Archive for October, 2013

Regal Properties Leads the Pack in 2013 Deal Closings

Less than one year after closing one of the largest retail purchase transactions in the United States, in 2013 Regal Properties has already successfully closed: (1) the purchase of a 40,000 square foot retail center on Cave Creek Road in Phoenix, (2) the purchase from a bank of a broken residential subdivision in Kerman, California, (3) the purchase of a 12,600 square foot automotive center in Phoenix, and (4) the office lease negotiations, on behalf of 22 tenant-in-common owners, for 123,000 square feet of rentable space occupied by US Cellular in Tulsa, Oklahoma.  Before the end of 2013, Regal Properties expects additional closings in the retail, hospitality, land, office, self-storage and residential sectors based on currently pending transactions and activities.

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122,826 Square Foot Office Lease Negotiated with National Credit Tenant in Tulsa, OK

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Regal Properties successfully negotiated on behalf of 22 tenant-in-common owners of a distressed office building in Tulsa, Oklahoma, a lease with USCC Real Estate Corporation (US Cellular) for 122,826 rentable square feet in this Union Pines Building at 4700 South Garnett Road.  Regal Properties has since been retained by the owners to sell the property.

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Shopping Center in Phoenix, AZ

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Regal Properties represented the buyer in the purchase of this 40,000 square foot retail shopping center on Cave Creek Road in Phoenix, Arizona.

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The Shops at Lake Havasu — 704,000 Square Foot Regional Mall Sold by Regal Properties

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Regal Properties represented BOTH the buyer and seller in the purchase and sale of this 704,000 square foot regional mall for less than $22 per square foot, after successfully facilitating an enormous loan write-down and riddance of the seller’s personal guarantee, in what has been referred to as “the commercial real estate transaction of the year.” Regal Properties orchestrated a complex workout with the seller, existing lender and anchor tenant to enable the buyer’s purchase and the seller’s release of liability to the lender.

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Automotive Center in Phoenix generates 11% Cash-on-Cash with Upside for Investors

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Regal Properties brokered the purchase of this 12,600 square foot automotive center in Phoenix, Arizona, which generates a cash-on-cash return of 11% for the investors in year 1, with remaining value-add potential in the lease-up of the existing vacant space, and a projected IRR of 25%.

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Commercial Real Estate Loan Workout Strategies

Increasing vacancies, decreasing rents, negative cash flows, rising cap rates, imprecise valuations, severely constrained financing, and personal guaranties will continue to put severe pressure on over-leveraged commercial real estate owners during the next few years. As the wave of commercial property loan defaults begins to crest, borrowers should be armed and prepared with practical strategies and solutions for dealing with their under-performing properties and maturing loans.

Foresight Analytics recently estimated about two-thirds of the $800 billion in commercial real estate (“CRE”) loans held by banks, maturing in the next 5 years, exceed the value of the property. U.S. bank regulators increasingly complain losses on souring CRE loans pose the biggest risk to lenders. “The most prominent area of risk for rising credit losses at FDIC-insured institutions during the next several quarters is in CRE lending,” FDIC Chairman Sheila Bair recently said. “Prudent loan workouts are often in the best interest of financial institutions and borrowers.”

Consequently, regulators have recently issued new guidelines to help the institutions modify loan agreements. On September 16, 2009, the IRS issued eagerly anticipated guidance of significant help to borrowers with conduit financing (securitized loans). This guidance will allow some commercial mortgage loans held by Real Estate Mortgage Investment Conduits (“REMICS”) to be modified prior to default, without triggering adverse tax consequences to the holder. According to Foresight Analytics, the flexibility recently extended by regulators will apply to about $110-$130 billion of the $800 billion in underwater loans.

Lenders and loan servicers will almost certainly become increasingly overwhelmed and inundated with troubled loans in 2010. Borrowers with distressed properties must prepare themselves to understand and compare all of their options, and then take a proactive and timely approach to alleviating their financial distress.

Maturing Loans

In a maturing loan situation, when no other financing seems to be available, it may be possible to simply extend the existing loan for a fee (usually ½ to 1 point), in order to buy up to 2 years. Under these circumstances, a borrower would be well advised to approach its lender, approximately 4-6 months before the loan matures, with evidence of the borrower’s unsuccessful refinance efforts and a specific proposal for the extension. As part of the proposed extension, the borrower might also request other modifications such as an interest rate reduction, if appropriate.

