The common approach to property management is broken and is not delivering optimum results, in my opinion. Here is why I believe this.

The Wrong Focus

The focus of many owners and property management practitioners is on ‘managing the property’ and ‘cost containment’. I feel those are the wrong areas to concentrate your efforts on. But don’t get me wrong - curb appeal, asset preservation and efficient financial management are all key points, they just shouldn’t be the primary focus of the property manager.  Why?

Let’s first look at it from the manager’s perspective. Curb appeal, asset maintenance and repair are visible demonstrations of active management, and some would say good management. It is easy for the manager to report to the owner(s) that something was broken and is now repaired or something was dirty and is now clean. I call it “cleaning the glass and cutting the grass” management. I don’t really blame the manager for concentrating on things they can point to as the result of their active management.

The real estate management industry is almost invisible to the general public. When everything is working properly no one notices. The elevators run, there is no garbage in the hallways, the temperature is comfortable, etc. These are expected norms. But if anything goes wrong, everyone notices. As a result, property managers toil away in obscurity. Unless they make a point of letting their employer, client and customers know of the physical, demonstrated fixes they made it is easy to have their work go unnoticed. Cleaning the glass and cutting the grass a simple way to validate their worth.

Now the owner’s perspective. Obviously, if things do go wrong people notice and when people notice they tend to comment or complain. In worse case scenarios, the situation can make national and international news. It is in the best interests of the owner to have no complaints, or bad news. A poorly maintained building is also more difficult to lease; which affects occupancy and rents.

Owners want their property to be competitive in the market when quoting lease rates and they would prefer to have the maximum amount of ‘gross’ or total rent paid go in their pockets rather than flowing through as maintenance and operational payments. Therefore, owners also look carefully at cost containment.

On face value both managing the physical asset and containing costs are sound practices for both the manager and the owner. And let me repeat, they are both important and prudent. The issue is when these become the primary focus of the property manager.

Effective asset preservation, or managing the property, should be considered a given in the industry. My feeling is any company - or anyone - who can’t execute correctly on this point should seriously consider their future in real estate. So, if this is a given, the need to demonstrate active management by spending the bulk of a manager’s time in this area should be taken off the table. It is no longer relevant for the manager to prove their worth this way.

There are also far better ways to ensure asset preservation than having the property manager handle this area. The solution lies in the organizational structure, a new set of practices and in technology. Likewise, a primary focus on cost containment does not provide for optimum returns. There are many reasons for this.

The first reason is that every building has a base line of costs that must be spent. Attempting to operate below that line affects asset preservation and curb appeal; which, in turn affects leasing and brand.

Another reason is that until that base line is reached, the effect of cost reduction is diminished over time. A simple illustration for this is to place 100 pennies on your desk and remove 10% of them at a time. The first time, you will remove 10. The second time you will remove 9. The third time 8 pennies will be removed. Each time you remove a fewer number even though you maintain the same 10% percentage target.

In practice, it becomes more difficult to maintain a constant 10% reduction. At the beginning inefficiencies may be easier to spot but over time, as one moves closer to the base expenditure line, the challenge shifts from inefficiencies to making choices that may affect the asset.

Effective financial management and efficient operations should also be a given in the industry, but a race to the bottom of the price tier of comparable rents should not. This is not optimizing return, though many believe it will. Do you agree?

Companies such as Walmart, Amazon and Costco, just to name three, have shifted the public’s perception of price. Other retailers who attempt to price match them found their margins cut, sometimes to the point of irreparable losses. Their perception was that they needed to price match to attract customers. They commoditized the products they sold and even their business in order to price match. However, many didn’t realize that these three companies (and others) created a different operating model and they weren’t simply operating on a thinner margin. The same thing happens when owners and managers look to achieve comparable rents without looking at the modelling behind the other rents.

The effect of operating cost reductions on increasing base rent in triple net properties also takes time to bear fruit. The concept is sound. If the total rent is, say, $10.00 with $3.00 going to operating costs and $7.00 to base rent; it would be more beneficial to have $2.00 in operating costs and $8.00 in base rent.

But the ability to realize that potential uplift may be years away depending on the term of the lease. Moreover, because triple net leases have compartmentalized rents, savvy occupiers will still negotiate the base rent and discount the operating costs as there are variables beyond the owner’s and manager’s control. In fact, some will use a low operating cost as an argument to lower the base rent claiming that the level may be below the base line required and thus it is unsustainable over the lease term.

Base year and modified gross leases that escalate every year can be trickier.

Again, I believe that sound and efficient financial management is important and should be a given in the business. I also believe that any ‘given’ in the industry shouldn’t be where the focus lies.

Return on Investment

Time and effort is usually spent on those areas where there is a focused outcome. In the traditional approach to property management, time and effort are mostly spent on managing the physical asset and cost containment activities, followed by reporting those activities to the owner.  Ask a manager to keep a two week diary of their activities and you are likely to find this to be true. Imagine an inverted triangle representing their time allotment. If their time was plotted on this triangle the widest part would contain operations, repair and maintenance activities, followed by cost containment and financial management, followed by reporting and so on to the smallest tip of the triangle.

The time spent on the top three activities in the triangle, that are common throughout the industry and should be minimum expectations, provide little tangible return as compared to other activities the manager can perform. The 80/20 rule applies.

Unfortunately, the traditional and typical approach to property management perpetuates the model. It is the first reason the current system is broken and not producing optimum returns.

Lease Enforcement

The second reason owners do not achieve optimum returns from the traditional property management model is a reliance on lease enforcement practices in property management. I am all for lease compliance and believe that both the landlord and tenant have to uphold the obligations in the lease.

However, using the lease as an ‘enforcement’ tool is commonly unproductive. By definition, enforcement is an ambulatory action and occurs after the fact. If everything runs smoothly, then enforcement wouldn’t be needed. The concept of enforcement dates back to the Middle Ages and the concept has inherently remained unchanged through to today – though the legal system has significantly complicated it.

I am not advocating that the lease be locked in a drawer and remain untouched during the term, nor am I suggesting a “Pollyanna world” where everyone always does what they are suppose to do. There are times when the lease must be enforced. My beef is when the property management system starts at enforcement because there are few options thereafter. A doctor doesn’t remove a broken arm. Instead the arm is placed in a cast.

