Author: Anita

Guest Blogger: John D. Pickering, Partner at Balch & Bingham, LLP

Predicting the future for commercial real estate is always difficult, but it’s made significantly more so this year because of the real possibility of massive federal income tax reform.  Big-time reform would have been unlikely if Hillary Clinton had won the White House and divided government had continued, but with a Trump victory and Republican control of both houses on Capitol Hill, tax reform on a 1986 scale may really happen.  That “1986” reference should grab the attention of anyone working in commercial real estate – older readers will remember the impact on the industry of the 1986 reform, and younger readers studied it in school or have heard the stories from their more senior colleagues.

So could it happen again?  Maybe.  Some of the specific changes being considered would certainly have big impacts on our industry.  For example, the elimination of 1031 tax-free exchanges, removing the deductibility of interest on real estate loans, and ending the current favorable treatment for carried interest.  If the industry is hit by all these changes at once, the consequences could be especially painful.

Let’s consider the context for these proposals.  Republicans are concerned about labor force size due to Baby Boomer retirements, a declining workforce participation and declining worker productivity.  The latter is a consequence in part of historically low levels of capital investment.  They hope to address these issues with large-scale reform that would include the following:

–Corporate income tax rate cut (from 35% to 20% or lower)

–Individual income tax rate cuts and simplification (three brackets instead of seven, with a top rate of 33%; increases in standard deductions to reduce need for itemization by many taxpayers)

–Elimination of corporate and individual alternative minimum tax

–Increases in child and dependent tax credits

–Protection of interest rate deductibility for home acquisition financing, but elimination of deductibility of interest on all other types of loans, including home equity loans and commercial real estate loans

–Elimination of estate tax

–Creation of a special 25% rate for income from sole proprietorships and pass-through entities such as partnerships and LLCs, with reasonable salaries to owners being taxed at ordinary individual rates

–Reorganization of the IRS into separate units for business and individual taxation, and the addition of a “small claims court” unit

–Get rid of multi-year depreciation for business investment, so capital investments are fully expensed in the year they are made

While these proposals are grounded in economic ideas about fair allocation of the tax burden and promoting economic growth, each industry will ask “what’s in it for me?”  For commercial real estate, the unfavorable proposals outlined above, or at least the ending of interest deductions, might be offset by the current year expensing of all capital investment expenditures, with the exception of land.  This proposal takes some getting used to for anyone who has thought in terms of 39-year depreciation!

Watch what happens in Congress carefully this year.  It may have a significant impact on your livelihood.

If you are a business owner, services firm manager or corporate real estate director, you likely have some strategy regarding your real estate.  That strategy could be to contain costs, or to encourage interaction and collaboration between employees, or to ensure that you have sufficient flexibility to grow, shrink or relocate as your business requires.  In order to assess whether your strategy is working (and get buy in from the executive team), you need to determine which metrics measure strategic success and then start benchmarking those metrics over time internally and against your industry. 

Which Metrics Should You Use?

There are a number of them that we recommend, including:

Square feet per employee:

To determine this number, divide the total square footage your company owns or leases and actually OCCUPIES (exclude subleased space) by the total number of employees.  A simple lease tracking system can provide you the square footage numbers.  In the absence of such a database, the accounting people who pay rent or the attorneys who negotiate the leases usually have this data.

You can also determine this ratio for each separate location.  This data can be used in several ways.  Some of our service provider clients compare the overall portfolio ratio with each office’s individual ratio to identify those offices that are significantly above or below the average.  Those offices may provide opportunities to right-size the space and improve portfolio efficiency.

Other clients use this number to compare themselves to their industry.  Industry benchmarks for square foot per employee can be found in the International Facility Management Association’s (IFMA) annual benchmarking report or can be obtained from your real estate services provider.  For instance, the IFMA average for insurance industry occupiers may be 200 square feet per employee.  If you are an insurance company and you average 300 square feet per employee, the reason for the difference may be worth investigating and incorporating in your strategy.  If your strategy then becomes densification, you can compare your square feet per employee at the end of next year to this year’s number to determine whether the strategic decisions you made improved this metric over the year.

Real estate cost per employee:

It is the total real estate cost per employee divided the total number of employees.  To make this number meaningful, you need to define real estate cost.  It can include rent, operating expenses, utilities and/or taxes across the whole portfolio. To be meaningful, the components included should be the same year over year.  The data can usually be obtained from the accounting department at your organization.

The real estate cost per employee is a great way to evaluate the relative cost of different locations.  For example, a law firm leasing five thousand square feet in downtown Manhattan for ten lawyers may pay $50,000 per lawyer for space.  If that same firm leases fifty thousand square feet in Birmingham for 100 lawyers, the cost per lawyer is $10,000.  The square feet per lawyer (500) is the same in both offices.  However, an improvement in the density of the Manhattan offices will produce an exponentially greater reduction in costs than that same improvement in Birmingham.  The law firm can use this data to identify high value cost savings opportunities.

