PPLBs may offer a way for firms to meet future expansion needs while controlling real estate costs.

Southland Businesses Explore New Real Estate Option

By Barry Saywitz

As real estate markets around the country continue to tighten and the rapid recovery and upswing of the commercial real estate cycle continues, many markets around the country are experiencing vacancy rates in the single digits–which makes finding available product difficult for many tenants. In Southern California in particular, desirable properties often have multiple bidders, both for acquisition and for lease. In many submarkets that are extremely tight, there are even bidding wars for available space.

As the economy recovers and companies continue to expand, many users of commercial real estate find themselves in need of new and/or additional facilities to not only upgrade systems and equipment but to meet future expansion needs as well. In many instances, tenants find themselves looking to build-to-suits to accommodate their expansions due to the lack of available product. These build-to-suits can come in the form of a developer constructing a new facility that they would lease or buy at its completion. The ultimate cost to the user in this scenario is a function of the price of land, cost of construction, and the cost of money available to the user and/or developer. In many cases, these costs are in excess of current market rents for existing product and, although such an arrangement gives the user the ability to expand, additional financial commitment is required.

Exploring an Alternative Option

Recently, The Saywitz Company, a national commercial real estate brokerage and consulting firm headquartered in Orange County, found itself faced with several scenarios in which clients were looking to expand their operations throughout Southern California. However, like other areas around the country, many of the markets in Southern California are extremely landlord-oriented and, as a result, available product is scarce and rental rates continue to climb.

To accommodate its clients’ expansion plans and control real estate costs, the real estate firm implemented an innovative concept called the Purchase Partial Lease Back (PPLB). Essentially, the PPLB combines the concepts of both the build-to-suit purchase and leasing scenarios into one transaction. The basic transaction goes something like this: the user will either purchase or construct a new facility to accommodate its requirements. However, because the company is uncertain about its growth rate and may not want to commit to additional space today and incur additional cost, it will construct a facility that exceeds its immediate square footage requirements. The company then owns the facilities and can lease back the portion of the facility that it doesn’t currently need to another tenant. The idea is that the rental income generated from the new tenant will offset–in part or in full–the company’s financial obligations for the new facility, thereby giving it the flexibility to gradually grow into the facility and reduce overall real estate costs.

Of course, the dynamics of the marketplace, the financial stability of the user, and future projections for the market and the user’s growth must all be considered in formulating this transaction.

Rewards and Risks

As in any real estate transaction, there are both rewards and risks associated with PPLBs. The major benefits include ownership, flexibility, and cost savings. First of all, ownership of a property provides tax incentives to the principals of the company, and projected appreciation of the asset as a whole offers an additional upside. Secondly, a PPLB arrangement gives the owner flexibility to control future growth. The user can rent out the excess space for short- or long-term leasing to coincide with its future growth plans and gradually ease into the overall size of the building. Finally, companies can realize significant cost savings. For example, when financial analyses are performed on a build-to-suit, lease transaction versus the PPLB, the overall expense of the latter can add up to 30 to 100% in bottom-line cost savings to the company.

Another plus: the lease signed with the tenant for the excess space in the building will typically have annual increases, while the user’s mortgage will stay fixed for the length of the mortgage. In time, the monthly expense to the user decreases as his rental income increases.

Of course, as alluded to earlier, PPLB transactions are not without their risks. Such transactions are, for instance, vulnerable to future downturns in the real estate market. Although today we are certainly in the “up” cycle of the real estate market, should the real estate market take a downward turn, the user may be left with an asset that’s worth less than what was paid. However, as long as the user continues to utilize the facility, the cost will still be cheaper than renting.

Another potential negative to the PPLB is that the new owner must assume ownership responsibilities. The user is now responsible for maintaining the facility and resolving any issues with its tenant. After all, in this arrangement the user is, in effect, the landlord. While this “risk” can be alleviated by hiring a third-party manager at a nominal cost to oversee those responsibilities, it is still something businesses must consider before deciding on this option.