Enforcement is a negative concept and tends to create an adversarial approach. This is counter-productive as it colors the supplier/client relationship.

Conversely, establishing and then continuously reinforcing conditions of mutual satisfaction creates a dialogue and positive atmosphere. Unfortunately, few property managers practice this because of the reliance on a process favoring enforcement. Moreover, there are few processes and systems in use today that support this mutual satisfaction concept .

How to Fix It

There are many other reasons why I believe the current property management system is broken. But by now I hope you see that the traditional way property management has been conducted over the past 100+ years – its standard structure, practices and technology - can’t continue to work. It is too simplistic to suggest that the way to correct and modernize the approach to property management is to flip the triangle, but that IS what needs to be done.

Returns are optimized by changing the focus and business model. It is something we have accomplished, but it takes new structures, systems, processes and procedures. Managers and others in the property management industry require new and different training.

As a result of our focus we have achieved rent 35% above comparable properties, created brands for the properties we’ve managed, increased occupancy to as much as 100% with waiting lists, increased renewal intentions by over 20% and generated 17% more rent tolerance at renewal.

We know what needs to be done and can do it for your company. Today’s returns must come from ongoing holdings. Doesn’t it make sense to have the most effective property management system in place to optimize those returns?

© 2011

Peter D. Morris SCLS, SCSM, SCMD

Greenstead Group LLC

Glendale, CA 91202

213-840-9879

May 17, 2011: Lloyd’s of London, the world’s largest insurance market, estimated net claims of $3.8-billion before tax from 2011’s Japan and New Zealand earthquakes and Australian floods. Lloyd’s also said that it expects insurance prices to rise as a result of those events and the tornadoes in the United States.

It cautioned that the final net claims figure “may vary” from the preliminary estimates, but said they are consistent with industry losses of $30-billion for Japan, $9-billion for New Zealand and $5-billion for Australia.

The Lloyd’s CEO acknowledged that there would be a “firming of rates” following tornadoes that hit U.S. southern states in Spring 2011. The death toll for the series of more than 200 tornadoes that ripped across six states is above 300, while U.S. officials are still tallying how many homes were destroyed.

This news story illustrates how even the lowest risk property is affected by world events. We started telling clients several months ago that insurance premiums were going to rise and now is the time to review current insurance policies.

While some insurance coverages are mandated by financial underwriting; many others are not. We advised clients to seek the advice of competent insurance brokers after reviewing their leases and financing documents with their lawyers.

That said, here are some prudent business steps owners should consider.

Check the rating of your insurance company.

While Lloyd’s indicated that their anticipated exposure to the world events above would not impact their capital; the same may not hold true for smaller companies. Just looking at the math, it is apparent that many insurance companies will be affected. Consider that Lloyd’s is the world’s largest insurance market. It is estimating it’s exposure at $3.8 Billion of the total industry estimated losses of $44 Billion. The last thing any owner wants is to find their insurance company can’t cover a loss.

Review the impact of potential increases on the total cost of operation.

For many well constructed commercial properties in North America, insurance premiums amount to approximately $0.20 per square foot of GLA. Even a 10% premium increase will be just two cents per square foot.

While this may be manageable for some properties and their tenants, it may not be acceptable for others; such as a property about to incur significant capital improvement amortization costs or large increases in other cost categories, or in properties with significant vacancy.

Review the leases.

Many leases allow the landlord to pass through deductable amounts as a common area charge. In light of a significant premium increase, which the tenants also pay for, it may be more prudent to consider increasing the deductable in order to blunt the impact of the premium increase.

This has to be done with great care and knowledge of both insurance and law. The owner must also carefully weigh the likelihood of a claim and research the risk profile of the property. In addition, the owner should consider the impact of a high deductable charge on the financial viability of the tenants, should there be a claim.

Make sure your tenants have valid and effective insurance in place.

Almost all leases require the tenant to provide proof of insurance in keeping with the types and amounts stated in the lease. Unfortunately, many owners and managers don’t have a process to manage this important function or the certificates tenants send are simply received and filed. This is a mistake. Our experience indicates approximately 1/3 of received certificates contain material errors that increases the coverage risk for the tenant and the owner.

Know the risk profile of your properties relative to the market average.

A lower risk profile provides you with negotiating strength. Plus, the impact of a percentage increase to premiums (ie: and across the board 10% increase) is greater on those with initially higher premiums. Once you know the risk profile the owner can take steps to mitigate and manage risk. For example, a standardized risk management and inspection program we created and use was, in part, responsible for a premium reduction for properties using the program. This was because the claims history was low due to our proactive management of potential risk and because we could visibly demonstrate active management via our reports.

It is safe to conclude that insurance rates will increase as a direct result of world and domestic events. Bear in mind too that the comments by Lloyd’s occurred before the massive flooding of the Mississippi and the wild fires in Alberta, Canada.

© 2011 Peter D. Morris SCSM, SCMD, SCLS

www.beyond-the-building.com 

 

 

Tom’s video store closed at the expiration of the lease because cash flow dried up during the recession and the business couldn’t be sold. Within a week a major tenant in the same property sent the owner a letter telling them they were reducing their rent payments in accordance their lease because the center’s vacancy exceeded the permitted amount. When one event causes an event or multiple events in other leases we call those “Cascading Clauses”. Here are three Cascading clauses to avoid if possible.

• Co-Tenancy

As our fictitious example demonstrated, the closure of the store allowed another store to reduce its rent. Co-tenancy clauses are quite common in retail properties today as one merchant looks to leverage the success of other merchants that attract the desired or similar customer base. These clauses may be tied to the continued operation of the anchor tenant, a percentage of the property being occupied, a category of merchandise being offered in the center or a specifically name merchant.

The tenant will use various strategies and arguments to convince the owner that a co-tenancy clause is warranted.  Most of these revolve around the continued viability of the tenant’s location. There are a number of strategies that we advise the landlord can introduce to minimize the risk associated with these clauses depending on the reason for the tenant insisting on a co-tenancy clause. To cover all those is beyond the scope of this article, and the best solution typically requires an understanding of the specifics of each situation so we encourage you to contact us if you would like assistance in your property.

The bottom line however is that co-tenancy clauses can cause a ripple effect across the property that significantly cripples the financial and leasing ability of the owner - sometimes through no direct reason of the owner’s actions. If at all possible, it is best to avoid co-tenancy clauses.

