Clear Height Misrepresented in OM - Thoughts?

20 Replies

We're in contract on a small bay industrial warehouse in the Phoenix metro area. We toured it today. It's a fantastic location and 100% leased. Downsides we were aware of is that there's too much office buildout And instead of overhead doors they have these stupid pedestrian double doors. But we were willing to deal with all of that. However we just discovered that the clear height is only 11 ft 7 in. The OM said it was 14 ft and the standard for the area which is very dense with this product type is 14'-16'. The leasing company that leases 95% of this product type in the area says this will eliminate 50% of prospective tenants.

however it is an incredible incredible location And currently 100% leased. 

question one. Do we ask for a discount or do we walk?

question two if we ask for a discount, how do we quantify it?

thanks!

Kim

@Kim Hopkins Probably worth going for a discount first. For quantifying the amount, I'd start by seeing if that leasing company you mentioned could give you an idea on how much the difference in potential rent is between a 14ft clearance and the 11'7" clearance is. Loosing 50% of the potential tenant pool is never a good thing, but if the seller is willing to give you a discount to offset that drop in value then I see no reason to back out.

Good idea. I've asked the leasing agent if he thinks it would actually lower the rate or just the number of applicants. If he says it wouldn't lower the rate, any ideas on how to discount based on the fact that it would lower the applicants by 50%?

Originally posted by @Jack Inman :

@Kim Hopkins Probably worth going for a discount first. For quantifying the amount, I'd start by seeing if that leasing company you mentioned could give you an idea on how much the difference in potential rent is between a 14ft clearance and the 11'7" clearance is. Loosing 50% of the potential tenant pool is never a good thing, but if the seller is willing to give you a discount to offset that drop in value then I see no reason to back out.

 

@Kim Hopkins

I’ve never purchased commercial real estate and recognize it’s a different kind of beast, but have you considered what it might cost to replace the current doors with an overhead door? That may help you determine the value and could be used as a negotiating tool.

Yes but my issue is with the clear height inside the building

Originally posted by @Kenneth Rolfe :

@Kim Hopkins

I’ve never purchased commercial real estate and recognize it’s a different kind of beast, but have you considered what it might cost to replace the current doors with an overhead door? That may help you determine the value and could be used as a negotiating tool.

 

Usually any kind of commercial door is 14'+ because 13' 6" is a common height limit for highway vehicles. So lots of RVs wouldn't fit into this building. However, if the location is good and the space is full, I'd move forward with it as not everyone's stuff is tall.

I do not believe that is a big issue, if it’s fully occupied now. It will certainly be less attractive than a 14’ ceiling, but that is a minor issue. Location is number 1 consideration, and lot size.

You can certainly use that as a negotiation leverage, but I would not walk away just because the ceiling is a few feet lower.

18 ft or taller is better. 

Yeah I would start with seeing how much different rents might be between the ceiling heights. I don't know about Arizona, but here in Indiana, the difference for a modern clear height to a much lower clear height is about $1/sf-$2.5/sf NNN for warehouse space. That being said, I would take an analytical approach and figure out what your NOI would look like if you had to re-lease the space once this tenants lease expires. If the difference in rent is about $1/sf, I would take that $1/sf for the remainder of a 10 year proforma and discount it back at particular discount rate. A good rate might be a rate that is closely aligned with a market CAP rate in this instance. Whatever the present value of the NOI differential is is what I would ask for a discount.

In my opinion, this is how you would quantify the discount but most people wouldn't take the time to do this type of calculation so you might want to ask for a discount based on your gut telling you what your risk tolerance is. That being said, convincing the seller of these findings is a completely different ball game. Wish you the best of luck.

James Storey, CCIM

 Yeah, a discount is the starting point.  If they balk, then decide whether to terminate (and then negotiate a discount).  This is a problem that isn't going away for them.  But if they had backup offers, then you are out there battling again.  But you are probably going to have to stick to your guns because this will come again on exit.  

