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What You Need to Know About Purchasing a Retail Shopping Center in Michigan

Retail shopping centers have long been a popular form of commercial real estate investment, due to their semi-passive cash flow and appreciation in value over time. A shopping center, sometimes referred to as a strip mall or strip center, is typically developed as a single parcel of real estate where a commercial property owner constructs a large building (or multiple buildings) upon with the intention of leasing individual spaces or units within the building to a variety of different commercial tenants. Your local grocery store is probably located within a retail shopping center surrounded by other commercial tenants, including restaurants, coffee shops, fitness centers, salons, and other types of businesses. The benefit to commercial tenants in leasing space in a busy shopping center is that you can capture foot traffic from the larger commercial tenants to drive customers to your business.

 

While many national companies own shopping centers across the country, there are also plenty of smaller investors who privately own and operate shopping centers in their local markets and serve as commercial landlords. This article will outline and discuss some of the most important considerations that investors who are interested in purchasing commercial shopping centers should be aware:

 

Due Diligence Before Purchasing a Commercial Building

 

  1. The Cap Rate: The most common way of valuing a retail shopping center is by calculating the property’s capitalization rate (referred to as “cap rate”). An income-producing property’s cap rate is calculated by dividing the property’s net operating income by the value of the property. For example, if a property is being offered for sale for $1,000,000 and has net operating income of $100,000, the property is being offered at a 10% cap rate, which means the investor who purchases the property can expect to receive an annual return on investment of 10%. If a property has net operating income of $90,000 and the market for that particular asset class is a 6% cap rate, then the prospective investor would divide $90,000 (the net operating income) by .06 (the 6% cap rate), which equates to a value of $1,500,000 that could be used as the sales price. Purchasing a property with a 6% cap rate, means an investor can expect a full return on their investment within approximately 16.5 years.

Properties in different classes trade at different cap rates and the market is always changing. A property with a low cap rate could be an indication that there is a lot of vacancy in the building, or it could be indicative of a lower risk investment. Some examples of properties that typically sell at lower cap rates are single-tenant triple net leases (or ground leases) where the landlord has zero responsibilities and the tenant is responsible for all property taxes, insurance, property maintenance, and where the tenant is a strong national corporation with tremendous assets and corporate guarantees (such as a CVS Pharmacy). Conversely, properties with high cap rates could be indicative of riskier investments and may include tenants with short terms remaining on their leases. Often times shopping centers are listed for sale and advertised with a “pro-forma” cap rate, which means that the seller is calculating the cap rate based on projections as opposed to actual net operating income. Purchasers must be cautious of relying on “pro-forma” cap rates and should always perform due diligence and review the seller’s financials to confirm accurate statements of income and expenses.

 

  1. Review of Existing Commercial Leases: Many investors decide whether or not to purchase a shopping center based strictly on the cap rate and the potential to add value to a commercial shopping center with vacancy. While cap rate and valuation are critical to evaluating any commercial real estate investment, purchasers should also be careful to review all of the commercial leases for a property as part of their due diligence process. Generally speaking, it is advisable to hire a commercial real estate attorney to review any existing commercial lease. Reviewing commercial leases for a shopping center is critical to confirm, among other things: (1) the names of the entities that are operating at the center; (2) the rental rate and other consideration for each lease (such as a percentage lease); (3) any escalations or decreases in base rent over the term of the leases; (4) the remaining term left on each of the leases (particularly important for anchor tenants and tenants with leases above or below market rate); (5) option periods that may be exercised by the tenants and the important deadlines related to notice for the options; (6) allocations of CAM charges (common area maintenance); (7) any amendments to the commercial leases that have been entered into; and (8) information relating to the guarantors of each commercial lease.

Investors who purchase shopping centers with poorly drafted commercial leases already in place could find themselves dealing with litigation or having to pay for an unexpected repair cost due to a poorly drafted lease that was inherited from the previous owner. In addition, it is extremely important for new commercial landlords to carefully review the allocations of expenses among tenants for property taxes, insurance, and maintenance. Poorly drafted commercial leases may include inconsistencies as to how these CAM charges are allocated among commercial tenants and different ways that CAM charges are calculated. It is particularly important to ensure that the CAM charge reimbursements are being managed properly by the commercial landlord and/or the property management company. Finally, commercial investors should familiarize themselves with each of the leases that are in place to ensure that there are no exclusive use provisions that prohibit the landlord from allowing any other commercial tenants from renting space to operate a business that is competitive with another tenant’s business.