• Most Favored Nation

This is our own terminology for this type of clause negotiated by some sub-anchors and tier two brand name tenants.  In many cases this comes at the landlord as a ‘trap-door’ clause too. Yes, that is our terminology too. A trap door clause is a seemingly innocuous clause that either through wording in the lease or practice can have a far greater effect than originally contemplated.

The concept of a most favored nation clause, as portrayed by the tenant, is that the owner won’t act negatively to the tenant as compared to other tenants. The tenant’s lawyer will submit broad wording that upon closer examination, shows its true intent. This intent means that the landlord won’t negotiate any clauses contained in the tenant’s lease on more favorable terms with any other tenant during the lease term. For example, if the tenant’s lease has a three mile radius clause and the owner agrees to a two mile radius for another tenant, the original tenant radius will now be two miles.

Obviously, there are many significant issues with this type of clause. Essentially, the tenant who has this clause is perpetually in a position of negotiating their lease terms for the duration of the lease, plus they obtain the benefit of concessions that may only be available to a stronger tenant.

The tenant requesting this type of clause may introduce it near the end of the negotiation as the owner counters other requests. The tact the tenant may use may be as simple as saying: “OK, we have given more on these points than we normally would. You beat us up Mr./Ms. Landlord, but we both want to conclude this lease; we just don’t want you to offer the next merchant more than you are willing to give us, so let’s agree you won’t do that, OK? That is a reasonable request and you wouldn’t do that, would you?” The last question is made more as a statement making it a rhetorical question to which they don’t expect an answer.

Be wary of all tenant submitted clauses that use words such as equitable, equally, etc. Tell your real estate lawyer to pay particular attention to these clauses. Ideally, they shouldn’t be included in the lease, but again there are strategies to mitigate your risk IF you absolutely must provide some comfort to finish the transaction.

• Limits on Anchor Share Contribution Transfer

Many anchor leases contain caps or limits on their contribution to common operating expenses. There are many reasons for this. Sophisticated leases recognize these anchor limits and exclude the anchor’s area from the calculation of share of expenses paid by other tenants. The objective is full recovery of the property expenses.

Likewise sub-anchor and brand name ancillary tenants know there is a form of ‘trickle-down’ effect because the anchor doesn’t contribute as much per sq ft as they do to the operation of the property. They introduce wording that limits the total obligation transfer to their contribution from the anchor’s presumed contribution shortfall.  Any amount exceeding the limit can’t be collected from the tenant with this clause, resulting in increased expenses covered by the landlord.

Aside from the internal cost of administering these leases and the potential recovery short fall; these calculations tend to create errors which compound problems for the owner financially, to their reputation and in tenant retention. Ideally, this transfer limit clause should never be agreed to for these reasons. However, in the real world, owners will come across these if they deal with well known and desirable tenants. Again there are strategies to deal with these depending on how the tenant submitted clause is worded; so it is important that your lawyer be aware of your issues with this type of clause.

In this article we have referred to ‘tenant submitted clauses’; we always recommend the landlord draft all the lease language via their lawyer or and have it reviewed by their lawyer. Ultimately, though the owner can expect the tenant’s lawyer to suggest revisions to the wording. This is what we mean by ‘tenant submitted clauses/wording’.

These are just three of the Cascading Clauses an owner will come across when dealing with knowledgeable tenants and their legal advisors. There are business and negotiating strategies to remove these requests from the table; or to mitigate their potential impact on the property if the owner must include some version of these concepts. We know what those strategies are and can advise you according, from the real estate business perspective, given our extensive asset management experience. However, we are not offering legal advice and strongly encourage owners to always engage competent legal advice to document the concepts you want in the lease.

If you would like more information, please contact use at 213-840-9879.

Peter D. Morris SCSL, SCSM, SCMD

© 2011

PMorris@beyond-the-building.com

The IASB and the FASB (the “boards”) discussed inception versus commencement, discount rate, initial direct costs, separating lease and non-lease components of a contract and sale and leaseback transactions at their meeting March 21 and 22, 2011.

Inception v. Commencement

The boards discussed the accounting for elements of a lease at the date of inception versus the date of commencement from both the lessee's and lessor's perspective and tentatively decided that the new leases standard would:

  a.       Require a lessee and a lessor to recognize and initially measure lease assets and lease liabilities (and derecognise any corresponding assets and liabilities) at the date of commencement of the lease. This is different than the evaluation draft (ED) that suggested this occur on the date of inception (ie: when the lease is signed).

  b.      Require a lessee and a lessor to use a discount rate calculated at the date of commencement when initially measuring lease assets and lease liabilities. This is consistent with the ED.

  c.       Include guidance on the accounting for costs incurred by the lessee before the date of commencement of a lease. This was silent in the ED.

  d.      Add guidance on accounting for lease payments made by the lessee before the date of commencement of a lease. Again, the ED was silent on this matter.

  e.       Include new application guidance for  accounting for lease incentives provided by the lessor to the lessee, such as free rent, allowances, etc . This guidance clarifies that the lessee will deduct all lease incentives from the initial measurement of the right-of-use asset.  

The boards also discussed ‘accounting for a lease between the date of inception and the date of commencement when the contract meets the definition of an ‘onerous contract’. The IASB affirmed the proposal in the ED to exclude lease contracts that meet the definition of an onerous contract from the Leases standard between the two dates. Those leases would be accounted for in accordance with IAS 37, Provisions, Contingent Liabilities and Contingent Assets, until the date of commencement. The FASB indicated support for applying Topic 450 Contingencies, but noted that this would be reviewed when the boards consider “impairment” at a future meeting.

Initial direct costs

The boards tentatively defined initial direct costs as costs that are directly attributable to negotiating and arranging a lease that would not have been incurred had the lease transaction not been made. This was supported by all board members concerning lessees, but six of 15 IASB members voted against this for lessors, indicating that this issue may yet be reviewed again.

The boards affirmed the ED that lessees and lessors should capitalize initial direct costs by adding them to the carrying amount of the right-of-use asset and the right to receive lease payments.

