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 5 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 certainty 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.

Now, some nearly 25 years hence, I truly do recognize the importance of “sorting” and the notion of elimination has become more and more a part of representing my commercial real estate clients effectively.

Of late, and driven by market conditions, there has emerged a new brand of bottom-feeding. It’s a concept I call “LOI Shopping” or, maybe “Networking the Deal” for better terms.

There is no doubt in my mind that this carp-like behavior among prospective tenants is a product of too much inventory and the desire of often marginal tenants to continue their vain attempts to shrink or even collapse the pricing envelope.

Mind you, there is no orchestrated conspiracy here; just a glut of inventory and an every expanding population of weak tenants who think if they shake the tree hard enough fruit will fall to the ground.

Well, I am mad as hell and not going to take it anymore! I am implementing new measures to expose and terminate the pretenders…these fakes and would be tenant hypocrites who are representing themselves to my clients as so much more than they really are.

Although I am not ready to strap on a six shooter like Richard Boone did in “Have Gun Will Travel,” and ride into some western town on a mission of settling scores, I am ready for a serious revision of my qualifying language and the way I handle the “wanna be” candidate.

Sorting through Hypocrisy

Since we are using some Latin, let me throw in some Greek too. The work “hypocrite” is derived from the Greek noun “υποκριτής” meaning “one who wears two masks.” It’s the source of the theater icon that depicts “comedy and tragedy.”

I am ready to pull back a few masks and find out what is behind them. I’m ready for a lot less comedy, especially since no one is laughing. Then too, I am not especially fond of the tragedy angle either.

Masks don’t work well in the empirical world of commercial real estate. Masks are only suitable for the stage, where the emotions of an audience are supposed to be toyed with.

I’m going back to what Del Webb taught me as a highly skilled Sales Counselor…the principle of Terminatio Simulatio Velociter or, in plain English, TERMINATE THE PRETENDER QUICKLY.

You see, guys like Del Webb understood clearly the principled approach to professional representation. There are only two types of real estate investors or, in the case of Del E. Webb, home buyers; the ones that will and the ones that won’t…the ones that can and the ones that can’t…the ones that do and the ones that don’t.

Those that will are those than can and those that can are those that do. No mask, no pretense.

To the Webb organization, the deliberately implemented sorting process begins at the first business encounter (give name, get name, use name) and continues as an integral component of all the follows, culminating in securing loyalty, examination, agreement and execution.

For the foreseeable future, the market is going to continue to hammer us all, owners, tenants and brokers. Too many properties, too little time and too few truly qualified tenants and investors.

I’m going back to the principle of Terminatio Simulatio Velociter or, in plain English, TERMINATE THE PRETENDER QUICKLY.

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.

 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