Good Money After Bad

In a distressed property situation, a borrower should first carefully consider whether it makes economic sense to even try to save the property. Throwing good money after bad makes no sense. In making this determination, the borrower must formulate realistic projections about the net operating income, cash flow and cap rate over the next 1-3 years, and consider the opportunity cost of nursing an ailing property back to health instead of investing the resources into something more stable and profitable. Tax ramifications should also be carefully considered.

Perhaps some equity and profit can still be preserved by a normal sale. However, if the borrower has no remaining equity, and his or her projections show little prospect for a timely recovery, then a short sale or deed in lieu of foreclosure might make more economic sense. Both of these options require the lender’s cooperation, and both may have significant tax and legal consequences, including with respect to previous tax-deferred exchanges and any forgiveness of recourse debt.

Loan Workouts and Modifications

In other situations, modification of various loan terms and other workout possibilities might provide the means for the investors and lender to salvage more of their investment and minimize their respective losses. The workout might include an interest rate reduction, amortization schedule adjustment and, in rare cases, a forbearance or principal reduction.

Several factors can influence the loan workout process. For example, a commercial bank will generally have more flexibility than a special servicer for a commercial mortgage-backed security (“CMBS”), especially with regard to principal reduction. The lender’s willingness to negotiate a workout may also depend on the story of how the property has changed, and whether the proposed modification will fix the problem causing the distress.

Certain strategies will also enhance the borrower’s ability to achieve a desired loan modification. The borrower should approach the lender early, before feeding the property for several months, and before going into default. Though not a necessity, it sometimes takes a monetary default for a CMBS loan to get transferred from a general servicer to a special servicer with workout authority.

Lenders and loan servicers have their hands full now and, therefore, the borrower should make its case easily comprehensible and thorough by including an historical and pro-forma cash flow model, credible and fresh market research, and a detailed strategy for emerging from the distress situation. The borrower must recognize that the lender/servicer desires a sound borrower and asset manager, who contribute to the modification and who will not default in the future. In general, the borrower will benefit by presenting multiple modification options. CMBS loan servicers may also require an illustration of the net present value of various modification options.

Illustration

The following example illustrates some typical differences in commercial underwriting criteria and economics for the same property in 2007 and 2009:

2007 Origination Underwriting

2009 Refinance Underwriting

Valuation/Price

$10,000,000

$4,533,333

Cap Rate

6.0%

9.0%

NOI

$600,000

$408,000

LTV

80%

65%

Loan Amount

$8,000,000

$2,946,667

Required Equity

$2,000,000

$5,053,333 additional

Amortization

Interest-only 2 years of 30

25 years

10 Yr Treasury

4.70%

2.85%

Credit Spread

45

500

Swap Spread

50

25

Total Interest Rate

5.65%

8.10%

Debt Service

$545,455

$275,261

DCR

1.10

1.30

In addition to more stringent underwriting criteria shown in the 2009 refinance column, the NOI in this example decreased after the loan origination in 2007, due to increased vacancy rates, rent reductions, and expenses. Assuming the vacancy rate is now 15% instead of 5%, and rents are now 20% less than they were in 2007, then the NOI might approximate $408,000 instead of $600,000, and the property might easily have gone from having a good positive cash flow to a distressing negative cash flow. Using today’s cap rate of 9%, the property value has plummeted from $10,000,000 to $4,533,333, as shown in the 2009 column, such that all equity has been lost, and refinancing has become economically infeasible due to the current equity shortfall of $5,053,333.

In this situation, the borrower might consider multiple concurrent strategies, including a short sale or deed in lieu of foreclosure (with a release of any guarantor), and a loan modification. The loan modification might include re-amortization over a longer period, with a reduction in the interest rate, and an elimination of principal reduction for a period of time sufficient to allow the property owner an opportunity to fill vacancies and improve rental income. In appropriate situations, the loan modification might even include a discount of the principal balance on the note as a means of incentivizing the owner to continue operating the property at least until it returns to stabilization. However, the lender may also require the borrower to demonstrate its continued financial commitment to the property by putting additional cash into an interest reserve or toward a principal pay-down.

Importance of Consultants

The importance of knowledgeable and experienced consultants to guide the borrower and guarantors through the process of a loan workout cannot be overstated. Borrowers will need to perform objective and sophisticated economic analyses and feasibility studies, income and expense projections, and property valuations. Terms and agreements will need to be negotiated with lenders and servicers. Transactions must be carefully documented for legal and tax purposes. Additionally, even a capable borrower would do well to employ a third party consultant to act as his or her negotiator and intermediary, and to provide emotionally and financially detached objectivity and advice.

