Most leases attempt to answer this question. A typical lease may say that when the term ends, “fixtures” or “improvements” stay and “trade fixtures” go with the tenant. But “fixtures” and “trade fixtures” are confusingly similar labels for improvements that get treated very differently in typical leases. Besides, these labels are vague , overly broad terms that have no specific legal meaning. Hence they invite confusion, misunderstanding, and disputes when the term ends.
A recent Michigan case illustrates this problem. In this case a hair-salon tenant learned the hard way that a special counter with sinks was not a “trade fixture” that the tenant could remove when the term ended. Instead, the counter belonged to the landlord.
When the lease was being negotiated, the prospective tenant wanted a counter with sinks installed in the space. The tenant would have purchased and installed this counter, but it didn’t have the cash. So the landlord agreed to purchase and install the counter. The rent would be increased to cover the landlord’s $60,000 cost. The landlord told the tenant the tenant would own the counter at the end of the lease term. So far, so good.
But unfortunately, the lease language didn’t read that way. It stated that improvements made by the landlord remained the landlord’s property. The tenant could remove, at the end of the term, only those improvements that that tenant had installed. So the counter stayed, because the tenant wasn’t the one who installed it.
Someone didn’t take a few minutes to compare the lease description with the actual deal. You can do better for your leasing clients.
What can we learn here?
Lesson #1: as hard as it may be when the lease is being negotiated, take the time to identify what happens to each improvement when the lease ends. Avoid relying solely on vague terms like “fixtures” and “trade fixtures”. Consider:
1. What improvements are we talking about? Counters, partitions, special lighting, plumbing fixtures such as sinks, etc.
2. Who installs each improvement? Who pays for each one?
3. What happens to each item on this list when the lease term ends? Your choices include:
1) The item stays, period.
2) Landlord has the option to require the tenant to remove the item (and restore the space to original condition).
3) Tenant must remove the item (and restore the space)
4) Tenant has the option to remove the item or leave it behind.
5) For possible improvements the tenant may want to make later on during the term, agree that if the landlord gives its consent, the topics of removal and restoration will be addressed at that time.
Lesson #2: remember the landlord’s promise that the tenant would own the counter when the lease term ended? Unfortunately for the tenant in this case, the lease had a standard so-called “zipper clause”: a statement that the written lease controlled over anything either party may have said to each other. So the landlord’s promise was unenforceable. The lesson: take a little time with your client to make sure any oral promises that matter are written into the lease.
You’ll serve your lease clients well by getting them to focus up front on what happens when the lease term ends. You’ll be avoiding disputes that can lead to litigation, and no landlord or tenant wants that.
Biden proposed a package (during his presidential campaign), that includes using the estimated $50 billion in tax revenues generated from eliminating 1031 exchanges, for investors with a net worth of over $400,000. The purpose is to pay for improved childcare and healthcare for seniors. The $400,000 level is an unclear number and subject to interpretation. Few if any news outlets questioned or challenged Mr. Biden on the full effects of the elimination. We have participated in conference calls including industry experts and have identified many reasons why this is not a quick stroke of the pen solution.
There a few people who would argue that childcare and healthcare for seniors are not important. Assisting these group hardest hit by the COVID 19 pandemic is important. Biden's economic recovery plan may have many initiatives, but there may be better funding sources rather than the elimination of the 1031 exchange.
Personally, I grow tired of legislators who reference the 1031 exchange as a "loophole". There are long term benefits from 1031 exchanges by deferring capital gains and depreciation taxes. However, the economy realizes far-reaching, long-term benefits from the process as well. Section 1031 of the Code is an engine for growth that pays for itself many times over. This includes jobs, taxes, increased revenue to states and municipalities and potential financial security for the individual investor.
