Triple Net

August 29, 2007

Triple Net

(c) copyright, View from Silicon Valley, 2007. All rights reserved.

Once in awhile, an article in the mainstream press makes not only the points they set out to cover, but also a few they may not have intended.

Today's example is from our local paper, "Spaces and Places: Tenants on the hook for higher taxes," by Katherine Conrad.
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Back in January, Crow Holdings of Texas bought an aging Los Gatos strip mall for an eye-popping $28 million. But it wasn't until late spring that Downing Center businesses experienced the tenants' version of California sticker shock.
--note to self: Make next $28M purchase AFTER tax assessments are locked in May.

On May 28, retail tenants at the 72,000-square-foot center, at the corner of Union Avenue and Los Gatos Almaden Road, opened their monthly rent bills to discover they owed thousands of dollars in back taxes - payable in two days.

"The invoice had an increase in property taxes back-billed since January," said Dr. Irene Polhemus, owner of Los Gatos Eye Care. "The total bill came to $10,000 and something dollars. It could very well put me out of business."
--Let's see, 1.2% of $28M = $336K. If $10K is five-twelfths of their total bill, the tenant represents a little over 5,000 square feet. If this size is typical, multiply this "problem" by 14.

Crow Holdings eventually agreed to give tenants six months to pay the bill, but that's as far as it can afford to go. After all, Crow has no choice but to pay the property taxes, assessed at the $28 million purchase price, a mighty jump from the $9.1 million value assessed in 2006.
---Let's not exaggerate too much here. You don't finance $28M and have the deal go under over the 1.2% tax bill. Or do you??

It's a scene played out across the valley. As commercial real estate has changed hands, tenants who signed leases known as triple net, in which they pay monthly rent based on their total square footage, plus their share of property taxes, common area maintenance and insurance, are experiencing sticker shock.

---The new owners paid at least 3x (probably more) than the previous owner's cost. Do they need to triple their lease rates to achieve a reasonable cap rate?

"Tenants are up in arms, and they are not alone," said Dan Wald, managing partner for investment services for NAI/BT Commercial. "Price escalation has happened throughout the country. It's not personal."

"It all comes back to Prop. 13," said Ted Kokernak, vice president of investments for Marcus & Millichap.

Proposition 13, passed by California voters in 1978, effectively holds down the amount property taxes can increase annually until a property is sold. Then its value is reassessed and that usually means a tax increase.

But, as Rodney Whitley, director for Crow Holdings, noted: "We don't make any profit out of it. We are passing along the expenses that we're already covering. We have to cover ourselves also."

Whatever the reasons, the increases are hitting hard, tenants say. "The town should be protecting the people who live in it," said Polhemus, who opened her business 4 1/2 years ago. "If my whole life savings goes down the drain, that stinks. It means a hardworking citizen of your town is going down the drain."
--Oh, puh-leeze. She enjoyed a tax subsidy for years and years but now she has to pay market rate. Just like we have since moving to California in the late-90's.

The optometrist currently pays $2.75 a square foot per month on her 1,625-square-foot office plus expenses. "The taxes work out to an extra $800 a month. I physically do not have enough money to make that payment," she said.
--The tax bill is the least of his long-term problems. Assuming the owners need to raise their rents to cover the ~3x price, should she be concerned that when the lease expires, her $2.75 per square foot is also going to triple? At $800 extra per month in RE taxes, she probably has ~2,700 square feet. If the lease rate jumps by the degree as the purchase price, that's an extra ~$7,500 --per month! Taxes are the least of her problems.

Savvy tenants, wise to the ways of California, will negotiate a lease so that even if the property sells, tax increases will not be passed along to the tenant.

"The more savvy tenants will build in for themselves Prop. 13 protection," Wald said. "Of course, you can't do it after the fact."

Whitley knows he has been accused of trying to drive the smaller local businesses out of the center, but he is not trying to drive anything but his company's bottom line. "This is not a sinister plot to kick people out," he said.
--Eventually, these buyers may find tenants are difficult to attract at the (3x?) higher rates they now have to charge. If eating the increase in their 1.2% tax bill (~$227K /year, or ~$19K /month) was really a hardship on a $28M deal, what will mulitple vacancies do to their cash flow?

This tax increase may be only the first higher cost these tenants face. As leases expire, tenants will find that the rents they had been paying - most under $3 a square foot per month - are now up over $3, sometimes as high as $3.50.

"My lease comes up Oct. 31," said Darlene Bass, owner of Curves of Los Gatos since 2002. "I'm going down in flames."
--No, you go out and find another place. Maybe not in tony Los Gatos, but there are planty of empty buildings around the valley. (See upcoming roller hockey article.)

Chances are good she will not be alone, given the popularity of real estate in Northern California. "Silicon Valley, and the Bay Area in general, are target markets in the country for both national and international investors," Wald said. "And Silicon Valley is one of the top markets in the country."
--Yes, she will not be alone.

The 35-year-old Los Altos Professional Center was sold by Peter and Gail Yessne to Ross and Lynette Farley for $4.5 million. The small, 10,500-square-foot office building is 100 percent leased to doctors, lawyers and counselors.

Gary Willard, LindaMarie Santiago and Tyler Sheldon with NAI BT Commercial's Investment Services Group represented the sellers. "This deal was put to bed and its loan was committed before the dramatic shift in the financial markets," Willard said, referring to the meltdown caused by the residential subprime market. "Timing is everything in real estate."
--Let's hear back from the $28M buyers in a year or two. Was their timing good because they closed prior the credit market seizures? Or will they be wishing they hadn't paid $28M a few months before tighter credit would have started driving down the price?
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The triple net insight was an interesting tidbit.

We've been wondering why so many seemingly-stable, long-standing small businesses moved over the last couple years --and maybe now we see "why."

This article wasn't so much of an "Aha!" moment as an "Um-hmm..."