In a typical workout situation, the borrower will need a team of professionals which include a CRE lawyer, tax advisor, possibly a broker to provide a Broker Price Opinion to the lender and/or to market the property, and an economic/financial consultant to assist with preparing income and expense projections, forecasts, valuations and feasibility analyses. In some less common situations, other consultants may be beneficial, including bankruptcy counsel and litigation counsel.

Planning and Preparation

Strategic planning and preparation will greatly enhance a borrower’s chances of preserving invested capital, minimizing economic losses, and weathering the CRE storm. Borrowers and guarantors should carefully consider all of their options, and the consequences of each, with the assistance of qualified consultants. Then, if the workout strategy includes a potential loan modification, the borrower should present the lender or servicer with substantiated cash flow models, credible market research, and a detailed strategy for emerging from the distress situation.

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* Larry Murnane is a broker and lawyer in San Diego, California, emphasizing commercial real estate transactions, including CRE loan modifications and extensions. He is also the founder of Regal Properties, a Commercial Real Estate Investment Company licensed by the California Department of Real Estate, which works with a team of experienced consultants handling a variety of CRE loan workouts.

This article is for general informational purposes only, and should not be considered legal, tax, business or investment advice for any particular person or matter. Each situation is unique in some respect, and the law as well as the real estate and financial markets and institutions are constantly changing, such that this article or the information in it may not apply to a particular situation, or may no longer be current and accurate.

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California Real Estate Foreclosure Procedures, Timelines and Strategies for Lenders and Borrowers

This article will provide a general summary of real property foreclosure procedures, timelines and strategies for borrowers and lenders in California.

As a precursor, it helps to understand that the creditor typically has a promissory note evidencing the loan or mortgage, which is secured by a recorded deed of trust. The deed of trust identifies the trustor, trustee and beneficiary, as well as the property securing the note. The truster is the debtor, and the beneficiary is the lender. The trustee is a neutral third party instructed to cancel the note and reconvey the deed of trust upon payment of the obligation, or to foreclose on the property in the event of a default on payment of the note. Trustees will almost always require the original note to do either.

The beneficiary/lender holding a deed of trust may generally foreclose by two different methods in California: (1) judicial foreclosure, and (2) non-judicial foreclosure (power of sale auction). The latter method constitutes about 99% of all foreclosures in California, for reasons discussed below.

Judicial Foreclosure 

A judicial foreclosure requires court action (lawsuit before a judge), and is generally used only to resolve complex and subjective issues and disputes involving the chain of title, destruction of property (“waste”), and fraud. The other primary advantage to this method of foreclosure is the possibility of obtaining a deficiency judgment (i.e., a judgment against the debtor for the difference between the value of the foreclosed property and the amount of the debt).

The primary disadvantage to a judicial foreclosure, and the reason so few creditors choose this route, is that the court action typically takes 8-14 months, at substantial expense to the creditor. The foreclosing creditor usually must hire an attorney to prosecute the case, while the debtor continues to occupy the property (and sometimes intentionally damage and strip it) without making any mortgage payments. Further, the outcome of the lawsuit can be uncertain. For these reasons, very few creditors pursue this method of foreclosure.

Non-Judicial Foreclosure

 A secured creditor may pursue a non-judicial foreclosure if the deed of trust includes a “power-of-sale” clause authorizing the trustee to sell the property for monetary default, as is common. This primary advantages to this method include expediency, relatively low costs, and a more certain schedule and outcome. A non-judicial foreclosure generally takes about 4-5 months to complete if handled by a qualified trustee. The primary disadvantage is the creditor’s inability to obtain a deficiency judgment against the debtor.

The non-judicial foreclosure process basically involves three stages: (1) recording a Notice of Default, (2) publication, posting and mailing of a Notice of Sale, and (3) the trustee’s sale.

In the first stage, the lender/beneficiary informs the trustee that the borrower/trustor has defaulted. The trustee then prepares and has the lender execute a Substitution of Trustee and a Notice of Default, which the trustee then records with the County Recorder and mails to the borrower and other parties who have recorded a Special Request for Notice. The trustee also orders a trustee sale guarantee from a title company. (For owner-occupied residential property, Senate Bill 1137, effective as of September 6, 2008, requires the lender/beneficiary make certain efforts to contact the borrower at least 30 days prior to recording a Notice of Default.) The borrower has a 3-month opportunity from the recording of the Notice of Default to bring the account current with the lender or to pay off the entire debt. (Senate Bill 7 and Assembly Bill 7, expected to become effective in May 2009, and expire on January 1, 2011, provide that for loans secured by a first deed of trust, recorded between January 1, 2003 and January 1, 2008, on the borrower’s principal residence, the reinstatement period is 3 months plus 90 days, subject to possible exemption for a lender with a “comprehensive loan modification program.”)

