How Long is the Commercial Real Estate Bid Process?
By Larry Feldman
Commercial real estate transactions can be daunting for new and experienced investors alike. They are often complex, can take months or even years to complete. The commercial real estate bid process itself may be fraught with peril, and missteps can end up costing stakeholders substantial amounts of time and money.
The length of the commercial real estate bid process depends on several independent factors, some of which you can control and some of which you can’t.
When an owner of commercial real estate wants to sell a property, typically they will engage what we refer to as an investment sales broker. These are commercial real estate brokers that specialize in selling commercial properties. These specialist brokers have nothing to do whatsoever with the residential business.
Typically, they don’t get involved in leasing office space and occasionally, though they are not appraisers, they may provide a broker’s opinion of value which serves as an informal appraisal.
Their primary specialization is in selling commercial properties. The investment sales broker category is further broken down into product types. For example, there are investment sales brokers that specialize in selling only office buildings and there are investment sales brokers that specialize in selling retail properties. Some investment sales brokers cross over into different categories.
In our industry, we usually only hire somebody who has years of experience in selling office buildings – particularly if it’s a large building that we’re marketing. Ideally, we look for somebody with a minimum of ten years of experience in marketing office buildings.
Here at Feldman, we’re specialists in high-rise office buildings, and the community of investment sales specialists with over a decade of experience in our market is only a tiny population of players. Here in Tampa, there’s probably only about a half a dozen folks who really qualify, and within those six, there’s usually three or four who control 80 or 90 percent of the business.
Hiring a Specialist
The Hiring Process
Step one is to interview and hire someone at one of the major commercial real estate brokerage firms who specializes in selling major office buildings. We would agree on a fee structure and would then retain the broker to put together what we refer to as an ‘offering memorandum.’ To be clear, there’s no retainer in the sense that money changes hands at this stage. In the commercial real estate world, when we retain an investment sales broker, their compensation is almost always 100% subject to the sale of the building. Their commission is usually paid on the day of the closing. This may take anywhere from several days if you have good referrals, or months if you take the time to do more research.
Typically, a broker on a significant building with, let’s say, a value of $30-50 million or higher, would earn something on the order of magnitude of seventy basis points times the sales price (meaning 0.70% of the sales price). This means that on a $50 million deal, they would earn a $350,000 commission. On a much larger office building, the commission might drop to as low as 60 basis points. These fees are negotiable in every instance.
The broker is engaged for a predefined period of time on an exclusive basis. Under the terms of a typical exclusive sales agency agreement, we are liable or payment of the commission during the term of the agreement. Even if we sell the building to one of our buddies at the golf club, we have to pay the brokerage firm we hired the commission as agreed in the brokerage agreement.
Occasionally, an owner will carve out exceptions to this rule. They may identify an individual or company with whom they have a close, pre-existing relationship and with whom they have already been talking about the transaction. In such a case, if this individual or company buys the building, the contracted brokerage firm may get a half commission, or in some cases, no commission.
That said, putting exclusions in the brokerage contract is fraught with peril because it can disincentivize the broker. Instead of focusing on finding a buyer, he may be looking over his shoulder, thinking we might sell to a friend and wind up with a half commission. It provides a disincentive right from the beginning and we tend to avoid these kinds of terms.
The Offering Memorandum
Once these sorts of terms are sorted out, it’s time to sign the brokerage commission agreement. The clearer and more agreeable the terms for the broker, the faster this process will be. The very first process that the broker wants to do is gather a vast amount of information from the seller about the building so that he can put together a formal offering memorandum which, in a large office building, can be as long as 100 pages or more. Incidentally, the jargon we use in the real estate business to refer to an offering memorandum is the “OM”.
Historically, the OM was exclusively produced in hard copy, and it was sent out in hard-copy to prospective buyers. Today they’re sent out electronically in PDF. Typically, a prospective buyer electronically signs a confidentiality agreement to expedite the process. Confidentiality agreements are signed because OMs contain a lot of sensitive information about the building’s inner working – for example, they’ll have every single lease expiration and what the tenant is paying and an owner would not want a competitor accessing that information to poach tenants.
The OM will also include information about existing problems with the building. For example, if a tenant is suing the owner for some reason or if there is an environmental problem. If you are dealing with a reputable investment sales broker, most things that might be found out during the process of due diligence are disclosed upfront to get them out of the way.