Discount rate

The boards tentatively reaffirmed the ED proposal, but clarified the following:

  a.       The lessee would use the rate the lessor charges the lessee when that rate is available; otherwise the lessee would use its incremental borrowing rate. This is an affirmation of the ED methodology.

  b.      The lessor would use the rate the lessor charges the lessee.

  c.       The rate the lessor charges the lessee could be the lessee's incremental borrowing rate, the rate implicit in the lease, or, for property leases, the yield on the property. When more than one indicator of the rate that the lessor charges the lessee is available, the rate implicit in the lease should be used. The boards also tentatively decided to provide application guidance for the determination the yield on property. What is not yet clear to us is if each lease would receive the current yield estimate for the property (appraised cap rate) or the yield used at the purchase date of the asset and what third party evidence would be required.

Separating lease and non-lease components of a contract

The boards tentatively decided that an entity should be required to identify and separately account for the lease and the non-lease components of a contract and decided that in allocating payments in a contract between the lease and non-lease components of the contract:

  1.      The lessor should allocate payments in accordance with the guidance on revenue recognition.

  2.      The lessee should allocate payments as follows:

a.       If the purchase price of each component is observable, the lessee would allocate the payments on the basis of the relative purchase prices of individual components;

b.      If the purchase price of one or more, but not all, of the components is observable, the lessee would allocate the payments on the basis of a residual method or

c.       If there are no observable purchase prices, the lessee would account for all the payments required by the contract as a lease.

The boards directed their staff to include application guidance on how a lessee should determine what would be an observable price, taking into consideration the relevance of guidance in other projects such as revenue recognition.

In the case of real estate then, operating costs, if separately observable would not be capitalized as part of the lease. Subject to the staff directive we would take it that items such as realty taxes and insurance premiums, if separately observable (accounted for) would not be included in the capitalized lease. This is different than the board staff originally suggested and as we originally reported.

Therefore, we continue to suggest that all leases be reviewed to determine if these costs can be reported separately. Lessees should request detailed accounting of operating costs from their landlord’s if they have base-stop, gross or modified gross leases.

Sale and leaseback transactions

The boards affirmed the ED that when a sale has occurred, it will be accounted for as a sale and then a leaseback. If a sale has not occurred, the entire transaction will be accounted for as a financing.

The boards tentatively decided that an entity should apply the criteria described in the revenue recognition to determine whether a sale has occurred. The boards affirmed the ED that in a transaction accounted for as a sale and leaseback:

 1.      When the price consideration is at fair value, the gains and losses arising from the transaction should be recognized when the sale occurs.

 2.      When the consideration is not established at fair value, the assets, liabilities, gains and losses recognized should be adjusted to reflect current market rentals.

The boards confirmed that the seller/lessee would adopt the 'whole asset' approach in a sale and leaseback transaction. The 'whole asset' approach deems that in a sale and leaseback transaction, the seller/lessee sells the entire underlying asset and leases back a right-of-use asset relating to part of the underlying asset. The boards tentatively decided that the leases guidance would not dictate a particular type of lessee accounting model for entities that are accounting for the leaseback part of a sale and leaseback transaction (ie: derecognition or right of use).

Next steps

The boards will continue their deliberations of the exposure draft next month.

It is becoming clear to us that the boards are reaffirming the provisions of the ED, while providing clarification and landlords and tenants should not expect a wholesale change to concepts outlined in the ED. Unlike, previous headlines that the board are “retreating" on the new accounting provisions, they are intent of seeing leases accounted for on the balance sheet with only clarification of certain provisions in the ED based on the comments they received.

Accordingly, we continue to advise landlords and tenants that they should develop and action plan that starts with a review of their leases and the supporting data, create a strategy plan for the implementation of the new accounting rules and start the process sooner than later taking into consideration the tentative decisions made to date.

We Can Help

Our experts can help you gather the information and data you need for compliance as well as analyze your leases. We can also help you develop a real estate strategy to deal with implementation and ongoing issues such as inquiry management. Please call us at 213-840-9879 or email us at pmorris@greensteadgroup.com today.

Disclaimer

We are not offering accounting or legal advice. All readers are encouraged to engage professionals in these areas.

© 2011 Peter D. Morris

www.beyond-the-building.com

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Product marketers have long known that every product has a consumer-perceived image. That image is good, bad or indifferent and is compared to other products in the same category. Product marketers also know that the image can be left to the marketplace to create or it can be managed. When the image is both managed and positive to the objectives of the product it is a “brand”.

Likewise, every piece of commercial real estate has an image. Only a few have a brand. And that is a problem for today’s owners wanting to attract and keep tenants while maximizing revenue.

We believe every commercial property today requires a brand to achieve success. Here are seven reasons why:

1.       Real estate returns must come from ongoing operations. Having a brand focuses all management and leasing activities on the core objective for the investment. For example, Volvo’s brand is safety so each product and model year is designed around and expands their commitment to safety.

2.       A brand differentiates the property from the general marketplace. It makes the leasing story easier to tell and more memorable for the potential lessee. If the leasing agent can’t describe the unique proposition of the property  then how is the prospect going to compare it to other options?

3.       A successful brand creates its own media and attention. People are drawn to the brands they desire so the property brand ‘pre-sells’ the property to the prospect. Any retailer, for example, can name the most prestigious shopping street in Beverly Hills. Every tier one law firm knows ‘the’ address to be in Manhattan, Toronto or Paris.

4.       A good brand identifies a market. This again simplifies leasing. It also identifies the lessee’s market and customer which makes the property even more powerful. For example, a well executed and successful retail property is defined by massing and specialization. In order to achieve that the owner must first identify the target market.

5.       The first to brand creates a perception of leadership. It places the competition on the defensive as their product will be compared to the leader in the buyer’s/lessee’s/consumer’s mind.

6.       A well executed brand commands a premium. Think brand name v. generic anything. The brand always commands a premium because of its focus on its market. A common misconception however is that this only applies to luxury brands. Walmart is not a luxury brand but few landlords would argue that Walmart doesn’t extract a premium during negotiations.

7.       A great brand creates its own market. A community shopping center we created a brand for commanded rents that were 35% above the general market and touched on per square foot rents achieved by the area’s leading regional malls simply because we could demonstrate all the points above. Comparable rent analysis for the asset type was meaningless and the property had a full waiting list of eager tenants.

 How is a brand built?

