Buying or leasing real estate is a necessary pursuit, yet one fraught with risk.
“If you don’t do your due diligence with regard to those risks, you may end up locked into an asset that, instead of helping your business prosper, drains your profits,” says Jeff Roberts, associate with Kegler, Brown, Hill & Ritter Co., LPA.
“The steps you take to analyze those risks will determine whether you have an asset or a large liability on your hands.”
Smart Business spoke with Roberts about how to manage risk when buying or leasing real estate.
What risks should companies be aware of when buying or leasing real estate?
There are different risks associated with buying and leasing. On the buying side, we can break it down into business and legal risks.
From buying standpoint, the No. 1 business risk is affordability. How does this purchase fit into your business plan going forward? What is your exit strategy with this location? If you are not paying cash, what are your financing options? Obviously, if you are in retail it’s all about location, location, location.
Legal risks include obtaining clean title to the property, environmental issues, access and the permitted use of that location. Does the zoning match up with what you are trying to do?
When it comes to leasing, the first issue to consider is the length of the lease: long-term versus short-term. If you find a space you really like, you may want to look into a longer-term lease because you can get better business terms. The flip side to long-term is it locks you in for a while, so you need to try to work as much flexibility into the lease as possible. Look into expansion rights and rights of refusal, because your company may potentially need more space to accommodate growth. Also, you may want to negotiate a termination right and subleasing rights, in the event that the business has a downturn and you have to shrink the space or get rid of it altogether.
From a leasing standpoint, if you are in a long-term situation without much flexibility, you can be stuck with a real potential drain on the profitability of your company. The same risks are present if you buy and you bought too much space, or the space is highly leveraged, or it is not exactly what you wanted.
Why is flexibility important?
If you are moving into a large space with potential for growth, it is more desirable to have the potential to expand your operations or offices than to have to find a brand new space and negotiate with a new landlord. You already know what you’re dealing with at that space at that time.
Conversely, you want to negotiate a termination right, or a right to sublease in case things start to go badly — especially when you are considering a long-term lease. Because, although these termination rights come with penalty, at least you can quantify what that downside would be.
Landlords will offer better pricing if you sign a long-term lease, because they have a longer stream of cash flow that will minimize their risk. Given this longer-term commitment, you should work these outs into the lease, just in case.
How should companies deal with risk in today’s real estate market?
If you’re looking at purchasing a property, explore your potential financing sources early in the process. Financing takes longer to get approved than it used to. Exploring financing sources early in the process will allow you to know whether buying or leasing that space will be an option for you in the first place.
If you are leasing, you should be aware that the financing is coming due on many commercial spaces. Banks have been shrinking their commercial real estate portfolios. Often, they are not willing to renew on a long-term basis for some buildings. From a tenant’s perspective, you want to protect yourself and your lease in the event your landlord is foreclosed upon and the lender becomes your new landlord.
A good tactic is negotiating subordination and non-disturbance agreements in connection with your lease to protect yourself in the event that the landlord’s financing goes bad.
Also, sit down with your legal counsel and do some business planning. You may want to create a single-purpose entity like a holding company to own the real estate in order to shelter the operating business from potential liability. The last thing you want is a slip and fall in your building leading to a lawsuit targeting the operating company, rather than the owner of the property.
In addition to talking to your legal counsel, get advice from either your tax counsel or your accountant to determine whether leasing or owning real estate would be better for you. One way may benefit the operating company more than the other.
What tips would you give someone in the process of buying or leasing real estate?
Be proactive throughout the process. Stay in front of potential issues before you actually purchase or lease that space. Ask lots of questions. There are no stupid questions, especially if you’re not experienced in the area. Make sure you do your due diligence. Determine your financing capabilities. No. 1, is it available to you, and No. 2, can you afford it? Last, consider hiring a good broker who knows the market.
These are all ways to manage risk, but the combination of hiring good counsel and being proactive rather than reactive is important.
JEFF ROBERTS is an associate with Kegler, Brown, Hill & Ritter Co., LPA. Reach him at (614) 462-5465 or firstname.lastname@example.org.