This was shot while tooling down Interstate 40 between Flagstaff and Kingman, Arizona. It’s all part of a new feature for this blog entitled CRE Road Kill. Stay tuned for more CRE Road Kill.

We are in a kind of real estate battle of the bulge. We have too much space (the bulge) and not enough users to quickly alleviate the bloat of vacancies. It is true, we have seen some spurts and sputters, which have caused some to optimistically think and even say, “the recession is over, we’re coming out of it.”

Everything I read, hear, view and all of my experiences at the street level are telling me the battle of the bulge is not over and the trick of trade for survivors is the ability to buy cash flow and to buy it now. Yes, you heard it correctly. Owners need to change their posture and assume a position of cash flow deal makers.

Before you write me off, think about it carefully. Owners have always been engaged in buying cash flow. CRE 101 is cash flow as the basis for property value. Owners have always traded space and rate for cash flow. Our problem is that we are in various stages of denial about the current cost we must pay to purchase cash flow.

As unemployment increases, consumer spending diminishes and for small and medium size investors such a climate can produce a lot of sleepless nights. As the current credit crunch begins to squeeze owner refinancing options and new lending diminishes to close to a 50 year low, we are once again going to have to buy the limited cash flow at discounted pricing in order to sustain our properties.

Let me give you an example of the battle of the bulge and the principle of buying cash flow. Let’s suppose a particular geographic market area has 1,000,000 square feet of total retail space with a current vacancy rate of 27%. Let’s introduce a tenant default rate of 12% per annum into the equation (not far off the current mark).

Finally, let’s assume a net absorption rate of 5% per annum, meaning we have 50,000 s.f. per year being leased. This equates to a sustained vacancy rate of 220,000 s.f. vacancy growing at 7% per year.

Furthermore, it means that we have less cash flow to buy, therefore the cost of the cash flow increases over time, i.e., owners pay more for each tenant’s cash flow in order to remain competitive. Bottom line, NOI drops and NOI is our commodity.

In a five-year market of the kind we are experiencing the numbers look like this:

• Year 1 end = 220,000 s.f. vacancy
• Year 2 end = 235,400 s.f. vacancy
• Year 3 end = 251,878 s.f. vacancy (we are now at 25% vacancy)
• Year 4 end = 269,509 s.f. vacancy
• Year 1 end = 288,375 s.f. vacancy

During this transition, which is exactly the type of transition we are currently experiencing, the cost for limited cash flow is increased due to the economic principle of supply and demand. We are leasing but not fast enough.

Owners ALWAYS buy cash flow, make no mistake about it. My point is that it is going to cost us more to buy the decreasing cash flow available from the decreasing tenant pool.

Fourteen dollar retail leases are becoming $10 or $11 dollar leases. We are paying $3 to $4 more per square foot to purchase the shrinking number of tenants. Tenants know this and they are not selling their cash flow easily. Like the game of golf, the lowest scores are winning.

The ugly side of this is the certanty of diminishing property values. It is a reality we are going to have to learn to live with for another 24-36 months. Those who wait too long to adjust their pricing and leasing models will certainly loose the battle for the limited tenant pool.

It is a competitive and nervous leasing market and therefore, it is wise for owners to abandon the “one-size-fits-all” approach to leasing.

Lease program development requires a careful examination of the prospective tenant’s business needs and qualifications. Whether the commercial real estate market is Prescott, Arizona, Tucson, Arizona or Phoenix, Arizona, presenting lease options to a prospective tenant can work well because options are non-threatening and they empower.

It is entirely possible that some leases can be optioned to the tenant where street rate is actually exceeded in years 4-5 of an initial term. In a market filled with vacancies and tenants seeking the best value in exchange for their commitment, it makes sense to offer optional leasing programs, which empower the tenant (let me give you a hint, they already have the power) to exercise the power of choice.

Vacancies are increasing and owners are competing for a limited number of truly qualified tenants. The option approach is another opportunity for economic performance. It will be some time before we can say to tenants, “The rate is the rate…” and have them sign off with little resistance.

Tenants come in two forms, good tenants and not-so-good (okay, go ahead and say it, “bad”) tenants. There seems to be no middle ground.

Tenants are capable of odd if not bizarre behavior and often they succumb to the same economic pressures impacting owners and landlords. Pressure can create abnormal responses in any person but when those pressures find their fundamental genesis in the economy, expect surprising tenant behavior.

Stories I have heard or read about lately make some tenants sound like Freddie Krueger…a bad Nightmare on Elm Street.

How to Handle the Next Nightmare. Whether on Elm Street or a strip mall in Atlanta, if you are a commercial owner, landlord, broker or property manager, you are going to eventually meet Freddie and have a nightmare tenant on your hands.

Dealing with Mr. Krueger begins with tenant screening and qualifying. If there was ever a precept that was violated by many owners during the market run-up from 2000-2006, it was qualifying tenants.

However, even after qualifying tenants economic and other factors can erode the performance of any tenant, creating desperation and a propensity to go sideways.

