Commercial Real Estate Strategy Tips

The Magic (Or Burden) Of A “Step-Up Lease” And Option

by Marvin Levin

Seller and Buyer, along with their brokers, met to tour the Acme building in San Francisco one rainy day. The building was vacant, and Seller was very anxious to make a sale. Buyer was the operator of a successful San Francisco business, and had received notice from his landlord that his current lease would not be renewed. Buyer had less than three months to find a new location.

Buyer had talked to his bank about financing a building like the Acme. However, Buyer’s broker wisely counseled him that it might be a long road between an informal conversation with his banker and the closing of a loan to acquire the building. The building was old and had many troublesome issues, including toxic and structural problems.

So, the first thing Buyer said was: “I like the building, but I’m going to need from six to nine months to do my due diligence and to arrange financing.” The first thing Seller said was: “I’m not holding this building for the next nine months only to have you walk away. You’ve got to make up your mind in 30 days, or I need to move on to some other prospect.”

The market rent for the building was about $15 net per square foot per year, and the fair market value of the building was about $6 million. Seller, Buyer and both of the brokers agreed with that.

The Seller’s broker came up with an idea, which is the central point of this real estate idea. Before reading on, however, you might pause to ask what you might have suggested.

The broker’s suggestion is offered here to illustrate the idea and, therefore, please concentrate on the idea and not necessarily the numbers.

The Seller’s broker suggested that Seller lease the building for 10 years, coupled with an option to purchase. The net lease would be for $10 per square foot per year for the first six months, increasing to $12 per year for the second six months, and then $16.50 per year for the balance of the nine years. The lease would provide for a CPI adjustment each year after the second year. It would also include an option to purchase at any time during the term of the lease for the price of $6 million, adjusted by the CPI after the first year.

Although it seems a bit like magic, the Buyer and Seller (now the lessor and lessee) shook hands, and both parties had exactly what they wanted.

First, look at it from the Seller’s point of view. He moved a vacant building to an income-producing asset in 30 days, avoiding the very serious risk that the building might be vacant for a long time. If the lessee exercised the option, the Seller got his full price with inflation protection. If the lessee did not exercise the option quickly, then the Seller, after the first year when the lease rent increased above market, had the choice of enjoying a better-than-expected income or selling the property to an investor for his target price or a little better.  And, if the seller needed some immediate cash, with the lease in place (even at the lower rate), he could refinance the building. After taxes, he would receive substantially the same net cash as if he had sold it.

The Seller agreed to pay his broker one-half of the sales commission upon execution of the lease, and the remainder upon exercise of the option.

The Buyer was absolutely delighted. He could occupy the building during the first year at slightly less than market rent. He was nearly positive that during the year he could finance the building and exercise the option. In the remote event that he could not exercise the option, he would continue to occupy the building without interruption to his business, although at an incremental cost slightly above market. The Buyer was still expanding his business, and although he gave a small security deposit for the lease, he was able to retain in his business the down payment that he would eventually make of approximately $1.5 million.
In the actual case, buyer exercised his option 14 months after executing the lease, so it turned out that the flexibility was very valuable. It allowed him to shop for a loan without the pressure of an absolute deadline. The flexibility also allowed the buyer to shop for consulting services that otherwise might have cost more because of the deadline atmosphere of a traditional closing.

If you know of a vacant or otherwise troubled building, please contact me.