Nevertheless, more often than not, the OM is authored to paint a rosy picture of the building – so caveat emptor!! It’s up to the buyer to find the things that are not being disclosed, and most buyers of, let’s say, a large office building are institutional buyers that have very sophisticated processes they employ to check every aspect of a building’s performance. This step will take you a couple of weeks to a month (or longer if the building has serious problems), but the time is worth it in order to make sure the property is worthwhile.
Wells Fargo Center / Tampa, FL
In the case of the major office building, let’s say in downtown Tampa, an investment sales broker might send out OMs to as many as 50 or 60 prospective buyers. Most of the prospective buyers that receive an OM, do not actually wind up getting the property. On a major office building, in today’s market, there may be as many as a dozen actual bids.
First Bid Round
The prospective buyers that elect to actually make a bid typically perform an initial evaluation of the building based upon the materials in the OM. The prospective buyer may also perform a degree of due diligence beyond the materials that are provided for in the OM. For example, they may call upon contacts they have in the local leasing market to get the “pulse of the market”. They will ask about such things as office rental rates and vacancies.
After finishing up the initial due diligence and underwriting process, a buyer’s next step is to make an offer to the seller of the property. The first offer made is important, as it shows how interested a buyer is in the property. In addition to the actual bid amount, the seller of the property will want to know how much work the prospective buyer has put into his bid. However, the first bid is just the beginning of the process. To successfully acquire the property in question, the prospective buyer will need to beat the competition and make it to the end of the process.
Many people think of the first bid round as the first several days or first week when a property goes on the market. If the market is slow, the first bid round may take longer.
Underwriting the Property
This process usually takes a little over a week. The underwriting process is comprised of a deep financial analysis that examines multiple data points, like building occupancy, rental income, real estate taxes, and ongoing costs like management or utilities. Underwriting also involves working to create accurate assumptions about how the building and local market will perform over time.
During the underwriting process, the buyers will ask many questions of the seller’s broker as well as conduct independent research relating to a host of questions. Topics include
How much can rents be raised
Short, and long term supply/demand
How much money the buyer will have to invest in capital and tenant improvements, and
Many other questions relating to the current and future performance of the property.
After asking questions and undertaking research, the buyer’s team will create a detailed cash flow projection of the property’s cash flow over the next 5 to 10 years. That projection includes defensible assumptions about rental rates, vacancy factors, the cost of tenant improvements upon lease expirations, free rent, etc.
The prospective buyer then applies a “discounted cash flow” return percentage that the buyer’s needs and those of their investor partners. In simple terms, the bid price is a function of both the cash flow assumptions as well as return threshold parameters. In most cases, the buyer team will finish multiple underwritings to look at the potential gains or pitfalls from a deal, which helps them understand the risk versus reward for the asset in question.
First Bid through Last Bid
For commercial real estate, a property in good condition will usually have a bidding process that lasts between six months and a year. The first bid through the last bid encompasses a number of processes, including underwriting, more due diligence, meetings, and anything and everything that buyers and sellers need to do to facilitate the winning bid. Think of the first bid as the starting line, and the actual property changing hands as the finish line- with the bidding process and eventual selection being the race.
Final Bid: Closing the Deal
The final bid represents the end of the bidding process. Closing the deal entails several different but equally important tasks, including a last review of documents, final due diligence checks, and the eventual signing of the necessary documents to finalize the transaction. There is no set timeframe for a commercial real estate bidding process. However, a typical timeline for a large commercial property will give the prospective buyer about six weeks to review the OM and perform its initial underwriting prior to the bid date.
After the initial bid, the investment sales broker, together with the owner of the building, usually agreed to reduce the number of bidders to a smaller list of 3 to 5 bidders that will be admitted into the “second round of bidding”. Typically, within a week thereafter, a Buyer Interview process is conducted with 3 to 5 “finalists”.
Factors Affecting the Bid Process Timeline
Once the list of prospective buyers has been whittled down, it is time for a more in-depth interview with the potential purchasers. Each buyer may bring different benefits to the table, one may have an advantage in the price they are willing to pay, and another may have a greater ability for faster and more reliable execution than a competitor.
