How to Invest in Commercial Real Estate

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Episode #084 - Everything You Need to Know About LEASE AUDITS!

by Criterion, Braden Cheek, Brian Duck
October 31st 2022
00:00:00
Description

Today hosts Braden Cheek, Brian Duck and Joel Thompson discuss the logistics behind lease audits and what to look out for when reading over lease agreements!

Time Stamps: 0:00 - Introduction... More

Welcome back to how to invest in commercial real estate. And we are back today with another exciting topic that is, um, actually, when we came up with from an incident that happened recently, but before we get into that, we wanted to talk about something new and exciting on the criterion front for a lot of our investors is we funded this kitty academy redevelopment fund, um, a few months ago and in that fund we went and bought two existing kitty academies and the goal was to remodel them and and sell them within a year to a year and a half. Well, both of those kitty academies have been remodeled. Both of the tenants are in the leases were signed beforehand and those sales offering memorandum are done and we are sending both of those deals out to market and we are expecting great sales proceeds to come from that. You're excited to get both of those done way faster than we thought to have any timing information. Um, they'll hit the market now, we thought it was gonna be the first quarter of next month or the first quarter of next year. So now, realistically they'll probably sell in the beginning of the second quarter, maybe into the first quarter of next year.

And then all of that equity will be distributed back to the investors and it should be a slam dunk of a deal. We won't talk about returns yet, but um, it's looking Absolutely. So we're excited about that and we got to find new deals to put that money to work. That's the challenging part in today's market definitely ways your said than done. We're talking about this right before the show but I'm quoting out a deal right now and my rate today right like december 20 or october 26th 27th. Whatever the rate today is seven or 6.5 6.5%. Its prime prime plus a quarter to seven and a quarter next week it's going to seven and a quarter and nobody's gonna lock it beforehand. So I mean that's a lot of the challenges that you're seeing in today's world when you when you think about it. I mean just have neutral leverage on a deal you would need to go out and find a seven and a quarter cap right? So in an a cap you're basically making no money at all in cash flow, you're paying down some debt and hoping to refi the rate lower. So it's it's really stalling things out. But anyway we won't spend too much time on that.

A couple weeks ago we had this crazy clip of a U. Haul truck driving through our building and that is obviously kind of a logistic nightmare because you have to figure out who's responsible for this right? Like and in your first reaction may be oh you're the building owner, you're responsible for it. But our initial thought which we're gonna get into, there's a lot of other people at fault here right? Like the there may be just one person at fault. There may be a lot of other people responsible for fixing it. Okay. Yeah that's a valid point. That's valid point. Obviously just gonna go blame a bunch of people for a truck U haul truck driving into our building. But we may make some people pay for it. Yeah. We want to look at the driver, we want to look at the owner since it was a U. Haul, the driver didn't own the car. So then we look at U haul. So there's lots of places to look. By the way it turns out when you put some music to a truck slamming into a building and get more views. Yeah, that's right. Let's do that. Some more anybody wanting to rent a U. Haul, we've got plenty of buildings to run into. Are you sure you weren't driving that car? Just for increased viewership? Yeah, I really just took one for the team. But anyway, getting getting back to that when this incident happened, we had to go to that property, we had to go to that tenants file and we pulled their lease and their lease abstract or at least brief as some people may call it and why we do that is because we need to figure out who's responsible for fixing this right, we're gonna claim on all the insurance is available, but there's certain things that a tenant maybe and their lease is specifically responsible for fixing.