Internal vacancy rates (how many unassigned seats do you have?):

To calculate this number, you need a seat count for each office as well as a headcount.  The criteria for determining the number of seats should be defined. For example, it could be one seat per workstation or office.  Conference and huddle room seats should not be counted unless they are used primarily as regular workspaces.  IT can be helpful in determining seat count as they can usually tell you how many phone lines or handsets are deployed and how many of those have numbers/employees assigned to them.

Once determined, this seat count can then be divided by the total number of employees to determine what percentage of your seats are vacant.  Depending on the volatility of a business and its growth plans, optimal vacancy rates may be as close to zero as possible or as high as 10-15% to allow for fast growth.

If you have a badge security system, you can also determine how many employees on average are in the office on a daily basis.  This information can help you understand whether those assigned seats are actually being occupied by their assigned employee each day.  In industries like accounting this data has been used to justify a hoteling strategy where some of the seats are left unassigned and may be used by any employee in the office on a given day.

Employee attendance, productivity and satisfaction:

These measures are more subjective but they can help you identify strength and weaknesses in your workplace design and operation.  They can also be utilized to gauge whether a change made to improve design or operations was effective.  When Deloitte built out 500,000 square feet in a new, highly-amenitized building in Toronto, the number of employees going into the Toronto office to work (rather than working remotely) sky-rocketed.  Because this increase was a desirable to Deloitte, they used this data to help them refine their strategy for future locations to focus on amenities.

Your real estate,whether a single location or a multi-market portfolio of properties and leases, is a significant asset and cost to your organization. It houses your employees, facilitates the operation of your business and brands your company to your clients. An evaluation of the metrics of your real estate can help you understand where you are and provide a benchmark for measuring future success.

I hope everyone shares this sentiment, certainly for me, 2016 was a fun year.  Professionally, with my partner, Joe, I was able to complete some interesting transactions that created a ton of value for our clients.  One of the highlights was a project I worked on with our client, ProAssurance, and its director of real estate, JC Blakely. 

We have been working with ProAssurance for several years and as part of that strategic partnership, we monitor their real estate portfolio for opportunities to save them money and/or create value.  ProAssurance’s portfolio includes some owned buildings across the country acquired through a various mergers and acquisitions.  Recently, some of the operations previously handled out of one of these buildings, a 35,000 square foot office building in Madison Wisconsin, were consolidated to another location.  This meant that ProAssurance had an opportunity to sell the building and relocate to an appropriately-sized space in a building with more amenities.  The building came with a few acres of cropland adjacent to the building and ProAssurance had been leasing that cropland to a farmer.

We partnered with a local Madison broker with whom we had worked previously — Mike Herl.  Because the land and the building were in a developing area of Madison, we thought there was a great opportunity to sell both the building and the land at a great price for ProAssurance.

In order to ensure that there were no negative tax consequences associated with the sale of cropland due to its likely conversion to commercial development, we identified a qualified WI tax lawyer to advise on the process.  Once that hurtle was cleared, we placed the property on the market.

Several buyers were quickly identified and two offers were received.  We negotiated on the best overall offer while also working to secure leased replacement space for ProAssurance.  Because the buyer wanted to close quickly, we negotiated a leaseback post-sale until ProAssurance’s new space could be built out. We were also able to negotiate the sale to the buyer of ProAssurance’s fully amortized furniture inventory.

The building brought a purchase price of $4.7M and the cropland brought an additional $1.75M.

The sale and relocation resulted in a 70% net reduction in ProAssurance’s occupied space in Madison and operating costs were reduced significantly.  In addition, in the new location, all employees will be located on the same floor in modern space built to increase collaboration.  Finally, ProAssurance will no longer have to provide facility management for a building remotely located and not fully occupied. Working on a team so focused on getting the best result for ProAssurance made all of the challenges associated with selling a building, structuring a lease back on a portion of the space and negotiating for a relocation site worthwhile.  It is rewarding to watch it all come together and I can’t wait for the next challenge in 2017!

Photo credit: CommercialSearch.com 

Surprises and vivid action matter far more than we imagine, and we regularly underinvest in them.  – Seth Godin

I read this quote earlier this year and in reflecting on 2016, I am overwhelmed by its truth.  For me, the high points of the past year almost all embody at least one of these two characteristics.  As examples:

·         Receiving two small brass elephant bookends hand delivered to my house on the date of the SEC championship by friends who just knew that I would love them.  (Roll Tide!)

·         Reading a text from a vacationing client thanking me for my efforts on behalf of him and his company.  Incidentally, this is not the first time he has done something thoughtful like this.  And I would do anything for someone who treats me like such a valued partner.