In my opinion simply looking at how to capture the deferred taxes politician may be oversimplifying the far-reaching benefits. Politician may harness a myopic view and ignore all the other benefits that have far reaching effects downstream and upstream. Many experts have opined that commercial real estate may drop 15-20% if the 1031 is eliminated. Naturally there are those who may challenge a drop in commercial real estate. However, the pandemic is already affecting real estate values in certain section of the country. That is another topic for in-dept analysis.
It's not just a paper transaction it is "Jobs, jobs, and more jobs"
The IRS 1031 Exchange rules do involve documentation and paperwork as well as strict time requirements. The impact and scope of the exchange reaches beyond a single investor looking to defer tax payment. Investor often use the funds that may have gone to pay taxes to make upgrades to the property. The investor may diversify their holdings and improve the community. Once a property is acquired there may be additional spending on building supplies and improvements that funnel money back into the local economy as well as sales tax revenue. As properties sell in local municipalities the increased assessed value adds incremental tax revenue to the local budgets and economy.
The impacts go beyond just the materials. The upgrades may include the services of architects, contractors, electricians, plumbers, laborers, and others. There is also the need for all the services that are utilized to complete the exchange including qualified intermediaries, lawyers, appraisers, and escrow agents. All pay federal and state income taxes.
Research has shown there would be a clear negative impact to the economy should 1031 exchanges be eliminated. 1 A 2015 Ernst & Young study found that repealing 1031 exchanges could shrink the economy by more than $13 billion, discourage investment, and lower tax revenues. Municipalities that would rely on the increased tax revenue could be the most effected.
Let's pause to understand how far 1031 exchange benefits reach
As mentioned, before we need to refrain from looking myopically at grabbing the immediate tax gain missed during a real estate transaction. This is part of the fight that involves the lens through 1031 is viewed. 1031 has been around for 100 years and needs a broader view to understand why this statue has been around so long. Facts are that Individual investors and small businesses are among the biggest users of 1031 exchanges. Using a 1031 could help to a secure financial future, a key financial planning tool, and an income stream for retirement.
Let's talk about the farmers
Many farmers have land holdings that have been in the family or generations. Often the farmers are a forgotten segment of 1031 exchangers. They are in a unique position to use the provision to secure their futures and assist their communities. Farmers are able to sell land that is no longer productive for farming to aid conservation efforts by selling easements that restrict crop production or other farming activities. They can also exchange property for non-farm property investments to protect multi-generational wealth. If the farmers sell the land for development, there is an immediate increase in tax revenue with a new development. Under all is the Land! This may be the only asset the farmer owns.
Education before action on 1031 exchanges
We urge all stakeholders to take an in-depth look at the 1031 exchange and fully understand the value of this 100-year-old section of the tax code before taking any action.
On the surface there is the ability to defer taxes by reinvesting the proceeds from the sale of one property into another. This provides a multitude of positive outcomes including the investors flexibility to spend more on property improvements, secure the income needed to last through retirement, accumulate generational wealth. There are also the facts that the 1031 exchange process generate jobs, and fuels economic growth. This may be the wrong time to consider eliminating certain property owner's ability to perform a 1031 exchange. The economy is still struggling in the midst of a pandemic. While programs that help children and seniors have universal appeal, funding them through the elimination of the IRS Section 1031 exchange has the potential to provide a short-term bump while unintentionally limiting long-term prospects.
1 Ernst & Young 2015 study results: www.1031taxreform.com/wp-content/uploads/...
Each year, RPAC sets a fundraising goal which is divided by the number of members of the Michigan Realtors to arrive at a “fair share” fundraising goal for each member. The 2020 ROAC fundraising goal was $1,160,000.00, making the fair share amount for each MI Realtors member $35.57. Consequently, the fundraising goal for CAR, with its 332 primary members, was set at $11,811.00.
I am happy to report that for the 7th year in a row we have exceeded our RPAC fundraising goal by at least 30%. RPAC’s 2020 numbers through October 31 show we raised $16,739, or 141.7% of our goal of $11,811. Additionally, each association across the state has a membership participation goal of 37%; CAR exceeded that goal by having 46.4% of its members participate in RPAC fundraising efforts this year.
