In earlier interviews Frank Bailey and Ed Correia each recommended using a broker as the most effective approach to finding an office. So I called Arwen Funk, a commercial and residential broker, to get some background. Arwen pointed out some potential land mines in leasing contracts such as property tax protection, methods of pass-throughs, and options to grow or adjust their office space. The Q&A that follows is an edited transcript of our call.
Q: Why do firms hire a commercial real estate broker?
There are a number of pitfalls in the leasing process; renting an office is not a cut-and-dry process. There is a lot of paperwork, sometimes with land mines you can run into from a leasing perspective. It can really help to someone who understands the process and helps you to prepare, explaining issues as you go and often alerting you to the implications of a situation. You should keep in mind, more often than not, it’s the landlord who pays the commission: so finding yourself a representative is normally effectively free. But even when you pay the commission, the up-front expense is normally worth it relative to how much an experienced broker can save you in unexpected costs. When you do it yourself, the three areas you can often get caught on are: property tax protection, reimbursements of operating expenses, and planning for their future.
Q: How are property taxes a risk area?
In the state of California, any property–commercial or residential–is assessed property taxes by its county government. When Proposition 13 passed in 1978, it limited California property taxes to no more than 1% of the assessed value at the time it was purchased, with increases no more than 2% annually. The assessed value is not necessarily the purchase price: people sometimes overpay or underpay, so each county has the authority to reassess for tax purposes if it believes that market value was not paid. In addition to the base property tax of 1% of assessed value, there are usually several bonds and assessments that are also on a property tax bill. These additional fees fund school districts, street work, sewer systems and other local public items. They all add a little bit to your property taxes, but it’s very rare for someone’s total property tax to be more than about 1.25%, normally it’s around 1.15%. As long as the same owner owns the property, the property tax can only go up by a maximum of 2% every year.
If you are a tenant in a building that is sold to a new landlord, however; property taxes get adjusted to a new baseline and this higher cost is passed through to all tenants in the form of expense reimbursements. Assume your landlord bought the property twenty years ago and has only had a 2% increase ever year since. The property taxes are low but the property’s value may have quadrupled in that time. When you started to rent, your property tax expense reimbursement was quite small. It’s a proportional share of the landlord’s total tax bill based on how much of the total property you actually occupy. When the property sells for four times what the original landlord paid for it, this resets the assessed value and the new owner’s property taxes, and therefore your proportional share, will increase significantly.
A broker can help negotiate “Prop 13 protection” for you as a tenant. This protection allows you to set your property tax amount so that you only have to reimburse the landlord at a certain base level, usually the price when you first leased the space. This way no matter how many times the property is sold or how much people paid for it, you will never pay more than the negotiated baseline, plus the 2% increase every year, for the term of your original lease. If the property is sold, the new owner absorbs the expense of those new property taxes. Thus, new tenants that sign after the property sells will probably pay more in property taxes whereas you will be locked in at the contract rate.
Q: Can you explain about reimbursement of operating expenses?
Normally when you need an office you will look at a variety of different spaces on the market that might fit your size requirements. These spaces will be offered for varying lease rates and the rates quoted will either have a letter “G” after the amount, or they will have an “N” or sometimes three N’s. The “G” is for gross and the “N” is for net. Three N’s stands for triple net, but it’s really a net lease, just a finer distinction. In a gross lease, the rate quoted is the gross amount, which means it is the base rent plus the reimbursements (also known as pass-throughs) for all the expenses the tenants owe to the landlord such as electricity, water, property taxes, insurance, common area maintenance, and more. You will not get other bills for other things from your landlord under a gross lease. A net lease, conversely, has these expense items invoiced separately. The rate quoted in a net lease will be the base rent amount only then the tenants will receive a separate bill for all of the expense reimbursements. A broker can help you understand what you are agreeing to as a tenant and get the best deal possible.
Another aspect of expense reimbursement is understanding the pro rata calculation (the portion the tenant leases in relation to the total building space). For example, assume your office is in a 5,000 square foot building, and you’re a tenant using 1,000 square feet. Therefore you use 20% of the pro rata square footage of the building. Subsequently, you will probably be asked to reimburse the landlord for 20% of the electrical that’s used for common areas. Depending on how a property is setup, the tenant might contract with PG&E directly. The important thing to remember is that nothing is free.
Q: What should I look out for in terms of planning for the future?
If you’re in a startup with three people you may only need a small space, say 500 square feet. It is wise to build in some kind of growth pattern for at least the next lease term. For example, you lease a space for $1.00 per square foot, and you lease it for two years. Right next door to you is suite that would be a perfect configuration if you needed to grow and add one or two people – you could simply knock out a wall and add it to your suite. When you negotiate your lease, request if that space next door becomes available during your current lease term, you want to lease it for the same rate that you pay on our current space. More so, you could negotiate for an option to extend the lease on both spaces when those two years come up.
Other ways to protect your costs for future could be to negotiate lease extensions with fixed lease rates (rather than risking paying the higher market rate when the time comes). Or to negotiate for the Right of First Refusal to Lease on other spaces that come available in the same building. Some tenants who plan for big success even negotiate options to purchase a property if the landlord ever wants to sell. Obviously, these options are all key to the future success of small businesses to allow them to plan appropriately for growth.
Q: So a tenant can negotiate to keep future costs down over certain period of time?
Absolutely! As in any industry, a layperson doesn’t know all of the possibilities–that’s why whole industries of “experts” are born! Somewhat who is not very familiar with real estate won’t know to ask for protections in the form of future options. If you own and operate a startup, you’re probably more concerned about operating your business than spending time learning real estate 101. Your worries more likely include funding, market timing, delivery, fulfillment, employees, customers, etc. You assume the business will take off, need ramping up, and ultimately be successful. Well, what do you do if you have signed a five-year lease, but you’ve only got a thousand square feet, and suddenly you are busting at the seams? Now you need more space, but rents have gone up so much that now you are competing with every other tenant in the world who comes up for that space just next door to you in your multi-tenant building. You are stuck and with leasing rates rising (theoretically) you won’t be able to grow without a large increase in your overhead which may stunt your growth. Now is when you’ll wish you’d had a broker who had negotiated some options for you to grow, move, etc. There are a lot of ways to anticipate and negotiate for future needs, the important thing to remember is that almost anything that you can imagine doing in leasing has been done at some point and a skilled representative will help you be prepared.
A good agent will know how to write options for extensions, refusals, expansions, and Prop 13 protection in your original lease.
Q: Founders are often starved for time, how much time would you normally would save a first time tenant?
Hiring a commercial real estate broker will save a newcomer dozens of hours–and headaches–depending on the situation. But I believe that the hours are not the main savings. Hiring an expert in any field is not just about the actual hours that are required to do the job, it’s also the years of experience that allow an expert to do it properly!
When hiring an expert it can be hard to understand what to ask for and what to expect. One way to mitigate the risk is to meet with the person and make sure they have a very clear understanding of what you need. A good broker will go out and do most of the leg work for you. All you need to do is look at a couple of spaces that your broker will have selected for you based on your needs and see which one you think is going to work best. Then listen to your representative’s assessments. They should be able to assess the type of owner of a particular building; is the landlord someone you could work with? Your agent can speak with other tenants on your behalf for feedback or aid you in those interviews. How are they in the negotiations; are they cutthroat or are they pretty easy to work with? Most properties have different people negotiate the leases and manage the property.