 

  1. Review of Title Work and Deed Restrictions: As with any real estate, it is important to review the title work and identify if there are any deed restrictions, easement agreements, or cost sharing agreements that impact a shopping center. Many commercial properties have reciprocal easement agreements or cost sharing agreements that impact the property and obligate the owner to pay for some shared maintenance expenses, such as a shared parking lot. In addition, depending on the proposed use of the property, parking and traffic considerations should be carefully reviewed to ensure that any existing easement will not limit the proposed purchaser’s intended use (or a proposed tenant’s proposed use) of the shopping center. Similarly, there may be deed restrictions that prohibit specific uses of the property, which could make the property unsuitable for use by a particular type of tenant. Since many purchasers buy shopping centers with hopes of bringing in certain tenants, it is critical to ensure that the proposed use will be in compliance with any deed restrictions.

Purchasers should also be aware of the “dark store” theory that certain large retailers have used in the state of Michigan to challenge and significantly reduce their property tax liability. These retailers have challenged property tax bills by arguing that their property values should be based on the values of vacant buildings of a similar size. The argument used by these retailers is that these buildings are customarily built to suit and will not be suitable for other retailers after the current retailer vacates the building. In certain cases, retailers may even include deed restrictions on vacant buildings to limit the types of future occupants and uses of the building once the primary retailer vacates. Purchasers will need to be extremely cautions of potential deed restrictions limiting the future use of the property.

 

  1. Review of Zoning Requirements: In addition to reviewing deed restrictions and title work, purchasers must also review the applicable zoning ordinances and restrictions to ensure that the current use of the property is compliant. Purchasers will also want to review the zoning requirements to determine if any proposed future use or development of the shopping center is compliant or if the proposed use will require a zoning variance. Although purchasers should perform their own review of the zoning, purchasers should also request zoning compliance certificates, zoning variances and approvals, and any code or ordinance violation records in the possession of the seller as part of their due diligence.

 

  1. Other Due Diligence Materials: Although the financial records are often viewed as the most important area for investors to review as part of the due diligence process, Purchasers should perform careful and comprehensive due diligence of any commercial property prior to closing while working with a commercial real estate attorney. Prospective purchasers should ask for a full accounting of all rent and other income paid by each tenant, including amounts billed/paid for common area maintenance, insurance reimbursements, property taxes, etc., tax returns, financial statements, profit and loss statements, and delinquency ledgers.

 

In addition to reviewing financials, purchasers should also perform the standard due diligence review for any property, including performing a survey, carefully reviewing title work, environmental inspections, and physical inspections of the building’s structure. Physical inspections are important to identify any aspects of the property that may need significant repairs or deferred maintenance, including the roof, the HVAC system, brick/masonry, and the parking lot. Although these costs may often times be billed back to the tenants, a new purchaser will want to make sure that the building is in good condition as disrepair can make it difficult to retain and attract quality tenants.

Purchasers may find it helpful to request and review the following items as part of their due diligence:

 

a. Surveys

b. Environmental Reports

c. Engineering Reports

d. Topographic Studies

e. Traffic Studies

f. Construction Blueprints

g. Engineering Plans

h. As-built Drawings

i. Permits

j. Certificates of Occupancy

k. Construction Warranties

l. Certified Rent Roll

m. Financial Records and Accounting

n. Security Deposits

o. Property Tax Bills and Special Assessments

p. Utility Bills

q. Appraisals

r. Insurance Policies of Tenants and Landlord and Schedule of Claims

s. Service Contracts

 

Finally, since the property will become “uncapped” for property tax purposes once sold to the new owner, purchasers should estimate the new property tax bill as part of their financial review and due diligence. In certain cases, property tax bills could potentially increase by tens of thousands of dollars per year, depending on the value of the property and how long the previous owner owned the property. These increased costs could drastically change the cap rate of an investment property.

 

What to Include in a Purchase Agreement for a Commercial Building and What to Expect at Closing

 