·         Arriving to work to find a large bag of my favorite dark chocolate with a kind note from a co-worker who makes my life easier on a daily basis.

·         Enjoying a lovely dinner out with my husband compliments of my partner who appreciated my work on a deal.

·         Opening my mail to find an article that one of my blog readers thought I would find interesting.

·         Being awarded a Colliers Blue Mont Blanc pen in recognition of a career milestone at a staff meeting.

·         Having a friend who could give Martha Stewart competition come to my house at noon laden down with tableware to set a beautiful table for me for a party I had planned in the evening.

The common thread?  When we are surprised, we recognize that someone was thinking of us and cared enough to let us know. And that feeling has staying power.  We may forget an offhand spoken “thank you”, but we usually bask in reading a well-written thank you note.

I have made a concerted effort this year in both my personal and professional life to let friends, family and clients know that I am thinking of them and value them. This might be the most important part of my job.  Have you been on the giving or receiving end of surprises and vivid action?  Do you agree with this quote?

If your firm or company leases office space, the odds are good that you pay your landlord for actual annual increases in the cost of running the building.  Leases are either set up (1) to include a base amount of operating expenses in the rent (usually equal to the actual total costs in the first year of the lease term) and in subsequent years, the tenant reimburses the landlord for actual costs in excess of that base year amount (“full service”) or (2) to exclude these amounts from rent but allow for separate reimbursement from the tenant for all operating expenses incurred by landlord (“net”). 

Whether net or full service, the landlord usually estimates operating expenses for the coming year and the tenant pays 1/12 of that estimated amount each month during the year.  After the year ends, the landlord reconciles what was actually spent to operate the building with what the tenant paid over the year.  The tenant then either pays any shortfall or is issued a credit for any overpayment against rents coming due.

These reconciliation statements typically arrive at the end of the first quarter and often accounting departments pay them without review.  However, in my experience, it is worth taking a little time to do a quick audit of the statement.  Here is our approach:

If your lease is full service, make sure that the base year reflected on the statement is accurate.

Oftentimes a company will add expansion space over their lease term and that space will have a different base year than the original space. Or, if a lease is renewed and the tenant is given a new base year, occasionally the reconciliation reflects the original base year which is lower, resulting in more cost to the tenant.  It is worth confirming that all base years are correctly stated.

Check “gross ups”.

Most leases provide that tenants pay their proportionate share of operating expenses based on their share of the total building square footage.  So, if a tenant occupies 40,000 square feet in a 100,000 square foot building, the tenant pays 40% of the total operating expenses for the building.

However, some expenses, like janitorial, are variable.  For instance, if 20,000 square feet are vacant in that same 100,000 square foot building, the landlord is not going to pay to have that space cleaned every day; the landlord is only going to pay to clean the 80,000 square feet of occupied space.  So, if the tenant pays its pro rata share (40%) of the actual janitorial costs incurred, that tenant is essentially paying for 32,000 square feet of cleaning which is less than  the appropriate cost.  As such, most leases contain clauses that allow the landlord to gross up variable costs to reflect a fully occupied building.

In reviewing gross ups, make sure expenses being grossed up by the landlord are truly variable. Variable expenses are often specifically defined in the lease and usually include janitorial costs, management fees and utilities which understandably fluctuate with occupancy levels.  When we see landlords gross up taxes, we will question it because taxes do not get reassessed each year based on the occupancy rate in a building. Similarly, grounds maintenance should not get grossed up because grounds have to be maintained to the same standard regardless of occupancy levels.

Compare last year’s itemized costs with this year’s.

Have any expense categories increased by an inordinately large percentage compared to the other categories?  If there is not a simple explanation for it, i.e. utility rates increased, it is worth asking the property manager for more information.

Are there any new categories of expenses reflected on the reconciliation that were not included in previous years?

I had one client receive a reconciliation billing them for “lobby art”.  Their lease specifically provided that artwork was a landlord expense and could not be passed through to the tenant so the tenant was able to remove that $20,000 expense from their bill.

Is the math correct?

Sounds simple but I make mathematical errors regularly and property managers are fallible too.

Check for capital expenditures.

Most leases do not allow landlords to include capital expenditures in operating expenses unless they increase the operating efficiency of the building thereby decreasing operating expenses over the long term.  If your lease has language like this and there is a large capital cost included on the reconciliation, it is worth a friendly call to the property manager to get more information about the nature of the expense.

As our team reviews reconciliations on behalf of our clients, we try to keep in mind the long-term nature of the landlord/tenant relationship; we want everyone to get along over the life of the lease.  As such, our approach is always collaborative in nature as we know most overcharges are inadvertent and usually quickly remedied by the property management team.  Is there a something I missed?  I would love to hear your comments! And, if you would like to download my list of operating expense exclusions, go to this page.