In the second stage, the trustee mails a Notice of Sale to the IRS and California Franchise Tax Board, if required, at least 25 days prior to the sale date; and at least 20 days prior to the sale date mails the same notice to the borrower and other parties requesting notice, and posts the Notice of Sale on the property and in a public place, usually the county courthouse. The trustee must also publish the notice for three consecutive weeks in a newspaper within the judicial district, the cost of which can be substantial in some areas. For owner-occupied residential property, Senate Bill 1137 also requires posting of a Notice to Residents and mailing of a Notice to Residents. The Notice of Sale is recorded with the County Recorder’s Office 14 days prior to the sale.

In the third and final stage, the borrower’s reinstatement right expires five business days prior to the sale date, and the property is sold on the sale date, usually on the courthouse steps, to the highest bidder. At the sale, the beneficiary gets a credit for the opening bid, in an amount equal to the monies due the lender plus foreclosure fees and costs. Anyone else bidding at the sale must have cashier’s checks (payable to the bidder in case they are not used). After the sale, the trustee records the trustee’s deed and disburses funds to the lender. The successful bidder cannot obtain title insurance with respect to the purchase, though subsequent purchasers can.

Under Senate Bill 1137, the party taking title at the trustee’s sale must also maintain the property, or risk a fine of $1,000 per day, and any tenants (other than the borrower/owner) must be given 60 days notice prior to being required to quit the property. Tenants can be required to pay rent during their occupancy.

Lender Strategic Recommendations 

Contact a reputable trustee to handle the entire foreclosure proceeding. The California Civil Code generally allows for either the trustee’s fees or attorney’s fees to be passed on to the borrower through a non-judicial foreclosure, but not both. The trustee’s fees are fixed by statute at 1% of the debt balance, so unless the attorney can handle the entire foreclosure proceeding for less, it will be more economical to retain the trustee as soon as possible.

After the sale, make sure any former owner-occupants receive a 3-day notice to quit, and any other tenants receive a 60-day notice to quit (assuming the city in which the property is located has not imposed a moratorium on evicting tenants of foreclosed residential properties). Because it can be tough to identify all of the occupants, and a defective notice has no legal effect, a 60-day notice is always safer. A plan to reasonably maintain the property should also be promptly implemented to avoid potential fines. In this regard, some lenders may find it economically prudent to offer the occupants approximately $1,000 to turn over the property in good and undamaged condition, along with the keys at the time of sale.

Borrower Strategic Recommendations

A borrower in default or on the verge of default should promptly contact the lender to discuss options, including: (1) forbearance or restructuring of the loan, (2) a short sale, and (3) a deed-in-lieu-of-foreclosure. Often lenders would rather modify the loan (e.g., lower the interest rate, re-amortize the loan over 40 years, reduce or defer a portion of the principal balance, etc.) and forgive late fees than take the property back. However, assuming the borrower and the lender cannot agree on a loan modification or forbearance, the borrower should ask the lender if it will agree to a short sale or a deed-in-lieu-of-foreclosure.

In a short sale, the lender agrees to accept less than the amount owed on the loan because the loan amount exceeds the property value. Before signing a purchase and sale agreement contemplating a short sale, the seller should get the lender’s approval, or condition the sale on the lender’s approval within a specific timeframe. If more than one lender is involved, both will have to be consulted, and the holder of the first deed of trust will usually need to agree to give the holder of the second at least a small portion of the sale proceeds in exchange for cooperation.

A deed-in-lieu-of-foreclosure only works if the lender desires to take back the property. If so, the borrower can offer to deed the property back to the lender, and pay for the lender’s title insurance policy (to protect against junior liens), for the purpose of avoiding the expense and embarrassment of foreclosure and, possibly, preserving a better credit rating. The lender will also want to make sure commercial property or vacant land has not been environmentally contaminated, and may even require the borrower’s indemnification against this risk.