The seller and their team will proceed to ask them questions pertaining to the deal – everything from info about their debt and equity capital stack, to the due diligence they performed, and anything else that is necessary for the seller to make a decision on whom to go with. Some of the typical questions that are asked or whether or not the buyer has all of the equity at his disposal and what levels of debt and equity that the buyer is assuming. The seller is likely to be nervous if the buyer is dependent upon extremely high debt levels and very low equity amounts, because the availability of the debt may be questionable.
The seller’s team’s eventual goal is to identify any potential warning signs that the buyer may be unable or unwilling to close at the stated price. On the buyer side of the interview, their goal is to convince the seller and their team that the property or portfolio in question is a priority and that they can and will close immediately if they are given a chance to do so. Buyers will often treat the process as a sales pitch and will do everything in their power to ensure they, and not their competition, comes away with the deal. Most sellers want to get this done as quickly as possible, so the process lasts between several days to a week.
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After the prospective buyer is selected, a purchase and sale contract is negotiated between buyer and seller. This contract often takes 2 to 3 weeks or more to get executed. During the initial contract phase, the buyer typically has 30 to 45 days to perform its due diligence. Typically, the buyer is not at risk with respect to the contract deposit until it has completed its due diligence.
Park Tower / Tampa, FL
During the due diligence phase of the contract, the buyer will focus in on whether or not the assumptions used in the OM are accurate. The key area of focus is to determine whether or not the operating expenses of the building reflect reality versus the amounts that are represented in the OM. For example, one of the single biggest ticket operating expense items is the real estate tax. Involved parties should look at what exposure there is on real estate taxes. In the Tampa market, over the last ten years, we’ve seen a big run up in assessed taxes, back up from what was the abyss of real estate valuations during the global financial crisis of 2007-2009.
After the 2009 collapse, real estate tax assessments ran way down to where landlords were able to reduce their taxable assessments by half. Believe it or not, 10 years later, the tax assessments for some Tampa area real estate still lag because the market is moving at a faster rate than these reassessments have occurred.
Unfortunately, when the building is sold, it automatically triggers a reassessment. You have to make sure that you’re not exposed, and you’re properly budgeting for what could be a significant increase in real estate taxes.
After tax assessment and related costs, repairs and maintenance are also a very big category. Buyers want to focus on the payroll costs to run and administer the property. Sellers often try to skinny these costs down in the OM because the skinnier they are, the bigger the net operating income is, and the bigger the net operating income is, the more buyers are willing to pay for the building. However, that may be a false illusion. Savvy buyers drill into all operational line items to uncover how a building actually functions economically.
Put another way, operational due diligence refers to the ongoing costs involved in operating the property, from employee payroll analysis to regular expenses and maintenance and any other facet of how the property is run, and how much it will cost to keep it running at a level where it is generating expected returns.
Related: Office Building Renovation Checklist: Everything You Need to Know
The biggest single thing that buyers must do during the due diligence phase of the purchase contract is to evaluate the stickiness of the tenancy. What is the likelihood that a particular tenant will renew upon lease expiration? What is their reason for being in the building? Is their physical space meeting their needs? And, what are their plans, long term? After a contract is signed, as part of the due diligence process, all of the major tenants are interviewed in a one on one interview by the prospective buyer.
There is a series of questions we ask along the lines mentioned above. We ask if a tenant is right-sized? Why they moved to the building in the first place? Does the space still fit their needs? Are there any specific issues with the building they’d like to see addressed? Buyers can also use that opportunity to survey the tenants regarding potential services that a landlord could provide to attract or retain tenants.
The tenant interview process may be the single most important item of the whole due diligence list. Buyers want to look at things like rent delinquencies – that’s a big issue. Are tenants paying their rent on time or are their tenants that are in arrears? If it’s a $50 item the tenant’s been disputing because somebody left dishes in the sink that they agreed to pay miscellaneous cleaning charges for, you don’t lose sleep over that. But if it’s base rent that hasn’t been paid for 60 days, you had better drill down heavy into that situation.
Legal and Physical Due Diligence
Wells Fargo Center / Tampa, FL
One of the most obvious areas of due diligence involves the physical due diligence, which involves obtaining a thorough inspection of all of the structural and mechanical aspects of the building. Such inspection and analysis will include things like determining the condition of the roof, analyzing the heating, ventilating and air conditioning (“HVAC”) system, etc. Very often, physical issues are found during this inspection that might require the seller to provide a credit to the purchase price in order to enable the buyer to rectify any physical defects.
