By: Manuel Fishman, Esq.
May 21, 2014
Perhaps because my perch is as a real estate transactional lawyer based in San Francisco, where the rate of office space absorption and of “mega leases” (see article on Salesforce and LinkedIn leases: “Are San Francisco Office Tenants Leasing Up too Much Space,” continues to accelerate, the market seems to be frothy, and precarious. Other major metropolitan areas seem to be experiencing similar spikes. My latest data point is the inability of long-term owners of real estate to find replacement properties when structuring a sale as a “tax deferred exchange” under Internal Revenue Code Section 1031. What that means to me is that the underwriting is off balance.
So, perhaps a few words of caution from a sideline coach that has seen this cycle before. While lawyers focus on the documentation of deals, we also get involved in the risk analysis of deals, and I now see a real focus on lease pro formas for years 2016 through 2020. Buying an industrial or office property today requires a steady – and conservative – hand at underwriting the cash flow to be generated over the next five to seven years. Careful buyers are seeing risk in the out years, not only in the credit of the tenants, but in regulatory compliance, including energy costs, business taxation and government exactions, and building code retrofit and compliance. One of the lessons from the last cycle was that over-leveraging and exuberant underwriting result in a toxic combination when the economy changes direction.
The other lesson to remember is that sometimes it is better to not do a deal than to do a deal. The pressure we all see as “deal junkies” is to join the fray. Caution should prevail. Sometimes, relooking at one’s existing portfolio to see if there are opportunities for increased cash flow, and to weigh the benefits of a stable cash flow versus the risk of a potential increase in cash flow is the best course of action.
Before heading head strong into a transaction, think about the sell-and-buy side check list, and understand your own pressure points, as well as known and unknown physical condition and title issues. Get them solved to avoid a price adjustment. Consult your potential lenders in advance and negotiate the term sheet based on an income producing property (will there be financial covenants, hold backs, guaranties, etc.).
In today’s environment, it is very important to get the deal right, as there is little room for error.