Whether you want it or not, your property already projects an image. What that is determines the specifics of the brand architecture. Does that image need to be torn down and rebuilt? Does it need to be reshaped or is it on the right track and only needs attention? Whatever the situation though, it requires active management rather than leaving it to the fickle marketplace.

The first step is a ‘cold light of day’ analysis of the present and the potential.

The next step is the creation a brand strategy. This is a manual that details how the brand should look and feel to the intended market and what is required to reach the objective.

We simply stated that no food outlet in the community center above would have ‘plastic chairs’, as just one item in our brand strategy. This eliminated most ubiquitous fast food burger operations. Instead our leasing focus was independent and regional burger emporiums. Our tenant design criteria also reflected the no plastic chairs policy.

Why no plastic chairs? If the consumer could get the same burger for the same price at any one of a few dozen locations under the same trade name in the area why would they choose this particular property location? Offering exactly the same as other community centers didn’t support our brand strategy. It diluted our market potential and transferred the property brand to that individual tenant.

The final step is to commit to the brand. This is not only publicizing it to everyone; but to stay the course for the long run because you will confuse the market by frequently changing what the property stands for. It also means the brand must permeate through everything that is done. There must be consistent and holistic application of the brand strategy in every action, communication, visual, etc.

Which properties need a brand?

We believe every commercial property needs their own brand. Certainly, retail properties must create a brand; but so must office buildings, business parks, mixed use developments, institutional and corporate real estate (these require special branding considerations) and even industrial properties.

Need a brand to propel your real estate success?

Call us. Our real estate executives team with brand and marketing specialists to create a distinctive brand. We can manage the entire branding process as well as your real estate. We also offer unique management and tenant programs that will elevate your property brand. Contact me to learn more.

pmorris@Beyond-the-Building.com

www.Beyond-the-Building.com

© 2011 Peter D. Morris

All Rights Reserved

Lease Accounting Changes Update #3 March 6, 2011

The IASB and the FASB met March 1 & 2, 2011. Part of their discussion was the proposed change to lease accounting. More specifically they discussed the application of the right-of-use model to all lease arrangements and the scope of the leases standard.

Confirmation of the right-of-use model

The boards affirmed the decision in the Leases exposure draft (ED) to use a right-of-use concept to all lease arrangements. A lessee would recognize its right to use an underlying asset during the lease term and a liability of its obligation to make lease payments over the term. The boards agreed that the use of the right-of-use model by a lessor will be discussed at a future meeting.

The boards tentatively decided that leases of intangibles are not required to be accounted for in accordance with the leases standard. Real estate is NOT considered an intangible and this decision primarily involved intellectual property and similar items. I note this so there is no confusion as the boards have lumped all forms of leases (real estate, equipment, IP, etc.) into one lease accounting standard.

The boards unanimously affirmed the decision in the ED that the following are in the scope of the standard:

•   right-of-use assets in a sublease
•   leases of non-core assets; and
•   long-term leases of land.

The boards also confirmed that the following are not in the scope of the standard:
1. leases for the right to explore or use minerals, oil, natural gas and other non-regenerative resources,
2. leases of biological assets plus timber; and
3. leases of service concession arrangements covered in IFRIC 12, Service Concession Arrangements.

Please read our other posts on this subject. We can help your company navigate through the proposed lease accounting changes. Email or call me personally for further information.

© 2011 Peter D. Morris

www.beyond-the-building.com

213-840-9879

The two accounting boards, the FASB and the IASB, continue to contemplate the proposed changes to Lease Accounting after concluding their roundtable discussions and after receiving 750 written comments on the Evaluation Draft (ED) issued last year. This update provides a summary of the Boards’ position and thoughts after their meetings from February 15 to 18, 2011. Please note that we are not providing legal or accounting advice and readers are always encouraged to seek out the appropriate professionals.

 

For a four article background on the ED and the potential concerns and impacts on real estate owners and occupiers in North America as well as our first update (to January 2011) please visit our blog at http://advance.beyond-the-building.com

 

At the February meeting the Boards discussed four aspects of the ED, namely:

• Lease Term
• Contingent Rent
• Definition of a Lease, and
• Lessee’s reporting

 

Lease Term

The ED suggested that the lease term to be brought onto the balance sheet would be the term mostly likely to be exercised by the lessee, including renewals. This was widely criticized by the real estate industry on a number of grounds including the ambiguity of the determination from one company to another. In January the Boards signaled that they would consider a higher threshold concerning term, moving from “more likely than not” to “virtual certainty”.

 

The Boards have yet to conclude on this matter but at the February 2011 meetings lent towards including renewal periods if they provided a clear economic incentive to be exercised. Not only would this include positive incentives if exercised (ie: favorable below market rent); but may include dis-incentives if not exercised, such as break fees, penalties and lease repayments.

 

The Boards also indicated favoring the actual contractual terms – for example, the initial term – as the basis. We understand this to mean that if a tenant has an exceptionally long term with an option or options to terminate at some point(s) during that term; the Boards would expect the full term to be placed on the balance sheet as compared to a potentially shorter term as proposed by the ED.

 

We believe that more clarity is needed in this area. For example, it would be difficult for a tenant with a hypothetical initial term of 20 years with stated rents plus two 5 –year options, also at stated rents, to determine if there is an economic incentive (via lower than market rents 20 and 25 years from the start of the initial lease). Therefore, the question of booking the two renewal periods is still open for discussion.

 

Furthermore, if the Boards continue with contractual terms as the basis, we may expect to see tenants who currently have exceptionally long terms and option(s) to terminate switch to shorter terms with more options to renew. In turn this may affect certain real estate sectors negatively, such as single tenant property values.

 

Contingent Rent

In summarizing this portion of the discussions the Boards’ representatives were quick to note up front that no decision was made and significantly more work was required.

 

The direction of the Boards in February appears that if the contingent lease payment, rent, was based on an index then it should be included.

 

At this point the Boards also feel that if the activity was “reasonably certain” it should also be included; however, if the activity was not certain it may not be included on the balance sheet. On this basis, rent tied to future sales (percent rent, sales rent, overage rent) would not be included as there is no certainty to future sales.

 

We note however that the Boards didn’t define “reasonably certain” during their meeting summary nor did they address the issues of insurance premiums and realty (aka property) taxes, that we noted on our earlier papers.

