David Weisman, Esq.
Board Certified Real Estate Attorney
When is a bargain not a bargain? With financial institutions and semi-desperate sellers anxious to dispose of an underperforming property, investors find that there are very attractive properties being offered at below market value. What they perceive to be an incredible bargain may be a result of only looking at one aspect of the valuation, which is the purchase price compared to normal market conditions.
What causes these properties to be offered at such a deep discount off of the normal value is typically a decline in income, due to an extraordinarily high vacancy rate. The purchase price reflects the operating income of the property. A savvy investor sees a great bargain, and buys the commercial property fully aware of the empty spaces, and with the hope that tenants can be found, the operating income of the property will improve and accordingly the value of the investment will increase. This strategy is referred to as value added investing.
While the market is recovering, the demand for retail space and office space is not as strong as some investors would like. Particularly if the bargain property includes a large block of vacant space, it may be more difficult to find a tenant. Another factor not always considered, is the capital required to renovate the vacant space in order to make it ready for a new tenant. While smaller space can be cleaned up and turned back into a vanilla shell to be marketed quickly, larger space is usually custom prepared for a particular user. If the prior occupant left the space in less than pristine condition which is often the case in a distress situation, the space they have may be unattractive and much more difficult to lease.
Another problem with bargain properties is deferred maintenance. The prior owner, struggling to meet debt service requirements, may have neglected major repairs or even periodic maintenance which results in the property being in less than desirable condition. The investor who picks up the bargain property must allocate sufficient capital in addition to the purchase price to take care of deferred maintenance and to restore the property to a condition which will be satisfactory to existing tenants and attractive to potential new tenants.
The process of acquiring bargain property is often hurried. If the property is owned by a financial institution, factors such as end of the year or end of the quarter reporting results in a push to close the sale more quickly than in a typical commercial transaction. Investors who are anxious to take advantage of the bargain often agree to a very short inspection period or even waive the typical due diligence contingency. This may not allow the investor enough time to analyze the extent of the deferred maintenance and results inadequate allocation of sufficient capital to deal with the property in the months following acquisition.
Once an investor gets past all of these issues, there is still the ongoing expense of carrying costs which, while anticipated during the planning process, may become financially burdensome as more time passes and the larger spaces within the property remain vacant. Whether the investor was able to pay cash or has to carry an acquisition mortgage, there is still a negative cash flow potential. There are also the expenses of taxes, insurance, and routine maintenance. Even if a portion of the property is rented, pass-through expenses are not being collected from the vacant space.
In order to fill the vacant space, it is not uncommon for investors to accept a reduced rent from a new tenant, or even to offer rent-free occupancy for an extended period of time in exchange for the tenant agreeing to take the vacant space in “as is” condition. This eliminates a need for an immediate infusion of capital to renovate the vacant space, but further delay its positive cash flow while the tenant enjoys an extended rent concession. It is important for the landlord to protect itself against certain risks in this scenario.
First, if the tenant undertakes the renovation of the space, the landlord must be certain that the tenant had adequate cash to finish the work, pay the contractors, and prevent liens from being filed against the property. Secondly, the landlord must be certain that the tenant is going to remain in possession and operate beyond the period of the rent concession. One way to protect against this possibility is for the landlord to spread the rent concession over several months in each of the first several years. In some cases, tenants may complain that they cannot afford to pay current rent at the same time they are being required to invest capital into the renovation of the space.
Ultimately, a smart investor must carefully analyze the financial condition of the property which is perceived to be a bargain. A simple question would be: why did the prior owner lose or give up the property? Detailed due diligence, planning, and budgeting can keep a bargain from turning into a nightmare.
David Weisman, Esq. is a shareholder with Greenspoon Marder’s Real Estate Group and has been board certified in real estate law since 1987. He is peer-rated “AV” (the highest rating available) by Martindale-Hubbell. Mr. Weisman’s broad-based real estate practice includes commercial leases, commercial acquisition, financing closings, real estate development, tax-deferred exchanges, landlord/tenant disputes and zoning and title issues. For more information, contact Mr. Weisman at 954-491-1120 or firstname.lastname@example.org.