Owners can reduce but not totally control the “Freddie effect” by bearing down on the up-front analysis of the tenant. Controlling a future nightmare on your street begins with qualifying the tenant but it does not end there…read on.

A Second Line of Defense against Freddie the Tenant. Exceptional lease documents, drafted and designed to anticipate nightmares are the second line of defense against the Kruegers of this world. “I’m sorry,” I recently told a prospective tenant who complained about the length of the lease, “…the 28 pages of your lease are designed to anticipate just about anything and to protect you and the owner from misunderstandings.”

Bad documents seem to become “badder” (is that a word?) in the hands of a Freddie gone wild. Simplicity in the lease document can be a formula for future complexity and trouble on Elm Street.

As an investor, you don’t want to ever meet Freddie, the tenant, armed with a deficient lease document, cluttered with ambiguity. Freddie loves ambiguity!

Another thing I have learned along the highway of success and failure is that taking a strong position backed by logic, not rhetoric, is something Freddie understands.

When tenants have escalated the action, so to speak, the best position is a position of strength based upon facts, not emotional responses. Freddie loves fear…he thrives on it.

When a recently signed tenant angrily complained to me about not being able to occupy on the commencement date my response was to take a position of strength behind a quality document. My response, in part, was “…that is addressed in clear language in the lease and there is nothing I can do about that issue…” This defused a potentially volatile situation and kept the tenant from going “Krueger” on me.

Well drafted lease documents keep Freddie in place. After all, it’s much better to have a Mary Poppins than a Freddie Krueger on your hands.

When Freddie Keeps Coming Back. Like the horror flicks, Freddie never really dies and neither to tenant problems. If you have great tenants, stick around, Freddie is hiding in there somewhere, waiting for a chance to make a comeback.

To manage the potential return of Mr. Krueger, I recommend owners always use experienced property management as the front-line defense against negative tenant eruptions.

Property management is the third piece of the investment puzzle and can serve to help an owner keep his/her distance from day-to-day issues that should be handled by a Manager who knows the tenant, maintains the property and is not subject to the same emotional responses an owner may experience when faced with Freddie.

A good property management company will have its finger on the pulse of the property at all times and keep the owner informed but at a safe distance, thus increasing long term value through focused attention on the asset. Your property manager can warn you that Freddie is loose and enable you to solve issues before the slashing begins.

If you have never had a Freddie on your hands, count your blessings and be thankful this Thanksgiving Day. If you want to diminish the odds of an encounter with Mr. Krueger, use the three best tools available to you; (1) thorough screening of tenant, (2) a great lease document and (3) a property management company.

Many businesses predicate and sustain their business model on the economic relationship they have with their lease. When the line of profitability intersects the economic demands of the lease, business owners are faced with tough decisions…so, too are Owners.

Truly, a lease is a function of sound business planning and, in these days, may prove pivotal with respect to sustaining profitability. Revenue for some businesses has decline by almost 30 percent, a huge and life-threatening decline for just about any endeavor.

My Property Performance Analysis (PPA) was orignally designed to assist owners with assessing their property performance and financing options in this “vicious market” but I am extending it to a new approach that assists tenants with evaluating their lease, lease options and streamlining their lease.

The Tenant PPA looks at a number of factors from the Tenant’s side of the relationship, then seeks to formulate a strategy of lease modification that will prove accepatable to the Lessee and Lessor. Some of the components of the Tenant PPA are:

1. Financial review of business performance
2. Creation of ecomomic model for lease performance
3. Streamlining the lease to cycle through the downturn

Bottom Line. As a result of the Tenant PPA, rental rate modification may result if supported by the financial analysis. The Owner maintains leased space with creative offsets to the streamlined lease that serve as incentives against a space “going dark.” These incentives may include early renewals, extensions and rent adjustments associated with positive market and business performance improvements.

The Cost of Going Dark. Going dark is expensive. Re-letting space in a highly competitive market is costly, time consuming and almost always results in revenue decline when measured against a well drafted lease modification.

When an Owner/Tenant relationship is economically strained beyond the breaking point, our position at Arizona Commercial is a simple one, keep the lights on! In a rapidly appreciating market with vacancies below seven percent, this would not be the normal case. However, these are not normal economic times and the decision to execute a Tenant PPA may be in the best interest of the Parties.

Three suites are currently available and are priced at $9.50 per square foot, triple net with graduated annual rent incentives and half rents for qualified tenants. Download the flyer.

Owner is offering graduated lease rates with half-rent incentive for qualifying tenants. Download the flyer.

Watch the short video below to preview this property

For more information about this property, contact Donald Teel by email or, if you prefer by calling 928.777.8100. Visit CommercialWebPage.com. Download the flyer.

Posted by Donald Teel, Arizona Commercial

Taking the guesswork out of commercial real estate investment requires more than a hope, a prayer and signature.

The genesis of commercial real estate investment is found in the analysis of the basic math surrounding the transaction. Costs, cash flow, depreciation, appreciation, money in and money out. Math is the science of the deal.