 

Lease Definition

The Boards continue to clarify what constitutes a “Lease” and more specifically the difference between a service contract and a lease. We expect that any changes the Boards make in this area of the ED will have little affect on the commercial real estate industry. Most of the issues raised in this area were from those that lease equipment.

 

 

Lessee Reporting

There is no question that the Boards continue to want to see lessees report the transactions on their balance sheet.

 

The significant item coming out of the February meetings was the current direction of the Boards to return to a straight line amortization of the expense rather than the frontload recognition outlined in the ED. If this direction is adopted then much of the concern about the escalation in expense due to the front loading is dissipated.

 

Again the Board’s representatives were quick to note that more work was required in this area.

 

Summary

The two Boards are still targeting the end of June 2011 for the release of the new standards and went so far in their February meeting summary to suggest that they will conclude on the above items by the end of March.

 

Given the interest in this subject lately the Boards continue to reach out to industry to provide input and tests as they work through each concept. While some have suggested that they feel the Boards may release a second ED for further widespread comment, we don’t hold that opinion given their stated objective of a Q2 release and their practice of continued industry input as each part of the standard is developed.

 

What Should Landlords, Managers and Lessees Do?

While many questions remain, many parts of the ED and the philosophy behind them appear untouched. For example, the distinction of service components compared to the lease of the underlying asset; and the need to segregate the two so they may be properly placed on either the balance sheet or the income statement. Accordingly, we continue to advise clients to gather the appropriate data and evaluate each of their leases against the information now known.

 

Landlords and Lessees who elect to wait for the final standard to be released may find a significant amount of work must be completed in a relatively short period of time.

 

We can help with a range of services including data gathering and interpretation, lease analysis, lease renegotiation, handling enquiries and more. Please contact us.

 

© 2011 Peter D. Morris SCSM, SCMD, CLS

pmorris@beyond-the-building.com

www.Beyond-the-Building.com

 

 

A perfect storm affecting occupancy in the office market is settling in and we predict it will linger for several years.

By now most investors are well aware the issues around the rise in cap rates, the increase in lease incentives, the decline in asking and net rents and the affects of lowered leverage demanded by banks. Office investors are also well aware that continued high unemployment continues to hurt the office market. Now, to add insult to injury several trends are unfolding. We’ll briefly highlight each of these trends in this article.

Bump in Lease Expiries

Approximately 25% of all office leases in the USA will expire in either 2011 or 2012. This is on top of an existing vacancy supply of 17 to 22% on most metropolitan markets. That means almost half of the entire office market is in play over the next two years.

 The Shrinking Office

In our article on the 20/20 office (click here for the link) we note the average area per office worker is shrinking.  In 1994 the average office worker had 90 square feet of space but that has shrunk to just 75 square feet by 2010 according to the International Facility Management Association (IFMA). Senior staff space also decreased from 115 square feet to 96 square feet over the same time. Intel is perhaps more extreme reducing their requirement from a snug 72 square feet to stations of just 48 square feet.

 According to estimates by design firm Gensler, their clients (representing approximately 70% of the Fortune 500) have reduced cubicle space from 8 X 10 feet to a compact 5 X 5 feet.

 The Wireless Office

Technology advances have also impacted the office and the overall requirements. Wireless technology now means the worker is no longer tethered to a specific place in the building. This allows for free form seating and “hotelling” of workers where several workers may  use the same space over the course of the work week.

 Scanners and online filing (the paperless office) combined with cloud computing are removing the need for massive server rooms and onsite file storage areas, contributing to smaller footprints.

 The Virtual Alternative

A study by the Center for Workforce Strategies, found more than 50% of North American companies offer telecommuting to their employees in some form and approximately 75% plan to expand their programs or introduce telecommuting.

Dedicated office space for employees who typically work away from the office has given way to scheduled landing pads – essentially a shared desk occupied at predetermined times. These arrangements may have been used primarily by outside sales forces in the past but, coupled with telecommuting, the concept is being adapted  to other functions/positions.

The New Urbanization

Just as the latest housing trend is a move to the urban core, for a host of reasons; the workplace is following the worker back to the central business districts (CBD). Even at the height of the market in 2007 the vacancy rates in the CBDs across America were 400 basis points lower than the suburbs. CBDs absorbed 1.36 million sq. ft. of space during the first three quarters of 2010, while vacancy rose in suburban markets by 10.4 million sq. ft.

The tenants for the CBD space continue to be those in industries that need a higher percentage of personal interaction such as finance and law; notwithstanding that both these industries were significantly impacted during this recession.

So What Should The Office Landlord Do?

There are many steps the successful landlord can take. Here are a few:

Blend and Extend

Or complete early renewals. A number of strategies need to be employed so the owner is not locked into a disadvantaged position for a long term.

Invest in Technology

Make sure your building is techno-friendly for the new work environment particularly to the needs of wireless connectivity.

Create a Building Brand

What does your property stand for? We are in an era of what we call Food Chain Leasing^SM where share of market is paramount. There will be those that survive and properties that can no longer effectively compete. The first step in winning market share is to create a compelling brand and position in the market. Product marketers have known this for years – real estate owners must now adopt the same tactics.

Adopt APL (pronounced APPLE)

Adopt Assertive Pinpoint Leasing^SM.  Create a lease marketing plan that reflects your brand, targets your desired tenancy, then hire and actively manage a leasing team that knows those tenants intimately and give them the financial tools to generate deals.

 

There are a number of other successful strategies we recommend to our clients such as creating a tenant strategy manual.

If you want to create a building brand, learn more about APL or our proprietary tenant strategy manual, need advanced asset and property management services we can help. Call or email today to start the discussion.

Peter D. Morris SCSM, SCMD, CLS

© 2011 All Rights Reserved

pmorris@Beyond-the-Building.com

www.Beyond-the-Building.com

 

The two accounting boards (the FASB and the IAS ) have concluded their four city, international roundtable discussions after receiving 750 written comments on the Evaluation Draft (ED) of the proposed changes to Lease Accounting. For a four article background on the ED and the potential concerns and impacts on real estate owners and occupiers in North America please visit our blog at http://advance.beyond-the-building.com

In this article we will recap the major themes brought to the board’s attention concerning real estate leasing.