A third risk relates to finding a tenant–or, as the case may be, [ital]not[ital] finding a tenant. As would be expected, additional costs may be incurred by the user if a portion of the facility remains vacant for a period of time following completion of the facility. This could certainly alter the financial analysis and require additional up-front costs to be incurred until a tenant is found. It should be noted, however, that the typical PPLB involves new construction, giving the user a minimum of 6 to 12 months to market the property prior to its completion. Assuming this transaction is being structured in a market that has decreasing vacancies and increasing rental rates, there should be no difficulty in finding a tenant for new construction prior to completion of the building.

In summary, the risks involved with these transactions relate to the future stability of the real estate market and the future business projections of the user. However, should the user employ an entrepreneurial strategy to take advantage of the current real estate market, favorable lending practices, and increased rental rates, the rewards will prove to undoubtedly increase the company’s bottom-line performance and control its own destiny with respect to real estate use.

Cases in Point

Several Southern California companies are already considering whether PPLB transactions are the way to go for their businesses. Sumitomo Metal Mining USA Inc., for example, recently acquired a manufacturing/distribution facility in Oceanside to meet its expansion requirements. After a thorough analysis of the marketplace, executives realized that the increasing rents made it more expensive to occupy additional space than to actually own the property themselves. The PPLB afforded them the ability to not only acquire a larger property that will ultimately accommodate their future growth plans, but also provided an end result in which leasing out approximately 50% of the building will reduce overhead expenditures to 20 to 25% below the cost of leasing a facility. Since Sumitomo opened escrow on the property less than six months ago, the rental rates in that market have already increased 10 to 20%. What’s more, company executives expect the value of their property to increase in excess of $1 million within the next 12 months.

Another potential success story may be found in Joico Laboratories, a worldwide distributor of hair-care products headquartered in Los Angeles County. The company’s current international headquarters consist of three separate buildings, but the firm is exploring the advantages of the PPLB. The company’s preliminary analysis indicates a potential savings of $2 million to $4 million over the next 5 years by employing this process. These figures do not include future appreciation of the property or any tax benefits related to owning versus leasing commercial real estate.

Similarly, another manufacturer and distributor headquartered in Los Angeles County is exploring the possibility of constructing and owning a 450,000-square-foot facility to accommodate its new corporate headquarters and distribution needs. A facility of this size located in Los Angeles will allow the user to take advantage of economies of scale and significantly reduce construction costs by utilizing the size of the facility. The net mortgage cost in this scenario could be as much as 50% lower than leasing a comparable facility.

While each of these companies’ motivations and desires are different, one thing remains true for all: PPLBs not only allow them to control their own growth in the future but also offer the opportunity to reap the benefits of a rising real estate market and the tax benefits associated with ownership. In fact, it’s such an appealing concept that The Saywitz Company itself is practicing what it preaches: The company recently purchased its own building in Newport Beach for its headquarters. The PPLB alleviated all costs associated with the real estate and, in effect, the company eliminated the rent line item on its balance sheet and acquired an asset in the process.

The Bottom Line

The user who understands the risks and rewards associated with PPLB transactions and employs a solid investment analysis combined with future growth projections will be able to either acquire or construct a new facility that allows them to incorporate better efficiency and use of space, along with technological change. Such users will be able to place an asset on their balance sheets rather than a rent expense and significantly reduce overall real estate costs.

Look for this type of transaction to continue to take place in those submarkets in which suitable alternatives for space are difficult to find and in which rental rates and property values continue to increase. Because as companies look to increase bottom-line profits and control overhead expenses, PPLBs will afford them this opportunity.

[ital]Barry Saywitz is president of The Saywitz Company and chairman of CORE Network, a worldwide organization of real estate companies. For more information on PPLBs, contact The Saywitz Company at (800) 930-6165.[ital]