If the lender will not cooperate with the above three strategies, and the foreclosure sale appears imminent, the borrower can possibly delay the sale by: (1) asking the lender to postpone the sale to allow more time for reinstatement, (2) filing for bankruptcy protection, (3) seeking a court injunction, and (4) requiring the lender to produce the original promissory note (which sometimes gets lost in the packaging and bulk-selling of loans). However, employing any of these tactics will simply delay the trustee’s sale, not prevent it. Filing a homestead exemption, transferring title, leasing the property, and even death, will not likely avoid or delay the inevitable.

As stated above, the debtor has no personal liability for the deficiency in the event of a trustee’s sale. However, this difference between the balance of the mortgage and the sale price has generally resulted in taxable “phantom income” to the borrower in the form of forgiveness of debt, causing the lender to send the borrower a 1099-C. The recent Mortgage Forgiveness Debt Relief Act of 2007, now excludes from gross income any amounts attributable to discharge of indebtedness incurred to acquire a principal residence, up to $2,000,000, until January 1, 2010. California’s Franchise Tax Board has adopted similar provisions. This benefit only applies to taxpayers who lose their homes in 2007-2009, and does not apply to investment properties or second homes, or to mortgages incurred subsequent to the home purchase.

Summary & Conclusions

Foreclosures have grown at such an alarming rate in recent years that law makers have attempted to stem the tide with recent legislation designed to force lenders to slow down the process and work with borrowers for alternative solutions. Lenders have been encouraged to adopt loan modification programs intended to help borrowers stay in their homes. Such programs typically include some combination of an interest rate reduction, extended amortization period, deferral of a portion of the principal amount until loan maturity, and reduction of principal, in order to target a ratio of the borrower’s housing-related debt to the borrower’s gross income of 38% or less.

In those situations where the borrower simply cannot or will not cure the default or reach a loan modification agreement with the lender, or the lender will not agree to a short sale or a deed-in-lieu-of-foreclosure, then the lender will likely commence a non-judicial foreclosure, which will take at least four months to complete (while the borrower is not making any payments). Upon such foreclosure, the borrower loses his or her entire ownership interest in the property, but will not be liable for the deficiency; and the lender now has a distressed property on the books to maintain and sell. Therefore, the borrower and the lender might both have been better off if they had successfully negotiated an alternative solution with the help of an objective, qualified professional.

This article is for general informational purposes only, and should not be considered legal advice for any particular matter. Each situation is unique in some respect, and the law is constantly and rapidly changing, such that the information in this article might not apply to a particular situation, or may no longer be current and accurate at the time of reading.

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The Landlord’s Response to a Retail Tenant’s Request for Rent Reduction

Retail landlord’s everywhere have almost certainly experienced tenant requests for rent reductions during these challenging economic times. When responding to such requests, the landlord should consider doing the following:

1. Require a written confidentiality agreement before discussing any rent or other lease modifications with the tenant, to reduce the risk of opening a Pandora’s Box with other tenants.

2. Ask the tenant to provide a current financial statement, a report of annual sales for the last 2 years (to show trending), and the most recent income tax returns, to assist the landlord in confirming the need and amount of an appropriate rent adjustment.

3. Ask the tenant how he or she plans to repay the abated rent, explaining that any abatement is merely a temporary measure to improve cash flow, and must be tacked on to the end of the lease or otherwise included in a restructure.

4. Inform the tenant that any abatement will be personal to tenant, and non-assignable, and will be conditioned on the following:

(a) Tenant shall remain open for business and not be in default beyond any applicable cure period;

(b) Tenant shall report its gross monthly sales to landlord by the tenth day of every month;

(c) Landlord shall have the right to terminate the lease and recapture the space, upon sixty days prior written notice, for the duration of the lease term;

(d) Tenant shall forfeit any options to renew or extend the lease;

(e) Any exclusive use provision in the lease shall be stricken.

(f) Tenant shall provide landlord with an estoppel certificate confirming the lease is in full force and effect, landlord is not in default or breach of any lease provision, and tenant has no right to any other credits, reductions, offsets, defenses, free rent, rent concessions, allowances or abatements of rent under the lease;

(g) Tenant shall obtain the prior written consent of any lease guarantors for the proposed amendment or modification of the lease; and

(h) In the event of an uncured default or breach of the lease, then all conditionally abated rent shall become immediately due and payable to landlord.

Any modification of lease terms, including the abatement or restructuring of rent, should be properly documented in the form of a mutually executed amendment to lease, using terms consistent with the lease and prior amendments, by a lawyer or broker skilled in drafting such agreements.