Well there's different parts to this to write. Remember he hit kind of the block in front then he shattered the window um ruined some brickwork. So um it's possible that different parties are responsible for different parts of this accident right? Yeah and and and another thing that just happened at the same properties. We do replace an H. V. A. C. Unit. Um So in the dollar general Sweet they have a specific paragraph in their lease that says any repairs or replacement cost our H. V. A. C. Unit over $1500 per incident is the responsibility of the landlord. Well we had a $12,000 part break. So now we're looking at replacing a $20,000 H. V. A. C. Unit. And we need to be able to quickly go to their file and figure out who is responsible for this. Because some of the some of these leases can be You know 30 plus pages. They can be renewed over over you know 30 years potentially. So there could be a lot of documents in there and you want to be able to know immediately who is responsible for this? But more important to going and checking who's responsible right now that got us thinking for the show today is how do we go through and alert people on what kind of instances are gonna hurt them before they buy because you need to not know once you buy, it's one thing to figure out who, who's gonna pay for it, but how you're building your model when you're evaluating a purchase, all this comes into play and that's what brought us to the topic today.

So, since you brought that up, when is when is the time to do this? When do you do your first least abstract? When do you read the lease at your point in buying the deal? And let's call, we're talking about lease audits. That's what we in the industry, it's called lease audits. And so for us, I would say you don't have to do a lease audit before you get the project under contract, but after you get it under and before your money goes nonrefundable, you're gonna want to do a lease audit on the entire rent roll. Okay. So why wouldn't you do it beforehand? Because they're probably just listening something and you're probably just assuming it's true. Well, for one thing I'm thinking, you just said some of these leases or 30 pages long and you have maybe, I mean, that's I don't know you have time to do that because it's just not practical. Yeah, Yeah. And uh in the offering memorandum, you will be getting a rent role and that will have a few of the really high level uh key points from the leases, you'll have, you'll have the rent and you'll have when it started and when it terminates the main point and, and kind of on a high level who's paying triple nets or who's the gross lease that gives you enough information to go ahead and make an offer and kind of make an evaluation of the value of the property.

Plus they're probably not just giving out everyone their leases without a signed contract. Right? Like it's probably a deliverable in the contract. So we're in contract on this new deal, we found, you know, we've got this information and now we need to go read the leases and figure out if it's actually true. Right up until this point, they've just shown us a bunch of numbers and said, hey, it makes X dollars. You can't just believe that, right? You have to go read the lease. You have to build your own model, you have to build your own budget and see here's the contractual money according to these leases that comes in. And if it's different, it's a great opportunity to say, hey mr seller. Uh I have something different. Help help me get to what you have. So you have to, you have to read it right? Yeah. And I'll say what if you're asking yourself, well man, I don't feel comfortable. I, you know, reading a 40 page lease and catching everything, there's good news is there's third party companies that will do the least audit for you and they're pretty reasonable on cost and that's all they do is it may not be all they do, but it'll be a sir that they can provide. And we've used a third party lease auditor.

Wasn't a company necessarily, but it was someone that was in the business in the industry that we trusted that could read the lease uh and build build the audit page that shows us everything that we're responsible for ballpark. What what might that cost, I guess? It depends on the number of leases or something, but how much We pay per hour, like $100 an hour. Okay? So, you know, kind of almost on the level of an accountant way cheaper than an attorney. And then they give you a summary of what they found is that right? It's typically a one page document. Um You know, so you're consolidating a lot of pages into one page and then they'll have the important points that we're going to go through here in a minute of what we may look for Annalise audit, but they're gonna have those points listed out like H. V. A. C. Repair replacement. And it's gonna make a quick note just so you know who's responsible like l l responsible for replacement tenant responsible for repair. And then it typically has a reference of where that is in the lease. And and again You don't want to just operate off of your lease briefs, right? Because we're all humans, we make mistakes, things get transcribed things get sold.

So that's why that reference is so important because at that point before I spend $20,000, I'm gonna go back to that lease and double check that reference mark and just make sure. So let me ask you a question. So it seems to me like we've talked about multi tenant retail lease audits at this point. What about multi family? Do people do lease audits or is that easier because every leases the same other than maybe the time the term and the rate. That's great. What do They are? Very different? Multi family is, let's say it's a 250 unit apartment complex. The great thing about those leases is typically they will be on an identical lease. Everyone's on it, the the exact same lease. So you don't have different businesses negotiating different terms. You have people that are just agreeing to whatever the apartment complex complex lease says. And you're really just very very, very rarely with someone never negotiate something in an apartment lease. And so all you're doing there, it's a lease audit. But you're really just very, it's more verification we want to know, okay, they say there are 92% occupied.