  1. Important Commercial Purchase Agreement Terms: The purchase agreement for a shopping center should be carefully tailored to the specifics of the transaction, but will also include many other standard terms that should be included for all commercial real estate transactions. In particular, the parties should: (1) ensure that the legal description for the property is accurately reflected in the purchase agreement; (2) identify the purchase price, terms (for example, mortgage contingency or seller financing terms), pro-rations of rents, utility bills, taxes, and pre-paid CAM charges, and the earnest money deposit; (3) outline the due diligence period and obligations of the seller to provide documents and cooperate with the purchaser’s due diligence and inspections; (4) determine what type of deed will be conveyed to the purchaser at closing; (5) reference a specific closing date or deadline to satisfy all contingencies; (6) carefully describe the representations and warranties of both purchaser and seller; (7) address the transfer of any personal property or fixtures that are included within the sale of the building; (8) address title insurance and transfer tax obligations (both of which are typically paid by the seller); (9) address risk of loss, property maintenance, insurance, and possession requirements up through the closing date; and (10) carefully outline the remedies of both parties for default. Purchasers may want to include a liquidated damages provision that limits their liability in the event of a default to the amount of the earnest money deposit. Purchasers should also ensure that the purchase agreement provides a right to seek specific performance in the event of a default by the seller. Sellers may want to include a contractually agreed upon limitations period on legal actions to shorten the statute of limitations for any possible claims that may arise related to the property post-closing. There are a wide-variety of different default provisions that may be used or advisable to any particular transaction, and these issues should be carefully reviewed with legal counsel prior to signing a purchase agreement.

 

  1. Estoppel Certificates: An estoppel certificate is a document that is typically signed by each of the commercial tenants at closing when a shopping center is being sold to a new owner. The estoppel certificate asks the commercial tenant to confirm: (1) that the lease with the current commercial landlord is still valid and in effect; (2) if there have been any amendments or modifications to the original commercial lease and confirmation that there are no oral agreements or understandings that modify the written lease; (3) that the commercial tenant’s obligation to pay rent has commenced (this is important for leases that provided an initial period of no rent during a time of buildout); (4) the rental rate currently being paid by the commercial tenant and whether any rent has been pre-paid by the tenant; (5) the amount of any security deposit that was paid to the original commercial landlord; (6) that the commercial landlord has paid any amounts owed to the tenant for improvements to the property; (7) whether or not the commercial tenant has exercised any options under the lease; (8) whether or not the commercial landlord is in default or has breached any provision of the lease; and (9) that the commercial tenant agrees to attorn to and treat the new landlord as the landlord under the lease upon closing of the sale of the property.

 

  1. Assignments of Commercial Leases and Security Deposits: The purchaser should also ensure that an assignment of leases is executed by the seller at closing. An assignment of leases is a document that transfers the commercial landlord’s rights under a particular lease to the new landlord. The assignment of leases is critical to ensure that the new commercial landlord that purchased the building has the legal right to enforce the terms of the lease against each of the tenants in the shopping center. As part of the purchaser’s due diligence process, the purchaser should also ensure that each of the leases allow the landlord/seller to assign the leases to the purchaser without needing to obtain the consent of the tenant. Poorly drafted leases could require the tenant to sign off and approve of a new landlord and the purchaser will want to avoid a potential legal issue with a tenant because of an invalid assignment. Each of the leases should also include specific language that requires the tenants to attorn to the new landlord upon the sale of the property. In addition, if any of the tenants paid security deposits to the landlord/seller, these deposits should be assigned and transferred over to the new landlord/purchaser at closing.

 

As set forth above, there are important considerations that investors of shopping centers must be aware of when looking to purchase commercial real estate. The above items are merely a sampling of some of the most important matters to take into consideration when purchasing a shopping center. There are many other important items to be aware of, and each of the applicable documents must be carefully negotiated and drafted, including indemnification agreements, representations, and warranties, closing contingencies, estoppel certificates, assignments of leases, subordination, non-disturbance and attornment agreements, bills of sale, etc. If you are purchasing, selling, or leasing commercial real estate, you should retain an experienced commercial real estate attorney to protect your interests throughout the process.

 

Brandan A. Hallaq is a Senior Attorney with Hirzel Law, PLC where he litigates cases involving defective construction, contract disputes, shareholder/member disputes, quiet title actions to determine interests in property, enforcement of restrictive covenants, real estate foreclosure actions, and bankruptcy matters representing creditors. Mr. Hallaq is also a licensed Real Estate Broker in the State of Michigan and prepares the necessary documents for business and real estate transactions, including purchase agreements, franchise agreements, loan/financing documents, and commercial and residential leases and mortgages. In each year from 2018 through 2022, he has been recognized as a Rising Star in the area of real estate law by Super Lawyers Magazine, a designation that is given to no more than 2.5% of the attorneys in the State of Michigan each year. He was also recognized as a 2020 Up & Coming Lawyer by Michigan Lawyer’s Weekly, an award given to no more than 30 attorneys in the state each year, and he was recognized by Best Lawyers in America: “Ones to Watch” for 2021 and 2022 for professional excellence in real estate law. He can be reached at (248) 480-8704 or at bhallaq@hirzellaw.com.

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