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Minimizing the Risks of Purchasing Commercial Real Estate

Almost everyone is familiar with the three cardinal rules of real estate investment: “Location, Location and Location.” Although property well situated certainly has fewer risks, an investor must carefully consider other ways to minimize the risks involved in the purchase of commercial real estate.

Focusing the Search

Commercial real estate includes apartment, office, industrial, retail and other income properties. Each of these property types has different advantages and disadvantages, risks and opportunities. Most commercial real estate brokers specialize in a particular property type for a particular area, because it is difficult to stay abreast of the issues and trends in multiple markets and industries. Similarly, most investors lack the time or resources to develop and maintain a thorough understanding of many different types of properties in different areas. Therefore, after conducting some basic research about the current and future strengths and weaknesses of different types of properties for a particular area, using local real estate forecasters, brokerage companies, universities and other sources, it would be wise to focus on a particular type of property in order to develop some expertise as an investor.

Analyzing Financial Information

Although “comparable sales” and “replacement cost” data provide some help in assessing value, most commercial real estate investment property is appraised on the capitalization of income it produces. Generally, this method of valuation is based on the present value of future cash flows, and assumes no growth in the future cash flows. This rate is typically referred to in the industry as the “cap rate.” The cap rate can be described as the investor’s required rate of return based upon the perceived level of risk being accepted. It includes both a return onal,sans-serif;”> invested principal and a return of principal as the investment is amortized over time. For example, a 9% cap rate might include a 6% return on investment, and a 3% return of investment. The choice of the appropriate cap rate is critical to the correct estimate of value, as even small differences in cap rates can lead to large changes in market value.

The purchaser desires a higher cap rate, and thus a better return on and of his or her investment, and the seller desires a lower cap rate, and thus a higher sale price. Although the price (and cap rate) is negotiable, in recent years the cap rates on commercial properties have been coming down considerably, primarily because low interest rates and poor investment alternatives have caused a significant increase in the demand for investment properties, thereby driving up the prices.

Different types of commercial properties, and different locations, may also have different cap rates. For example, apartment buildings may have lower cap rates (e.g., 5%) in areas where tenant demand for apartments is high, and strip shopping centers may have higher cap rates (e.g., 8%) in areas where retail space is plentiful. Retail properties with more national or regional credit tenants like Starbucks and Jack in the Box are generally lower risk investments and thus warrant lower cap rates than centers consisting primarily of less stable or secure “mom & pop” stores. Therefore, cap rates are generally determined by comparisons with other similar properties recently sold. Most active commercial real estate brokers in a particular area can tell a potential investor what the market range of cap rates is for particular types of properties in that area.

Because the cap rate calculation is dependent upon a property’s income and expenses, there are many variables that can significantly impact these analyses. For example, if net income from the property decreases due to more tenant vacancies or increased expenses, then the effective cap rate will diminish as well.

In performing any economic analysis, a potential investor should not take the seller’s income and expense figures and assumptions at face value, as closer scrutiny often reveals that the actual cap rate is lower than represented. For example, the seller’s stated rental income may not be based upon current actual figures, but on future projected figures (after rent increases), or it may fail to include a reasonable vacancy factor, a post-sale reassessment of property taxes that will not be reimbursed by tenants under gross rent leases, a reasonable sum for property management fees, potential percentage or abated rents, or other income and expenses. Thus, the investor should always look for hidden risks (and opportunities) by conducting his own investigation and analysis, which will require a careful review of the rent roll, operating statements, leases, loan documents, and maintenance records.

Contracting

Assuming the property can be purchased at a reasonable price, the next step is to make a formal written offer to purchase, usually through a broker, with the assistance of a lawyer. It should be noted that contract forms vary widely, and there is not much “standard” about them, despite the title or the source of the form. Further, most brokers are not particularly skilled in the art of drafting contracts and protecting buyers. The contract will govern the parties’ rights, obligations and remedies throughout the transaction, and therefore, the importance of it should not be underestimated. Purchasers of commercial property generally have fewer legal protections than homebuyers, as the parties are presumed to have relatively equal bargaining power and sophistication in commerce. Therefore, a prudent buyer should usually have an experienced real estate lawyer review the contract before submitting it for the seller’s consideration.