Let's verify that the, that they are 92%. Let's look at all the leases, make sure there's a valid name, let's verify the start date, the end date and a security deposit. And we really, that's all you're doing on a multi family lease audit way different though when it comes to retail and office and maybe even industrial because you're dealing with businesses and more common areas where the tenants are gonna share in the responsibility of the upkeep, where an apartment, it's just not the case if things break, they're calling you, you're fixing it. Another example you might ask is single tenant deals. There's a lot of single tenant deals and a lot of bigger institutional investors like hi credit, single tenant deals like a chick fil a or even R pads we sold in in Wichita. That person wants to know that the tenants are taking care of everything. There's no responsibility for them. They don't have to pay taxes, they don't have to do insurance. A lot of those things can be built in a lease where the tenant gets the tax bill and pays it directly. The tenant ensures the building itself and you're just getting verification the tenant is handling the common area maintenance and they're sending you a report of what they paid.

So nice and clean triple net. Even some of those can be called absolute net where there just isn't any landlord responsibilities, but it's easy because you only have one tenant and they own the whole, they don't own it. But they lease the whole premise is so you don't have any any shared uh maintenance, any shared plumbing, electrical parking lot that you have to divvy up, who's responsible, who's paying for all this. Okay, let's get to, let's get to the main points that you would look for? Uh What what are the main things that you would look for in a lease audit for multi tenant retail. Now the first thing that we're doing is we're verifying term and rent. And so you know as we build our our model, we're trying to get to a net operating income and we're trying to verify that because they've obviously pitched and uh you know I to us, so the first thing we're doing is okay are the tenants there uh is it a valid lease in place? What are they paying? And when did they start? And when does it end? So that can pretty well uh that can pretty well tell you if they know I that they that they suggested is correct. Right. It's more, I'm sorry go ahead.

No, I was gonna say it's more in the triple nets. So it's more of a gross rent. You can verify from that you're getting the gross rent from the rent they're paying and and you know if they're in there. But really it's once you get into the expenses and the responsibilities, you start chipping away at that. Noor i depending on who's who's paying for what? Okay, next. And it's number two on our list is verifying. Well I'm gonna call it triple nets versus gross lease. And and most likely the leases are somewhere in between those two. So is the tenant paying, you know their full share of triple nets, let's talk about what that means real quick. Yeah. So this is a big thing that I find a lot is when you're looking through an om they're trying to be short and simple and sweet. So they're just calling it a triple net lease. They're not detailing it out saying there's a five percent cam cap. Well, cam cap means that year over year, your cam dollars, Common area maintenance dollars, you can't spend more than 5% or whatever percentage they assign than the previous year. Sometimes it's cumulative, sometimes it's not cumulative.

So you can dig into that even more, But at face value it just looks like a triple net lease. And you can say, Okay, they pay 5% of the expenses no matter what the expenses are when in reality it's so much higher now and they've been capped that really, they're not paying 5% or whatever their proportionate share is, they're paying a significantly lower amount and you've got some slippage there and your actual expenses versus what you're being reimbursed. Alright, we always try to bring samples for people that, so they'll understand what we're talking about. So let's say that you're buying a $5 million building and it says triple nets on the leases, but they have a 5% camp cap. And let's just not call cam, let's say it's 5% triple net cap. And so then you find out after you close that the previous owner, he had purchase that building for $2 million. And so the real estate taxes and the insurance are really low. But you buy it for five now the taxes more than doubled. And you think you're just gonna pass on that expense to your tenants.