How to quantify the discount is a bit difficult.  James Storey has the the right approach I think.  Should be some lease comps out there that can help you build a base case/downside sensitivity analysis.  But another wrinkle is what is the specific leasing strategy for this asset if you have to backfill vacancy down the line?  Is this an airport-based use?  Logistics/freight forwarding use is going to be challenging with a 11'7" clear height (and the other physical dimensions), no matter what the broker/CoStar reports say.  Machine shop/light assembly isn't going to care as much about clear heights.  R&D/flex can probably deal with that kind clear height just fine as well.  Construction-type uses may be tougher as they might not be able to get equipment over a certain size in there.  Retail-ish consumer facing uses might be OK as long as they don't have to rack too much product. 

We had this come up on a deal in the past (that we didn't wind up getting for other reasons) where the building had 12.5 foot clear when market was 15-18 clear.  To be very conservative, we discounted $2 psf off market rents (modified gross) in our projections.  And put in a longer lease-up period. It was a great submarket with very solid underlying demand and supply drivers for small bay space, similar to what it sounds like you have here.  

Hopefully this helps.

@Kim Hopkins Is the structure an actual metal building, or is it block and bar joist? Do you have pics of the inside you can share?  If it is a metal building, I am assuming when you say clear height that is underneath where the rafter and column come together or are your saying that is the clear height everywhere on the inside? 

If it is a true metal building, there is a lot you can do to better accommodate tenants, including cutting in larger overhead doors and removing some office space without compromising the structure. Industrial projects are my specialty and I am happy to help in anyway I can. 

Sounds like if it is 100% leased and the number's work, it is a no brainer. 

Definitely do a discount, we were under contract on a large flex building. They had popped in double ped doors in old roll ups, but it was A) very obvious and b) just hardiboard so other than the cost of the roll up, pretty easy (structurally) to put back in the bigger doors.

Thanks all for the feedback, sorry for the delay in responding, been swamped. It turns out this deal has a lot of other issues stemming from misrepresentations in the OM (which I believe were unintentional, but nonetheless). We haven't presented our analysis to the seller yet but I'm concerned b/c the broker said the seller has said they will not give any credits on price. Here are the issues if you want to weigh in.


  1. Omissions in the opex from the OM compared to the P&L.
  2. Clear Height Issue discussed above. @James Storey I ended up saying that since it eliminates 50% of the tenant pool, that doubles the vacancy rate per year in the OM.
  3. A vacancy for 20% of the RSF starting 1/1/22 that they assumed in the OM would renew. 
  4. A claim that a new roof was put on in 2017 but turns out it's much older and needs repairs.

    @Andrew Tripp I'm really on the fence with this one. The COC was already a slim 4.5% and now with the above corrections to the OM, it's an embarrassing 2% or something. Great location. Great vacancy rates. 100% occupied but horrible cash flow. I'm questioning my original intent on this one to "plant my money somewhere" to avoid inflation and break into the Phoenix market, and wondering if I should just go find another property in Dallas instead.

    I'm thinking they'll tell us to walk when we ask for a credit. We've already paid for the inspections and appraisal. Any thoughts? 

    Thanks

    Kim

    @Kim Hopkins that's tight for CoC. Any big value-add possibilities that can justify that going-in price with all the issues or is it all downside risk? Some vacancy to be backfilled, which presents opportunity (and some costs). In this market, I would be prepared to look past the opex discrepancies, and maybe the roof too depending on the scope of the repairs. But I'd at least try to hammer out some reduction based on the clear height, because that will come back on them if they go back to market. Outsider looking in, but lots to like about Phoenix overall as an industrial market. Maybe a long-term growth play if the back end looks promising? Not sure what your hold period will be.

    Tough call though.  If you have a strategic need to be in Phoenix, might make sense and just overpay a bit.  If you are looking for a place just to park money, can probably find a better deal elsewhere.  Just my two cents.

