Thinking of Selling Your Industrial Building in a Few Years? - Then Be Careful Before You Lease It

Anyone who owns industrial properties these days is in a very favourable position. Why? Because the industrial market has been one of the strongest real estate asset classes over the last 3-4 years both in terms of value appreciation as well as rent appreciation. As a result, if you own one of these assets, you're either in a position to collect much more rent on it than in previous years if you have a vacancy or renewal approaching, or you're able to sell the asset at a price that's never before been as high, in some cases many multiples of what you may have paid for it (depending how long ago you bought).

But one thing that I come across again and again in my practice as a commercial real estate agent specializing in industrial properties is that owners are often unaware of the very critical correlation between their building's value and the lease that may be currently in place on the property. Whether there is a lease in place on a property and what the components of that lease look like can really impact the re-sale value of the property, and so it is incumbent on industrial property owners to understand this relationship so that they put themselves in a position for a maximum sale price if and when they decide to sell.

One of the major impacts that an existing lease has on the value of the property is a result of the fact that commercial property values are often based on the Net Operating Income (NOI) that the property produces annually, as well as the expected Capitalization Rate ("Cap Rate") for that asset class in the particular area where it's located. Where the lease factors into this equation is in the NOI, which is based on the amount of rent that is being collected, which is stipulated in the lease. Industrial property values are often determined based on the following equation:

Property Value = NOI / Cap Rate

If the rent price that was agreed on in the lease is higher, then the NOI is higher, and thus as per the above equation, the property is valued higher (the Cap Rate stays constant). If the rent collected is lower, then the NOI is lower and the property is valued lower. It's pretty simple but this is a critical calculation that most property investors are doing when determining a fair purchase value for a property.

Therefore if your property is locked into a lease that does not have favourable rates, or perhaps does not have a high enough annual escalator on the rent price, you could be impacting the value of your property if and when you choose to sell. If on the other hand you have negotiated a strong rent price at or above market rates, with strong escalators, then this will bode well for the value of your property.

You may be wondering, how does it work if your property is vacant? Well, from a rent price perspective, prospective buyers and their brokers will simply do a projection of rent rates for that property based on their research for similar properties in similar areas at that time, and then use that to determine the potential NOI on the property. The advantage with that approach is that the projection of rents will always be based on the latest market data, and if you're in a market where rents are increasing (as they have been significantly over the last few years), then this means you are always using the latest, highest prices and thus projecting a maximum NOI for the property. This is as opposed to using actual rent numbers from a lease that was signed when market rents may have been lower.

There is one other huge advantage of having your property vacant at the time you put it up for sale - occupiers. These are businesses that are in the market to purchase an industrial property in order to actually use it for their business. Naturally, because they are buying with the objective of occupying the space, they and their commercial real estate agents are only looking at spaces that do not have a lease in place or have one expiring soon. For this reason, if you have recently leased out your property for 3 years, 5 years, or longer, and then decide to place it on the market for sale, you will be excluding a massive chunk of buyers - i.e. the occupiers - who cannot wait that long for the property to be vacant and may have otherwise been interested in your property, and this is likely to impact the sale price.

As a case in point, I have been working recently with a client who is looking to sell their industrial warehouse building in Vaughan, and they have a not-so-favourable lease in place on the property. The tenant has several renewal options on the space that could allow them to keep occupying the space for the next 15 years. Furthermore, the rents negotiated are below current market rates, and the annual escalations that are in place are below current escalation standards and well below the actual pace of annual rent increases. Lastly, the rent on the renewal periods is capped at a maximum increase as opposed to being based purely on market rents at the time of renewal. Because of this lease, the potential sale value of their industrial building is likely to be significantly below what it would be had it either been vacant or had a much more favourable lease in place.

You may be thinking, but don't investors love it if you already have a lease in place on your industrial property because they have a guaranteed tenant? In a softer lease market, perhaps this is true as the new buyer doesn't have to worry about the property sitting vacant while they search for a tenant. But in the kind of market we've had for the last few years, with sub 1% industrial warehouse vacancy in the GTA and where the competition for tenants to find and lease suitable spaces is fierce, property investors don't have any concerns about buying vacant properties. They know they'll find a great tenant quickly, and at a great rent rate.

Given everything I've said above, I'll summarize the key takeaways below, which is advice that I give to my property owner / landlord clients all the time:

  • If you're planning to sell your property within the next 3 years, do not sign a lease that extends beyond that period. If the existing lease is expiring before you're ready to sell, look at a short term extension or a new lease on a short term basis.

  • If you have flexibility on when to sell but want to sell at some point, you are better off waiting until the property is vacant or close to being vacant, as this will provide the greatest flexibility in terms of potential buyers and NOI projections.

  • If you're not quite ready to sell and you must lease the property out, make sure to get the maximum rent rate that the market will support, the highest quality tenant you can, have a strong annual escalation to the net rent, and limit or don't allow renewal options. This will provide you with the flexibility to have the property vacant when you're ready to sell, or allow there to be strong rent in place with a shorter lease term remaining if you do need to sell it before it is vacant.

Of course if market conditions change then this approach may change as well, and likewise if you do not have any plans to sell any time soon, then there is no reason to fear longer term leases and/or several renewal options.

If you have any questions about the value of your industrial property, the industrial market, or anything related to commercial real estate, we should talk. Feel free to contact me any time for your commercial real estate needs.