And when you send your tenants the bill for the new higher taxes, which is more than double, they say no, we're gonna pay taxes on the $2 million level plus 5% increase because our lease allow allows us a maximum of 5% a year. And so you're totally screwed. Your your ny isn't gonna be what you thought it was totally screwed. It's over. You're you're gonna quit investing, you're going to give it up. But that's an example of the caps. You have to make sure that the caps don't come out and bite you. You don't want to see caps. But if you do see them, you want them on actual common area maintenance and you want them exclusive of real estate taxes and insurance and other things that can take big swings. Uh year to year. Last night, I would add is an administrative fee. A lot of the times when we're doing a lease renewal or on our new lease, we put an administrative fee of 5, 10, of whatever the triple net costs were that we built in addition to that for facilitating the payment in the negotiation and everything like that. So you may be looking for those, you may be looking, um, maybe that's upside value for you that you can add those.

Just something to know. All right, Next one we're gonna talk about is, I'll call it out, you have all these great leases and it says they're paying this rent and you're gonna make all kinds of money. But if certain trigger events allow those tenants to just get out of their lease, then you don't really have the guaranteed income stream you thought you had or you thought you were gonna buy this just happened on our salad and go deal in, in Owasso is 15 year lease, but they have an out in year 10. What's the out in year 10, 4. Oh, just if they want it. So, so we have a 10 year lease Absolutes have a 10 year lease. Did not have a 15 year lease. So, and it, It sounds ridiculous. But they're, they're a lot of tenants have them there or I'll do this renewal. But I wanted 1012, I mean, so examples that you're looking for some outs, maybe if the occupancy of the entire center falls below a certain amount. So, so now you're getting hurt because of the economy tenants left and then that gives other tenants the ability to leave and it will devastate your deal. That's one another one.

If the anchor goes out, that could be an out, it could just be a specific tenant. Like hey, if it could not, it could be a tenant not in your shopping center. Like hey, if the wal mart next door goes dark, come out. You'll see that a lot in the shadow anchored walmart deals, like you're kato, your Gamestop. I mean it's the same time some, some out could be, if our sales don't achieve a certain number, then they'll say, hey, I'm not meeting sales and, and this was a criteria I'm out. So a lot of different ways that tenants can get out of course, as land, as landlords. If I was negotiating these leases, I wouldn't budge on virtually any of this stuff. I don't know what all the motivations are of landlords that agree to some of these things, but they're in there and you got to make sure that you're catching it. Yeah, absolutely. And, and again, just the nature of a lease or an offering memorandum, they're consolidating 40 pages to one page or less than a page. Sometimes it's like one line in the offering memorandum. So you can't expect for them to consolidate all of this information for you in the offering memorandum, it's not like people are trying to hide it from you even though sometimes they are.

Yeah, they're just not putting all of that in. Okay. Uh, you know, we talked about triple net leases and that's more, sorry. Uh, we talked about the triple net, their share of triple net expenses which those ongoing expenses like parking lot sweeping and landscaping and things commentary electric but you need to check the leases for who pays for the ongoing maintenance items. Uh And and specifically like we talked about with the Dollar general is we have the H. V. A. C. Go out. Sometimes the tenant pays for that. Sometimes the landlord pays for it in that case the tenant pays for some of it and the landlord pays for most of it. But that will eat into your budget because you're gonna have those things happen especially if you have older H. V. A. C. S. Uh sometimes plumbing isn't included. So you need to check on what I'll call ongoing maintenance who's responsible for ongoing maintenance or things outside of the normal triple net budget. And you may be thinking like Brandon, you just said you had to replace a $20,000 H. V. A. C. Unit for Dollar general on a property you just bought, do you guys not take your own advice? What do you idiots?

How did you not know? What I would say is we bought that property on auction. Right so we've talked about auction purchases before and these are the risks that you really run into when you buy a property on auction because you don't get to do your own inspections, you don't have time to do anything, everything is rushed and you get stuck with what you bought. It's very as is so, yeah, this is and you wouldn't necessarily see all the leases first. You would see all the leases. But even even if I saw that, how am I supposed to know that their H. V. A. C. Unit is about to go out? I have no idea what it was a property condition report. But that's okay. I mean we we did as much due diligence as we could and then you have to reserve money. It's not like we can rewrite that lease. We can't change it. But the important thing of going through this list that we're talking about today is that you can accurately evaluate the deal and you build your your budget based on the risks in the lease audits. Because once again, you don't know when when an H. V. A. C. Is gonna go out. But you you may allocate capital for the what ifs or let's say a parking lot.