Ideally, the contract should include some basic representations and warranties by the seller concerning the condition of the property, as well as some buyer contingencies for such things as approval of title, leases, physical inspections, and financing. At a minimum, the contract should provide for a reasonable “due diligence” period (generally between 15-45 days), during which the purchaser can have the property physically inspected, review the leases, operating and financial statements, rent roll, title report, service contracts and any environmental reports, as well as consult with a loan broker or lender to verify available financing. If this investigation reveals anything of concern during the due diligence period, the buyer should then have the ability to either terminate the contract and receive a full refund of his or her deposit, or renegotiate for additional time, a price reduction, seller repairs, or other concessions.

Inspecting and Investigating

Unless the buyer has some construction expertise, he or she would be well advised to hire a competent inspector. The physical inspection should include the roof, mechanical and electrical systems, as well as the structural integrity of the buildings and the need for any Americans With Disabilities Act compliance work (e.g., parking lot spaces, striping, signage, and ramps) or deferred maintenance work in common areas, such as painting, resurfacing the parking lot, and replacing heating, venting and air conditioning units that are not the responsibility of tenants under the leases. If the property has any potential history of contamination with hazardous materials (e.g., asbestos floor tiles or ceilings, on-site dry cleaners, lead paint, petroleum products from nearby gas stations, pesticides, solvents, or chemicals stored, used or disposed of on or near the property), the buyer should conduct an appropriate environmental assessment, which would include a Phase I report, and possibly a Phase II investigation. This assessment is necessary to protect the buyer from potential cleanup liability after the purchase.

Other basic due diligence tasks should include: (1) early contact with an experienced commercial loan broker or lender for loan possibilities and application, as it generally takes at least 30 days to get formal loan approval; (2) a legal review of (i) the preliminary title report for potentially problematic easements, liens or encumbrances, (ii) the loan documents for things like recourse obligations, lock-out periods and prepayment penalties, and (iii) the leases to confirm that they include appropriate landlord remedies and protections; (3) review of tenant estoppel certificates for consistency with the rent roll and leases; (4) review of service contracts for the maintenance and management of the property; (5) investigation with the city’s development planning department concerning any proposed development in the area that may impact the property (e.g., street widening, competing stores, rezoning, etc.); and (6) some casual discussions with particular tenants about how well their businesses are doing, and any future plans they might have to renew their leases or to expand, close or relocate. Although the broker should help with some of the due diligence investigation, ultimately the buyer should assume responsibility.

Limiting Personal Liability

Prior to closing escrow, and depending upon various other considerations that may involve other investors, potential tax consequences, and the lender’s requirements, the buyer should generally form a limited liability company or other asset protection entity (not a corporation) to hold title and shield the buyer from personal liability for such things as injuries on the property, hazardous materials on the property, and contracts like the loan agreement, leases, and service agreements for the property. Some lenders may still require the buyer to personally guaranty the loan if the buyer uses an entity to take title, but the added liability protection afforded by the entity is almost always worth the extra paperwork and costs. In any event, the buyer should definitely consult with an experienced insurance broker about obtaining adequate coverage for appropriate risks, consistent with the lender’s requirements, and should make sure that policy covers the correct parties upon the closing.

Monitoring the Operation

The buyer should take steps to insure a smooth transition upon the close of escrow and change of ownership by making sure that utilities will be transferred without interruption, all necessary insurance is in place, a property manager has been hired, and all keys and other items needed for operation of the property have been transferred. The buyer and the property manager should promptly visit with each tenant to introduce themselves and to deliver written notice of where to send future rent checks and who to contact with any questions or problems. By promptly addressing any significant deferred maintenance issues such as a leaky roof, the new owner may also engender some good will with the tenants and avoid some future headaches.

Although most commercial properties are professionally managed for the owners, particularly if the leases obligate the tenants to pay for this cost, an owner would still be well advised to periodically inspect his or her property to see how well it is being maintained and to keep abreast of any significant tenant concerns. The owner should also carefully review the monthly financial reports and cash distributions from the property manager for accuracy, as common mistakes or discrepancies include such things as ambiguous expenses and failure to bill tenants for scheduled rent increases or common area maintenance charges. A watchful owner can also make sure that the manager aggressively works to fill tenant vacancies as they occur, in order to maximize the owner’s return on investment and to benefit the remaining tenants with more customer traffic.

In short, property managers typically handle numerous properties at any given time and, therefore, do not always give any one property the attention it requires. Therefore, it pays for an owner to monitor the manager and the property.

An Ounce of Prevention

As illustrated above, the process of identifying, evaluating, purchasing and owning commercial real estate is not overly complicated, but a buyer should certainly minimize the risks involved by consulting with a knowledgeable and experienced broker and real estate attorney.

