerity or lack of will on the part of the agent, but if you won’t trust your agent with a reasonable listing period, why should they trust you to work with them in the long haul and how can you expect a full marketing effort with not enough time to perform?

Since January 1, 2008, it has taken an average of 132 days (just over 4 months) to sell commercial listings on the Peterborough MLS® (data from Filogix database as of 11:00 am on January 23, 2009). Still think a 60-90 day listing period is reasonable?

Not providing enough information about the specifics of your property.

There are a great many things your REALTOR® will need to know to adequately be prepared to offer your property for sale. Failing to provide enough information and worse yet – concealing defects – will cost you time and money in the process. You want a buyer to be able to make a buying decision quickly and easily; the best way to accomplish this is to provide as much information as you can right up front.

This does a couple of things for you: it simplifies the due diligence process once you’ve obtained an offer making the process quicker and easier, and it pre-qualifies the buyers. How? If you have a building with 10 apartments showing a really great return it should attract a fairly sizable pool of buyers. But what if your building has an historical designation that also required a certain level of care beyond what is normal in an investment of this type? This isn’t necessarily a detriment to the property, but it probably eliminates a few of the buyers who might have long term visions of conversions or redevelopment. Why not weed out those buyers with extra information before you and your agent spend a great deal of time trying to get showings arranged and offers presented only to find out that the property ‘isn’t what the buyer had in mind’.

Provide ample information up front and shorten the time it takes to get an acceptable offer – and usually for more money.

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More Mistakes When Selling

Trying to ‘Keep it Quiet’
Occasionally a seller will approach to ask for assistance in disposing of a property ‘on the q.t.’. “I really don’t want everyone to know it’s for sale, but go get me a buyer and I’ll gladly pay you a big fat commission!” My first question is, what’s the big secret? If you want to sell your property don’t you want to realize the most money possible from a sale? Don’t you think that if more people know about it, that might generate a little competition for it? Granted, the current economic climate makes this more unlikely, but the concept stands ;)

The only time I agree with sellers who want to ‘keep it quiet’, i.e. not announce to everyone that the property is for sale, is when there is an ongoing business included in the sale. In these instances, there is a small risk of a flashback against the business itself which might harm both the seller’s cash flow and their ability to attract a ready willing and able buyer as a result of reduced profitability. An uneducated public (non-business owners who are unaccustomed to operating and selling a business) sometimes get the mistaken impression that every business that is listed for sale simply must be failing and should therefore be avoided like some kind of biblical leper. While it’s true that a lot of poor businesses wind up listed for sale with a REALTOR®; that’s because the seller has usually tried to do it themselves and was unsuccessful. What? You didn’t think we only got the easy jobs did you?!

In point of fact, selling a business is part of business. Properly presented with all of the necessary checks in place to protect confidentiality and trade secrets, a business can be listed for sale on the open market – not as a secret – and sell for a better price as a result.

You’ve got a valuable asset to sell – scream it from the rooftops!

Not allowing signage on the property.
While it is true that signage alone won’t sell a property, it’s like playing hockey with a player in the penalty box. Your REALTOR® uses all of the tools available to assist in attracting the right buyer for your property. One of those tools is the 24 hour sales person, the For Sale Sign. Often, site selectors and investors will drive a city or neighbourhood looking for ideas and one of the best ways to grab their attention is with a well placed professional looking sign.

I think reticence on the part of sellers to allow For Sale signs relates to the ideas I discussed above wherein they have a concern about being too public with the availability of the property.

Why do you think that retailers like to use such large colourful signs? Billboards? Because they alert the consumer to their location and hopefully will attract them into the store to buy something. The real estate For Sale sign is simply making the consumer (real estate buyer) aware of the availability of your product (your property). The principle really is the same.

Don’t make your REALTOR® work with one hand tied behind his/her back, the sign is a helpful tool let them make use of it.

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Common Mistakes When Selling Commercial Real Estate

Over my next few posts, I'm going to go over what I think are some of the biggest mistakes property owners make when trying to sell their commercial properties. These are common to all types of property, and in fact probably translate well to residential properties as well.

Failing to prepare for the sale well in advance of offering the property for sale.
Once in a great while, the need to sell a property comes up quickly – a new contract that necessitates moving to larger quarters is a good example, but for the most part, you should know many months in advance that your company may need to move, or that you'll need to liquidate an asset to move on to another opportunity. As soon as you have any idea that a move may be necessary in the future, no matter how far into the future that may be, you need to start the process of educating yourself and seeking expert advice. Not familiarizing yourself with the market and with current regulations and procedures will cost you money when it comes time to sell.

Not keeping accurate property records.
Document, document, document! Rule number two in real estate, after location, is documentation. When you need or want to sell someday, the more information you can provide the better. Record maintenance done on the building, major repairs, changes you’ve made since you bought, dates of when the roof was last inspected and/or repaired, etc. Buyers love to see a complete history of the building they are contemplating. Make it easy for the buyer to make his decision and you’ll realize a higher price on closing.

Overestimating price.
This is a big one; and there's an important lesson here for both sellers and agents new to commercial real estate.

You've probably heard that home owners think that they live in a castle, the bank thinks it's a quaint home, the appraiser thinks it's a tear down, and the buyers think it's a shack. Somewhere in the middle of all of that is the truth. This applies for commercial real estate as well as residential - I know this from experience! I've gone into many properties, done my research - looked at comparable sales in the area, analyzed cash flows, evaluated market capitalization rates etc., etc. - and come up with what I hope is a reasonable approximation of what the market will bear in terms of price, only to have the owner act insulted and shocked at the range of values I forecast.

"But I've put my blood, sweat and tears into this place! You can't be serious! Surely you can find a big city buyer that'll be dumb enough to pay us this grossly inflated figure!", say some of them.

I know you have, and I know that you do have something of value. But I don't set the market value, and neither do you! The marketplace does. Putting too high an asking price on the property only harms your position. If it's too high, you won't even attract offers. If you're lucky enough to attract prospects at all, and they're interested in the property, many of them won't make an offer because of the fear that they will 'insult' you with their (often realistic) offer. Bye-bye buyer.

Secondarily, if you do insist on a high list price, and your agent is willing to take on an over-priced listing, both of you lose; in six months, when there have been no offers and likely no showings, you are justifiably upset and you probably think that your REALTOR® hasn't been working hard enough - which usually isn't the case. You've just priced yourself out of the market.

Do your research, find an experienced commercial REALTOR® and *gasp* rely on their experience and counsel - that's why you're paying them!

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