It's it's in need of repair. You don't know when it's gonna need repair to replace. But you may put the yearly budget in there if the landlord's responsible and the tenants are gonna pay for that. So that's all we're talking about here is it's just going in eyes wide open and building an appropriate budget to make sure you have some of this. What we did in that particular example is we had a good reserve and and it's not gonna it's not a huge surprise. We've got the money to cover it. All right, Let's keep moving restricted. Uh Let's see, restricted use. Uh That is not a huge deal, but a lot of tenants, they'll, they'll go in and then they'll restrict what you can put into the vacant units if it conflicts with with their business. So that's something you need to be aware of. If you say, hey, I've got all this vacant space, I'm gonna go lease it up. You need to be aware of what you can and can't put in there. It may make it harder to lease up than you than you think it would. I've got a great example for this one. We bought Plaza West back in january multi strip center after we bought it. We we come to this problem of um there's a rent a center and a furniture, uh sales store. They just sell furniture. We'll rent.

A center has an exclusive use for the financing of consumer goods, Not financing furniture. The financing of consumer goods and the furniture sales store, started financing or allowing people to pay installments on the furniture and rent a center sent us a default letter and said, Hey, you guys are in default of this section of our lease. There's another tenant renting furniture. And as a result of that, they're paying 50% rent, 50% rent, asked me what I did what you do, what you do? Brandon. Well, I had two options to ask, I Could kick out the other tenants because they just flat out, flat out refused to uh stop financing their furniture. So I could kick them out and they said they would leave. But um, rennes enters 50% payment is less of a loss than kicking out the furniture sales store. So we're literally just riding a default and I haven't figured out a way to get it cured yet. That's interesting. We'll have to talk about solutions on that offline. I think we've covered most of it.

I have a couple other here Capex, which I briefly mentioned once again, there's a lot of reoccurring expenses or maintenance issues, but that still may not cover who's paying for the roof. The structure, the parking lot and obviously tenants don't want to pay for those things because they may or may not be there five years from now or 10 years from now. But if it's in there, it's a huge win. So you need to understand at least what those risks are. Uh, it verifies the security deposit which you need to know because something that, that the tenant will fight you on when they leave. Uh, And I think last one, which we can cover quickly here is future increases in rent and option periods and the future increases in rent is great. You'll be able to see those. But one thing is interesting is the option periods because we've run into deals where on the surface it looked like a great deal. Let's say it was an 8.5 cap. I'm good to go. Uh that's all I need. But then I looked further into the lease and they have maybe four option periods with no rent increases. And so if that tenant stays and if they exercise their option, then that 8.5 cap slowly deteriorates into an 8, 7.5 7 cap deal because I can't increase my rent over time and other deals that I could compare it to.

Yeah, I can keep up with inflation and my income goes up or hear my income is gonna stay the same. So that's a that's the last one I think you should look out for. Okay. Anyway, leases are super important. It's the lifeblood of the business. I mean it's your contractual income. It it can leave you exposed to lots of different risks that we just mentioned. So. And I do real quick. I don't I don't do least audits for us. I'm not a detailed guy. I I understand it but I want other people to do it because by nature I'm gonna miss something. So I'd much rather pay someone to do it or someone on my staff to do it and then I review that so you don't have to do it personally. You just need to make sure that you understand where the risks are and make sure it's getting done by somebody. Yeah, absolutely. Well, anyway, I think that is it for today's show, and we will catch you guys next week on how to invest in commercial real estate. Thanks guys.

Episode #084 - Everything You Need to Know About LEASE AUDITS!
Episode #084 - Everything You Need to Know About LEASE AUDITS!
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