 

* Larry N. Murnane is a licensed broker and lawyer in San Diego, California, emphasizing commercial real property purchase, sale, exchange and leasing transactions.

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Anonymity and Other Benefits of Title Holding Trusts

A Title Holding Trust (“THT”), sometimes referred to as a land trust, holding trust or blind trust, can be a simple and inexpensive method for taking and holding title to California real estate or personal property, confidentially and privately .

A THT can be established by an individual, partnership, trust, limited liability company or corporation. The person or entity that sets-up the THT, the Trustor, enters into a standardized THT Agreement with the Trustee he or she appoints, typically a fiduciary services company. The Trustee then designates one or more Beneficiaries (usually the Trustor) and Successor Beneficiaries (usually the Trustor’s children) of the THT, under the terms of the THT Agreement. The Trustee has no authority to act without specific written authorization and direction from the Beneficiary of the trust. The Beneficiary owns the THT, and retains all ownership rights and complete control over the property, including the power of direction over the trust. The Trustee executes grant deeds, promissory notes, deeds of trust, leases and otherwise manages the property held in the trust, only upon specific written authorization and direction from the Beneficiary of the trust. The trust may be modified, updated or terminated, and additional California real estate or personal property can be added to the trust, at anytime.

The Trustee holds title to the property under its name, in its fiduciary capacity, as Trustee of the trust.  Public records, including the County Recorder’s, County Assessor’s and County Tax Collector’s public files and records, reflect the legal title and ownership of the real estate or personal property in the name of the Trustee, “as Trustee for Trust No. 12345.” The Beneficiary is not identified on any public record, and the Beneficiary’s information is not disclosed to any party unless authorized by the Beneficiary, the trust agreement, or required by law or court order.

When title to real estate is held in a THT, courts have held that the beneficial interest in the trust is personal property. This beneficial interest includes the right to receive any income and any proceeds from the sale or mortgage of the property. The Beneficiary reserves the right to occupy or otherwise possess and use the real estate. However, as personal property, the beneficial interest in the trust can be easily assigned to another party without the need to prepare, sign, notarize and record a grant deed.

Reasons a THT may be desirable for acquiring, holding and disposing of real estate or personal property include:

  1. Anonymity and privacy of ownership;

  2. Succession of ownership and avoidance of probate for California residents;

  3. Partial distribution of property by assignment of Beneficiary interest, without the necessity of recording a deed;

  4. Protection against liens or judgments being enforced against the property, or clouds on title, caused by one investor’s death, divorce, bankruptcy, and debts;

  5. Protection against a partition action by one of the investors to force a sale of the property;

  6. Convenience of conveyance or refinancing, by requiring only the Trustee’s signature, rather than that of multiple owners;

  7. Assignments of beneficial interests in a THT without requirement of any 1099-S reporting, as a transfer of a personal property interest and not a real property interest;

  8. No requirement for a registered agent for service of process, unlike for a corporation or limited liability company;

  9. As a fully revocable grantor trust, the THT is a pass-thru and disregarded entity, so no separate tax returns or other filings are required;

  10. The assignment of a beneficial interest in the THT is considered a valid conveyance of title for income tax purposes, which qualifies for tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code;

  11. The Trustee has no personal liability as Trustee of the THT;

  12. THTs are generally more cost-effective compared to other forms of real estate ownership, with no annual filing fees, tax return preparation fees, minimum annual taxes, Secretary of State filing fees and registered agent costs – requiring only the annual Trustee fee;

  13. The Trustee of the THT remains the insured party before and after any transfer of beneficial interests, obviating the need for costly title insurance endorsements with respect to transfers of beneficial interests;

  14. Real estate investors can acquire real property without tipping off sellers or competitors.  (Walt Disney acquired all of the land for Disney World in Florida through a THT, so no one could take advantage by inflating prices); and

  15. The beneficiary’s interest in a THT can be used as collateral for bank loans without the additional need and expense of obtaining a mortgage, even if a mortgage already exists.

It should be noted that, although THTs provide many benefits to real estate investors and property owners, they will not serve to circumvent income and property taxes otherwise payable. Nor will they circumvent a due-on-sale clause contained in a promissory note secured by the property, if 100% of the beneficial interest is transferred.

Though a THT can be established at any time, in order to take maximum advantage of the confidentiality and privacy benefits of the THT, the trust should take title to the real estate or personal property when it is first acquired, so the Beneficiary never appears on any public record tied to the property.

 

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