An automatic item that we perform in 100% of the properties we acquire is an environmental inspection. We retain specialists that analyze the environmental history of the property in order to ascertain whether or not there are any issues.
In addition to the physical due diligence, there is also legal due diligence. The term legal due diligence can cover a broad spectrum of items. For instance, say you own a building that has a parking garage overhanging the neighboring property by five feet. It is important to make sure that the neighboring property owner would not sue you in that situation, for obvious reasons.
With an item like that, the best bet is to get title insurance. The title insurance company may be willing to actually ensure that problem because they’ve done the research and they found forty-nine years ago that there was a waiver given and title is clear. In addition to title issues, there may also be zoning issues, compliance problems, permitting problems, and concerns relating to tenant contracts- among other categories. If you can think of a legal problem originating from a commercial deal, it falls under this purview.
Another key legal due diligence item is to determine the current zoning and whether or not the property is fully compliant with the use restrictions. Typically, we hire a zoning specialist to perform a thorough analysis of the legal risks, if any, associated with the zoning of the property.
Letter of Intent
When we are selected as the winning bidder of an office building, prior to executing the purchase and sale contract, very often there is a letter of intent (the “LOI”). This should be sent out as quickly as possible, and usually should be written in one to two days. In almost all cases, these letters of intent are not binding. When writing a letter of intent, it’s important to make clear that all of the terms and conditions contained in the letter are non-binding, are for expressions of interest only, and may be withdrawn at any time by any of the parties.
That prevents it from becoming a legal contract. The purpose of a letter of intent is only to summarize the business terms of the deal. The only exception to the non-binding provision might be the confidentiality portion of the agreement. In most cases, neither buyer nor seller want the bid information to leak to the public prior to the closing.
In the case of the purchase of an office building, the most important term in the LOI is the purchase price. It will also describe how long the due diligence period is before which time the buyer’s contract deposit money will be at risk. It will describe how much of how much contract deposit will be required and what is the expiration date of the due diligence period at which time that deposit becomes non-refundable to the buyer – whether they close on the transaction or not.
For example, let’s say you’re buying an office building for $80 million. A deposit of $1 million would likely be posted at the time the contract is executed with a 45-day due diligence period, after which time the $1 million is nonrefundable to the buyer. In addition, the LOI identifies who pays what closing costs or any other costs that arise or need to be satisfied as a result of the contract. Finally, the letter of intent is turned over to the attorneys who use it as the framework from which to prepare the final purchase and sale contract.
The negotiating of a transaction’s terms can take anywhere from two weeks to as much as a month. Many issues may come up during the negotiation period that can cause delays, but once the contract is signed, the due diligence period begins and that starts a stopwatch.
If the due diligence period is 30 days, the buyer has 30 days to complete all their inspection work and decide whether they’re going to proceed with the contract and close at some point in time thereafter. That could be another 15 or 30 days following the end of the due diligence period, depending upon what was originally negotiated.
Park Tower / Tampa, FL
As a last word, let’s take another look at the factors affecting the bid process timeline.
When you’re regularly acquiring properties, as we do here at Feldman Equities, you have to optimize the process to compete with other players. To get a deal started off quickly and on the right foot, we like to use forms prepared in advance that we email over to an investment sale broker, along with references and phone numbers.
We also like to pitch the seller with the idea of using a contract form that has been heavily negotiated on a prior deal so that both sides can start from a position of equality in the ‘bias’ of the contract, instead of starting with some boilerplate form that the seller’s attorney puts together that is going heavily favor the seller and require time-consuming and consequently costly negotiations just to get back to a fair contract. We’re not always successful in asking for this, but tactics and strategies like these are a good way to bring about efficiencies in the process.
Finally, we always try to anticipate the things that sellers want to ask us during the bid process, like how much discussion have we had with our lenders. When we know that we’re facing tough competition, it may behoove us to call our lender and get them to come up to speed quickly on a deal. We will sometimes get them on the phone with the seller’s broker to underscore that we’re ready to go and we have the “dry powder”.
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