    @Andrew Tripp Thanks I appreciate your feedback. There are only two value add opportunities I can think of: 

    1. Replace pedestrian 8.4'x8.4' double man doors with rollup 10'x10' overhead doors. Not planning to do this in the near future. Very expensive and requires an architect to move the lintels.
    2. In place rents are at $0.86 PSF and market should be $1.00 PSf, provided the clear height doesn't deter too many tenants. 

    I would typically overlook opex discrepancies too, but do you think that's feasible if it drops COC to 2%?

    We plan to hold forever in theory. 

    The location is in Tempe and is a killer location. 3% vacancy in this market, but 20-30% vacancy during 2008.

    Do not have a need to break into Phoenix, just like the market a lot and live a couple hours away so would be a convenient market to get into. 

    We are overpaying on price PSF according to several people I've spoken with, however the comps they've presented me with are at a lower cap rate. Since I'm used to doing deals in DFW and SLC (before it was overpriced), I'm not used to this horrible cash flow. On the fence... 

    If you do think I should ask for a credit, any experience or suggestions on the best way to be successful with a seller who does not want to budge? 

    Thank you!

    Kim


    That's looks really skinny for a 2% CoC. If we are taking recourse on the loan, we usually won't dip below 5% for a stabilized asset with the in-place income looking pretty solid for the first few years while we digest the asset. The possible rent bumps aren't adding much (although I would guess markets rents are going to keep going up as inflation sets in). And those improvements will be expensive. Are you comfortable underwriting overall market rent growth to carry the returns upward 3-4 years out? Rising tides lifts all boats type of theory? I go back and forth on that myself. But if the market is that tight on vacancy, users might look past the clear heights and pay the going rate anyway.

    If you are going to ask for a credit, I would position it like "hey, you've got issues on the roof, and the opex is a little higher than we originally thought.  We're big kids, and we'll deal with all that.  But the clear height is a problem on the leasing side.  And it will be for any buyer.  We need $X off the purchase price to account for the greater vacancy risk.  If we can get to an agreement on this issue, we're otherwise ready to go hard on our earnest money."  Again, this assumes you are comfortable with the roof as-is and completely ready to go otherwise.

    If they balk, I'd move on and then keep in touch.  Our first deal was a stretch from a return perspective in a good market just like this one, and its never made any material amount of cash flow for us despite attempts to raise rents pretty aggressively.  It has helped us build equity that we have used elsewhere though and its pretty low-maintenance, so not a total dud.  But I wouldn't do it over again.
      

    @Andrew Tripp Hi Andrew, that's really good advice and makes me think a lot about our situation. This not our first deal. We are experienced investors and long-term-holders. We want properties that cash flow. We're also a 2-person shop so there is a major opportunity cost if we buy a property that doesn't cash flow or worse, doesn't cash flow and costs us time and headache. So your story about your first deal which sounds like this one is very helpful. We don't need this deal to get started and don't want that experience if we can avoid it. 

    My original thinking here was A) we should break into the Phoenix market sooner rather than later at the cost of cash flow so we could get established in a market we'd like to be in long term and B) I thought there was a rush to find a deal before inflation hits and/or interest rates rise. I'm not necessarily sure I was wrong on this, especially B, but we are still seeing some new deals come through in better cash flowing markets like DFW, still expensive, but better cash flow than this. Although there is the thing about the bird in the hand...

    Still so on the fence with this one. I guess I'll see what he says with the credit. I'd usually ignore the opex like you said, but the margins may be too slim otherwise.

    @Kim Hopkins , remind me again what the name of your firm is (if you don't mind sharing)?  Sounds like you guys are doing some interesting things.

    Also, a couple of people here started a mastermind/networking group for commercial investors (non-multifamily division) where we spending some time doing this kind deal dive on what we are working on. A few industrial-focused investors in there.  If you're interested, DM me and I can put you in touch with the organizers.  Also a FB group to go along with it.  
      

    Yes, we are local to Chicago.  Four assets in select submarkets here.  O'Hare/I-90 corridor, and branching out into northern Kane/McHenry/Lake counties.

    I like your website.  And nice portfolio coming together as well!