This week, I had the pleasure of advising a family. Held as income properties were two parcels of commercial real estate which had been in the family for years.
As the ownership morphed over time due to succession, the heirs were looking for counsel – thus they contacted me. The conversation which ensued I believed was column-worthy – so here goes.
As a qualifier, these folks are arms-length investors – they reap the rent the buildings generate and do not occupy either building with a business.
So, if you own commercial real estate as an investment, I believe the ownership directions are fourfold:
Continue to own and manage the buildings. Vacancy throughout the term of ownership has been minimal – the family has managed to keep the spaces filled by offering below market rents. This is a great strategy for a long-term hold. Avoided is the origination of a new tenancy which costs time – abated rent and vacancy – and money – tenant improvements and broker fees. In some instances, originating a new lease can consume 25% of the expected rental revenue! Wow. That’s a big bite just to nudge a tenant up to a market rate and risk them moving.
The next three scenarios could potentially generate a taxable gain – which is the subject of another column.
Sell the buildings leased. Remember those rents at below market rates we discussed? Yeah. That is the downside of selling the buildings leased. You see, the value is determined by the cash flow produced – less cash flow equals less value. So, if your desire is to maximize your sales price by selling with tenants in your commercial real estate, you should consider moving the rents to market – potentially suffering the vacancy and re-letting. Easy math would analyze the expected increase in the selling price minus the cost to re-rent the buildings if necessary.
Sell the buildings vacant. Your ideal buyer for the real estate may be the tenants the buildings house. Afterall, they are in residence and may dream of owning the space they occupy. Approach them. If you receive “no interest”, explain your strategy of allowing their leases to expire and locating an owner occupant to buy the buildings. Their tenor may change. In most cases, an occupant will pay more than an arms-length investor – because occupants look at utility – investors at their returns.
Scrape the buildings and sell the land. Sadly, at some point, the improvements eclipse their useful life and the underlying land is worth more than the land with a building. You’ll need to take a look at the necessary upgrades – roof, air conditioning, seismic, parking lot, plumbing, electrical, etc. A review of the costs to bring the building up to “market standards” will help you determine the value of your building improvements – and whether they are worth salvaging.