The boards reaffirmed the requirement for leases to be record as an asset and a liability for most leasing transactions and the boards still expect to issue a final standard in June 2011. However, the boards may reconsider the most controversial parts of the ED, including the following:

• the definition of a lease,
• the treatment of contingent rentals, and
• the inclusion of renewal options.

Additionally, the boards may consider a straight-line expense recognition for many leases rather than the front-end loaded expense required by the ED.

Lease Definition

The majority expressed concern that the definition of a lease in the ED is too broad and may include contracts that are really service contracts. Many also expressed concern about determining whether items such as common-area maintenance, insurance, and property taxes would represent “distinct” services that should be accounted for separately from the lease arrangement. This is an issue we first highlighted in a previous article.

The boards began tackling this at their January 2011 meeting but no outcome was achieved.

Variable Lease Payments and Contingent Rent

Many letters objected to the proposal’s inclusion and treatment of variable and contingent rent, with several stating that the ED approach could add significant earnings volatility and would add significant costs to implement. Several comments were concerns about the reliability of estimates for long-term leases.

Many opposed the use of a probability-weighted approach to estimate any contingent lease payments, citing the complexity of the model and the subjective requirements to determine probabilities. As an alternative, many suggested using a “best-estimate” to determine the lease payments.

It is not yet clear how the boards will deal with the divergent views expressed by respondents to this part of the ED.

Lease Term and Renewal Options

The ED states that the lease term to be placed on the balance sheet should be the “longest possible term that is more likely than not to occur.” The vast majority of letters disagreed with this approach noting as the most common objection that rental in a renewal period does not represent a liability until the lessee actually exercises, and thus commits to the renewal option(s). Most felt the provisions in the current accounting standard for lease term are suitable. Specifically, if a renewal option is reasonably assured to be exercised, then the renewal period would be included. Others feel a renewal option should only be included if it is completely certain to be exercised.

Based on the volume of criticism in this area, many believe the board will set a higher threshold to include the renewal terms, from ‘most likely’ to ‘reasonably assured’. It is unclear if the boards will still require a continuous reassessment of this as expressed in the ED – with the incumbent management costs- given a higher threshold.

Expense Recognition

Most comment letters and round table participants disagreed on how a lease should be stated on a lessee’s income statement, or a lessor’s income statement when the lessor is using the performance obligation approach according to the ED. They argue the ED would result in:

• higher expenses in earlier periods of the lease and
• greater divergence from the cash payments actually made.

Government contractors and non-profits also noted concerns of using an interest and amortization expense as compared to rent expense.

At the January 2011 board meeting some members seem divided on the way to tackle this issue so we may expect some changes to the methodology suggested in the ED.

Lessor Accounting Model

Several suggested there was no need to amend the current U.S. GAAP and IFRSs lessor accounting standards. They felt the performance obligation approach or the derecognition approach outlined in the ED are not an improvement over the current standard. Many felt that the lessor accounting proposals need further refinement and guidance to determine which approach to use.

There was no agreement on lessor accounting. Some wanted the current model left as is while giving further guidance for subleases and sale-leaseback transactions; others opined one model based on the derecognition approach (which simply doesn’t work in most real estate situations); while others wanted an approach consistent with another ED currently under consideration regarding revenue recognition.

Most comments from lessors in the real estate industry advised the board that real estate leases are fundamentally different from equipment leases. Some reasons for the difference were:

-          that real estate lessors are involved in the active management of the asset,

-          the asset is typically not depreciating nor depleted,

-          the rental rates are market driven rather than based on financing of the space being leased in addition to the underlying value, and

-          the lease only covers a small part of the useful life of the asset.

Fundamental to the basic comment was the opinion that the economics of the lease will become obscured in lessors’ financial statements taking the recognition on the income statement further from the real cash payments. This is caused by front-loading income even as payments may be increasing due to rent steps over the term.

At the January meeting the boards agreed to first review issues common to both lessors and lessees before reviewing the lessor’s accounting approach.

It must also be noted that the boards intend to release an ED on new standards for investment property before the end of the first quarter of 2011. Many in the real estate industry want to be assured that the currently separate EDs on Lease Accounting, Revenue Recognition and Investment Property are consistent with each other.

Retail Lessees

Retailers specifically are one of the most impacted industries by the proposed accounting standards and as a whole have their own concerns, in addition to the general issues previously noted.  As such the industry had significant representation at the round tables and provided a large percentage of the response letters. The additional concerns included the overall cost of implementation and compliance, the subjective nature of estimates for lease terms and contingent rent (including percent rent) and the treatment of lease incentives, a subject ignored in the ED.

Competitive Comparability

Many publically traded retailers questioned the ability to compare competitors even with identical contractual commitments, given the subjective nature of each company’s estimates of lease terms and contingent rent.

Forward Estimates

Many retailers expressed concern that a potential and unintended consequence of adopting the ED as drafted would be a need for long-term, store-level revenue forecasts (to determine lease renewals, contingent percent rents, etc.) These best guesstimates would be subject to error and unreliable.

There is disagreement by retailers that the lease should even be on the balance sheet. Some argued that a property lease is not like a financing arrangement as in an equipment or vehicle lease. For example they cited mall retailers who must lease the premises and do not enjoy the option of purchasing. Therefore, no buy-lease decision is made as in a financing model so the current operating lease accounting treatment would be appropriate.

Many also said the front- loaded expense of the lessee right-of-use model is magnified for long-term leases and the issue is replicated each time the tenant enters into a new lease.

Other Industry Concerns

Other industry sectors such as telcos, financial institutions, government entities, non-profits and healthcare all had additional concerns specific to their industries. We will deal with those in a separate, brief article.

Summary

The boards have committed to release the final standard by the end of Q2, 2011. Some have countered that given the significant changes proposed in the ED and the significant reaction and opposition to the original proposal the board release a second, revised ED with a time period for further comment.

It is unclear what the outcome of a second ED would be and the boards may reject the idea of issuing a second ED for fear of creating an endless loop of input. If the boards decide to go through a second round of commentary, then it would be reasonable to expect the implementation date of new lease accounting standards would be pushed out to 2013.

While the comment letters and roundtables produced areas the boards will need to reassess other provisions in the ED are likely to remain in the form originally outlined in the ED or they will closely resemble what was contained in the ED.

