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Good Space In Bad Times

By Heidi Schwartz

In the recent past, facility executives in the manufacturing sector were frequently forced to settle for properties that were merely acceptable. But in today's slowing economy, industrial fms are in a stronger position than ever, which means two things: better than expected renewal terms when existing leases expire, and attractive relocation terms at new facilities.

The latter option encourages industrial fms to upgrade to modernized facilities with better physical characteristics. This means deeper truck courts (110' to 120') that are better equipped to accommodate longer trailers. It also means higher ceiling clearances (26' to 30') and racking systems that permit storage of more products in the same square footage.

Concessions Being Made
Most landlords are aware that a facility professional with a specific space requirement now has many available properties from which to choose. Furthermore, many of these competing properties have already been vacant for several months.

In areas with softening real estate markets, concessions being offered by landlords include the following.

Higher allowances for interior up fit. At any given rental rate, a landlord expects to invest a certain amount to modify an available space to accommodate the needs of a specific client. For example, a landlord with a 20,000 SF space that is in "shell" condition in a new multi-tenant building might propose a rental rate of $5 per SF. An allowance of $6 per SF ($120,000) is to be used to construct the office area and outfit the warehouse with basic heating and lights. In a softening market, the client whose up fit needs exceed the proposed allowance may find that the landlord is more willing to provide a higher allowance without a corresponding increase in the proposed rental rate.

Up front, rental abatements (free rent). Most investment real estate is valued on a capitalization rate basis. Thus, an investor requiring a 10% rate of return would be willing to pay $35 per SF for a leased property that provides a net cash flow of $3.50 per SF. Because of this valuation system, many landlords would rather offer free rent and maintain their "face rate" versus lowering the rate and therefore the value of the property.

Shorter lease terms. Back filling vacant space can be an expensive proposition, so most landlords prefer longer lease terms and annual rental escalations. Occupants, on the other hand, may have difficulty projecting their space needs far into the future. Some may want to use soft market conditions as an opportunity to lock in low rates. Companies for whom flexibility is the more important issue, however, may now find that landlords are willing to offer shorter terms of three to four years (instead of five to seven years) in response to more competitive market conditions.

Lower lease escalations. The relatively tight market conditions of recent years have enabled landlords in many areas to demand annual rental rate increases in the 3% to 6% range. Softening markets are now reversing this trend and minimal or even flat rental rate increases are becoming the norm in many areas.

Getting The Best Terms
Whether or not the local market conditions offer an opportunity to "make a better deal," fms and their companies are always best served by a methodical approach to leasing industrial space. This 10 step timeline may help to assure that the most favorable terms will be achieved for the best possible facility. The time period given here–six months–represents a useful rule of thumb; however, the actual time varies widely depending on market conditions and the company's willingness and ability to adhere to a structured approach.

Step 1: Define Requirements
People with responsibility for warehousing and/or production may suggest that "bigger is better," while financial officers may point out that "smaller is cheaper." Geography is almost always a factor because of the need to maintain reasonable proximity to existing employees, suppliers, customers, and transportation arteries.

Obvious physical needs include total square footage, ratio of finished office space to unfinished production space, and ceiling heights. Sometimes, less obvious factors must also be specified, such as electrical capacity, floor loading capacity, front versus rear truck loading, auto parking, and availability of public transportation. The expense of moving and the lengths of lease terms also require that future growth be taken into consideration.

Step 2: Develop An Inclusive List
A wide net should be cast to develop a list of properties that might fit the defined requirements. At this point, it is important to keep an open mind so good candidate locations aren't overlooked. Depending on market conditions and the nature of the requirement, an expanded list of properties might include between 10 and 15 locations.

Step 3: Tour Properties
It is usually worthwhile at least to drive by all the long list properties; most of the properties will warrant a thorough inspection. It should be noted at each candidate property what improvements would be required in order to bring the property in line with the stated requirement: cleanup, office modifications, power upgrades, lighting changes, etc. If the landlord representative is on site to unlock the building, the property tour can also provide an opportunity to gain a sense of how aggressively the property is marketed.

Step 4: Develop A Short List
After comparing the company's defined requirement to the properties toured in Step 3, a fairly obvious list of three to five candidate properties should emerge, and proposals from the owners of these properties will be solicited. Again, consensus among the members of the company's management is of great importance.

There may be a temptation to maintain a long list under the assumption that more landlords pursuing the project will lead to proposals that are more competitive. Often the opposite is true; a landlord who knows his/her property has a one in three chance of being selected is three times as motivated as he would be if he has only a one in10 chance.