While the origin of commercial transactions is found in the science of basic mathematical functions, the art of performance is found in the crafting of the document; this is the model. Well crafted documents are extensions of the numbers and the intentions of the principals.

If there is to be any semblance of predictability of performance such must be memorialized and embedded in the language that constructs the investment, i.e., the purchase agreement or lease agreement.

Then too, the document’s credibility is only as good as the integrity of its signatories; their motivations. They who sign are those who are called upon to act in accordance with their written promises.

Summary: the deal is as good as the numbers (the Math), the performance is as good as the document (the Model) and the execution of the promises is only as good as the integrity of the principals (the Motives). Upon these three the investment hinges.

The numbers are the science, the document is the art and the performance is the warranty. Upon these three the deal hinges and the door of performance opens and closes.

I have seen and written a lot of documents. In my career I have seen short documents that were good and long documents that were bad. There have been times when the short word accomplished as much as the long word and vice-versa.

Good numbers, contrary to the opinions of some of my contemporaries, are seldom the guarantor of performance. My experience has shown me, countless times, that the integrity of the transaction is always found in the fulfillment of the promises of the principles and this only as a result of superior documentation, whether short or long.

In retrospect, I have seen great documents backed by great numbers end in disaster due only to the diminished capacity, whether intentional or not, of a Principal Party to perform as promised. Lawyers want us to believe that documents are everything. I have seen good deals with superior documents go south because of bad intentions.

Nothing can overcome a Principal with a misguided principle, no matter the document, no matter the math.

Then too, I have seen miserable documents when placed in the hands of principled Principals run their course without incident.

After more than two decades I have learned that the math, the model and the motives are the three inseparable ingredients of any commercial real estate transaction; the most powerful being the later.

To me, this is the holy trinity of real estate investment and one cannot function without the other two.

Upon these three the deal hinges.

 I’ve mentioned the SNDA in previous posts (Subordination, Non-Disturbance, and  Attornment). The ND portion refers to non-disturbance of the tenant’s right to have its lease  recognized as valid in the event of the foreclosure of a senior trust deed. The S refers to the  Subordination clause and the A refers to the Attornment clause. I’ll discuss the Subordination  and Attornment clauses in separate blog posts. From the Tenant’s standpoint, the non-disturbance clause (“ND”) is most important. 

The use of the Non-Disturbance Agreement depends on the timing of the recording of the trust deed and the recording date of the lease (or the recording of a Short Form Notice of Lease) ,collectively “Notice”. Usually neither the Tenant nor the Landlord want the whole lease recorded. The lease may or may not provide for the recording of a Short Form Notice of Lease. As a Tenant you may want a Notice recorded. Check with your attorney for advice.

Both California and Arizona follow the race-notice theory of recording. [If you'd like more information about how recording of documents works in Arizona, contact Donald Teel at 928.777.8100.]  The first legitimate document recorded has priority over subsequently recorded documents. If a trust deed is signed on January 2, but not immediately recorded, and the lease is signed on January 10 and its Notice is recorded on January 11, while the trust deed has not yet been recorded , the lease would have priority over the trust deed. If the trust deed were subsequently foreclosed, it would NOT have the right to evict the Tenant so long as the Tenant was not in default under the terms of the lease.

However, if the trust deed were RECORDED first the lease would be subject to the priority of the trust deed. If the trust deed were foreclosed, the foreclosing party could evict the Tenant! The reason most Tenants want the ND is that they usually have spent quite a bit of money on leasehold improvements, moving costs would adversely impact their bottom line, they may have spent substantial amounts branding their location, and they may be out of business while moving to a new location. A Non-Disturbance agreement should protect the Tenant in those circumstances.

Before entering into a lease, or when renegotiating a lease, the Tenant should determine whether or not there is a recorded trust deed encumbering the property. If there is, the Tenant should make it a condition of the lease that the Landlord provides a Non-Disturbance agreement signed by the lender. Obtaining a Non-Disturbance Agreement often depends on the negotiating position of the parties. A tenant leasing 1,000 square feet of retail space in a mall probably won’t be able to obtain the lender’s consent to a Non-Disturbance agreement. However, a major Tenant in a development should insist on an ND agreement. Merely having the ND clause in the lease will not protect the Tenant if the lender has not provided the signed agreement. The ND clause may provide that the Landlord will use its best efforts to obtain the lender’s Non-Disturbance Agreement. In the standard lease used by commercial brokers in Carlsbad and the rest of San Diego, the lease ND clause provides that if the landlord doesn’t obtain the ND agreement within 60 days, the Tenant may go directly to the lender to try to obtain the Agreement. Without the lender’s signed agreement, the Tenant is at risk. [Contact Donald Teel to review the lease form used in Prescott and the rest of Arizona.] There are various forms of ND clauses and agreements. Be sure to have the language reviewed by your attorney if you want to protect your rights to retain your lease rights in the event of foreclosure. 

If you have general questions about commercial leases, please send us a note at Lee@leesterling.com