One of the most significant of these is the determination of the service contracts vs lease payments. Landlords and tenants should continue to make plans to address base stop leases, gross leases and modified gross leases. This will require research and resources to research and quantify the amounts to be categorized. And this need not wait until the final standards are released as the passage of time will only complicate the task.

We also continue to believe that a prudent approach to the lease is to migrate to a Triple Net or carefree lease form rather than base stop leases. This simplifies the information management and reduces internal costs. Another area unlikely to change, in our opinion, is the lack of grandfathering of existing leases. This will impact leases entered into today even if the implementation date is postponed to 2013. This is another reason to considering a different lease form as soon as possible.

Need Help?

 

We can help. Our associates can assist you in every step of implementation and ongoing compliance regarding your real estate from education and advice to historic lease cost research and verification to handling the complete implementation process (starting with pre-implementation activities) and landlord/tenant enquiries.

Call us today to learn more at 213-840-9879

 

© 2011 Peter D. Morris SCSM, SCMD, CLS

pmorris@beyond-the-building.com

 

www.beyond-the-building.com

http://advance.beyond-the-building.com

If it is not already completed, landlords should shortly be sending statements to their tenants outlining last year's actual expenses against the prepayments. Every landlord and tenant should carefully examine these statements because they are prone to error.

It is estimated that 50% of all billings contain errors and 30% contain material errors. Our associate in Canada related the time when he found a $2 Million error for just one retail location.

These errors can occur for a number of reasons. Here are some of the most common:

• a math error
• a transposition error
• the wrong area is used
• the wrong premises is identified
• an incorrect cap is calculated or used
• the wrong inflation index is used
• the lease language is misinterpreted

of course there are many more reasons, including -on a very rare occasion - deceit and misrepresentation. Most of the time, the reason for the error is an honest mistake.

Let's look at the issues from both the landlord and the tenant's perspective, starting with the tenant.

Tenant
It is so important to ensure each billing is consistent with the lease. Ignoring a careful review may cost the tenant more than required for that billing cycle and for subsequent years, compounding the overall cost of occupancy. This is particularly true if the lease includes any of the following provisions:

• A base year or stop year
• A cap on expenses
• A cascading calculation where a subsequent figure is reliant on the accuracy of the preceding figure
• A offset amount provision

Consider the lifetime effect of an uncaught error not only during the initial term but also during the renewal periods and consider that rent is typically one of highest non-staff expenses for any business - if not the highest.

When should a tenant be particularly vigilant? The following is the rule of thumb our associates use:

Review the first lease year's expenses if the tenant has a base, gross, modified gross or base stop lease. This is important to catch any cascading issues noted above.

Review the initial lease year expenses for a net or carefree lease if the first year billing period is less than one year.

Review the expenses in the final year of the term, whether or not you have renewed or intend to renew the lease.

Review the expenses if the property ownership changed during the year.

Review the expenses if a catastrophic event occurs during the year that affects the property.

Review the expenses if a major capital expense or repair program is undertaken during the year.

Many leases used to be silent on when and the number of times the tenant could examine the expense records; therefore, most lease audit firms would review the current operating year and the preceding two years at the same time. Accordingly, a tenant with a five year term should consider a mid term review while a tenant with a 10 year term should perform two reviews during the life of the lease.

Another matter to consider at this point in the real estate cycle is that many landlords and their managers have coped with revenue losses by cutting back staff. This may mean the remaining staff are overworked and under tight time deadlines. A surefire combination that may result in errors just due to the workload.

Even as some owners are restaffing their offices we see a trend to rehiring at a more junior and less experienced level. Expense reconciliations can be very complex and require a certain level of expertise.

Who should perform a review of the reconciliation? Always use a company that has direct experience in this area. Just as you wouldn't as your family doctor to perform specialized surgery, don't ask your bookkeeper or accountant  to perform this work. It takes a keen financial eye and extensive knowledge of the lease for the best results. Likewise, this is not the type of work a real estate agent is skilled at handling.

While frequent reviews of expenses by trained experts sounds expensive, it really isn't. Most charge the greater of a modest retainer and a percentage of the savings found over a period of time.

Landlord
There are two critical concerns for the landlord: loss of revenue and loss of credibility.

While the tenant may believe that all the errors are in the landlord's favor - and some less-than-reputable lease audit firms perpetuate that belief - the errors noted above cut both ways. There have been many times when we have assumed management of a property only to find the landlord was not fully and properly invoicing the tenants, due to errors they didn't catch.

It may also be difficult, if not impossible (depending on the lease) to correct certain errors detected a few months after the landlord has sent its reconciliation.

Certain expense errors may also impact the marketability of the property. For example, the total cost of occupancy arising from an error may place the property out of the market. As a result the landlord may have to reduce their asking base rent.

The issue of credibility also has a financial impact when it comes time to renew tenants. In extreme cases the landlord can earn a bad reputation discouraging tenant representatives from presenting new prospects.

Errors also raise the internal cost of business since considerable time is spent in correcting the issue; in addition to the time cost of money if a tenant witholds a payment due.

Not to be forgotten are those less-than-reputable lease audit firms. Although they are few in number and most firms are very reputable, it is not uncommon for the bad ones to work with one tenant in the property, claim errors in the billing (real or not) and then canvass the balance of the tenants with the promise of finding similar errors in their billings. The ill-will and costs of managing the situation can be excessive.

When representing landlords we will cooperate with legitimate inquiries about the billings. However, we require the auditing firm to sign our confidentiality agreement and our standard lease also contains a number of provisions about lease and expense auditing.

In the majority of landlord cases we found their errors were caused not by accounting or bookkeeping errors; but by poor lease administration processes and systems. In short, the recovery rules set up for the property are flawed. This may be the result of a lack of understanding or skills, having the wrong people involved, not considering each changing lease in the context of the entire property or a host of other reasons.

Recognizing this we provide a service to landlords to review all the property leases and review, set up or correct the lease administration system all for a one time fee.

Alternatively, we can manage the entire lease administration process on an ongoing basis, if you prefer.

Our full service accounting package combines ongoing lease administration and accounting services for the landlord. With this package we also vet the annual reconciliation and handle all tenant inquiries and challenges.

If you would like to learn more about these services for landlord or tenants, please contact me.

© 2011 All Rights Reserved Peter D. Morris