Step 5: Requests For Proposal (RFP)
The next step is to create a competitive environment for the company's tenancy. An RFP is typically two to five pages long, depending on the size of the project in question and the finish requirements involved. Common sense should be exercised when deciding on the level of detail to include in an RFP. A five page RFP for a simple 10,000 SF warehouse requirement would seem excessive to most landlords. The RFP should stipulate the tenant company's requirements and should address lease term, occupancy date, and other relevant business points.

Step 6: Analyze Responses
When reviewing RFP responses, company officials should ensure that comparisons are done on an "apples to apples" basis. At the proposal stage, most developers offer an allowance for tenant improvements, especially in the case of properties that are in "shell" condition. In some instances, these allowances are not stated explicitly in dollar amounts, but instead are offered in terms of "landlord will provide 6,000 SF of standard finish office space." This is not useful for comparison purposes and further probing is appropriate to obtain specific data (including operating expenses that are to be passed through to the company).

Frequently, industrial properties are leased on a net basis, requiring occupants to reimburse the landlord for property taxes and insurance. Passing through expenses for common area maintenance has also become a commonplace practice. In recent years, landlords have also begun to pass through expenses for roof and parking lot repair. Misunderstandings at this early stage about improvement allowances, definition of operating expenses, and other factors can lead to some kind of major confrontation later on, so clarity is very important.

Step 7: Negotiate Business Points
Once a preferred property has been selected, the negotiation process begins. An offer is usually sent to the selected landlord by the company. This offer generates a counter offer, and hopefully a mutually beneficial agreement is struck between the parties.

The agreement should be documented by a letter of intent that outlines all relevant points. The letter of intent, while usually not legally binding, details the intent of the parties and provides a basis for negotiating a formal lease document.

In the case of projects involving significant improvements, adequate architectural drawings must be created (hopefully at the landlord's expense) to allow contractors to price out the proposed improvements. Without drawings to generate construction pricing, finish allowances are meaningless. Any architectural drawings should be referenced by the letter of intent.

Step 8: Negotiate Legal Points
The letter of intent is generally used by the landlord as the basis for generating a draft lease document. Then the respective attorneys for the landlord and company work out the final details. If the letter of intent is appropriately thorough, the attorneys will only need to focus on refining lease language. Attorneys also typically address issues such as condemnation, insurance limits, and liability.

Step 9: Construct Improvements
While the landlord is up fitting the space in accordance with the lease agreement and drawings, the fm will be planning for the move to the new location. This period provides an opportunity to arrange for installation of telephones, computer cabling, and equipment hook-ups, but the timing of these events must be coordinated with the landlord's contractor so as not to cause delays.

The finish construction period varies depending on the size of the project, dynamics of the construction market at the time, availability of materials, and local permitting requirements. Painting existing walls and replacing carpet might require only two to three weeks, while a complicated project in an area with lengthy permitting requirements might take three to four months.

Step 10: Punch List
Once improvements have been completed by the contractor, a final "walk through" meeting is scheduled. Attendees at this meeting might include: the fm and other representatives of the company, the landlord's representative, the contractor/subcontractors, and the architect.

It should be confirmed that all improvements called for in the drawings have been put in place and are working properly. Any open issues should be documented and responsibility for addressing the issues should be clearly assigned. If problems are brought up weeks or months later, it may be difficult to get subcontractors who have moved on to other jobs (and who have already been paid) to return for repairs.

Getting It Done
It all boils down to six months and 10 easy steps. The problem, of course, is that none of this activity takes place in a vacuum. Each person who works for the company already has at least one full time job before any of this begins, and few companies have on-staff employees with experience in securing new facilities and negotiating leases. In fact, most companies conclude that an outside advisor is needed to navigate this process.

Because landlords have limited resources and cannot possibly track the activities of all corporate space users, they budget to pay commissions to licensed brokers who bring prospective occupants to their properties. Sophisticated companies interview several broker/advisors and select one company to represent their interests. This arrangement assures that the commission budgeted by the landlords is put to work on behalf of the occupant company.

If sales of a consumer good lag, the manufacturer may have to offer discounts, rebates, new financing terms, and product modifications. From a landlord's point of view, empty space is unsold product. As more space sits empty, industrial companies have the opportunity to use a methodical, professionally managed approach to assure they get the best facility in the best location on the best economic terms possible.

–Ed Riggins, CCIM
Riggins is executive vice president of Atlanta, GA-based CRESA Partners of Georgia, LLC. For more on CRESA Partners of Georgia, call (404) 257-8866 ext. 233 or e-mail Riggins at eriggins@cresapartners.com.