Where does the money go? In an election year like this one, the RPAC Trustees oversee a process through which candidates for state and federal office can receive campaign donations from RPAC, specifically from a fund called RPAC I which is designed to support candidates and their campaigns. Local associations handle candidate interviews for state representatives serving their areas; MI Realtors then receives recommendations for endorsement from the local associations and suggests a donation amount based on the office, historical experience with the candidate, and the perceived importance of the race or seat in question. Those contributions are then approved by the RPAC Trustees. The Trustee board also conducts some direct interviews with candidates for state Supreme Court, Governor, US House of Representatives, and US Senate. For the judges and Governor candidates, contribution amounts are recommended by MI Realtors and approved by the RPAC Trustees; for the federal offices, contribution recommendations come from NAR. This year, MI Realtors and the RPAC Trustees saw 96% of the endorsed candidates win their races.
On behalf of the RPAC Trustees board, I would like to thank all of you who contributed to our RPAC fundraising efforts this year. For those of you who are still thinking about it, there’s never a bad time to get involved. I and the other members of the Political Affairs & Government Committee are always happy to answer any questions you might have.
Retailers will try to make it through the holiday season, which in the past has been such a profitable time. Some of the projections are that nearly 60% of retailers and restaurants closures will be permanent (Kreznar). Those business which have remained open have forced many operators to defer their rent payments and landlords will have to make the difficult decision on whether or not they continue to be flexible on payments or if they should recapture the space and start the process of looking for new prospects. As we look towards the beginning of the new year, we are undoubtedly going to see a rise in vacancies occurring in Q1 and Q2. Many of those vacancies will be the larger spaces and in-line spaces will be difficult to release as many retailers prior to Covid-19 had begun to recognize that they did not need as much space.
While the numbers continue to grow for bankruptcies and closures of businesses there have been several businesses that have thrived during this period. Essential businesses who remained open throughout the pandemic have seen record sales. Walmart, Target, Dollar General and many other big and medium box retailers often face the difficulties of empty shelves due to a strong demand. Restaurants with drive-thrus also saw strong sale volumes even when forced to shut down their dining areas. Uber Eat, Grub Hub and other delivery service apps become widely used as dine in options were at limited capacity.
As we progress into 2021 there are a lot of unknowns, but the one thing remains, the resilience of the American people. There will be business which fail and go under, but there will be those who learn from 2020, thrive in 2021 and the years to come. This year was one that no one anticipated, and it will surely impact how businesses move forward from this moment.
Kreznar, Christian. “Small Businesses Are Closing At A Rapids Pace, With Restaurants And Retailers On The West Coast Among The Hardest Hit”. https://www.forbes.com/sites/christiankreznar/2020/09/16/small-businesses-are-closing-at-a-rapid-pace-with-restaurants-and-retailers-on-the-west-coast-among-the-hardest-hit/?sh=67bbeae25033
All disasters have three stages – the assessment, the repair and the on-going phases – we are in the assessment phase, but we may still be assessing the assessment.
There are three types of recovery – a short V, a long U and an L. Bell says that from studying detrimental conditions since the 1980’s, in most markets he expects a V recovery, where distressed owners sell and drive the market down, followed by a steep recovery. Some are forecasting a W shaped recovery, somewhat similar to seasonal ups and downs, if COVID re-emerges and the economy pauses again. No matter the type of recovery there is light at the end of the tunnel.
In the commercial markets, those REITS and landlords who have good management and proper reserves will go through this relatively unscathed. He predicts cap rates will likely surge about 2 points due to distressed sellers. Distressed players will go away while blaming the coronavirus, however they likely were on thin ice anyway.
From a recent Co-Star survey, Office leasing is beginning to rebound but still down from previous years. A study regarding planning for the reimagined workplace shows a significant increase in the number of employees working from home 1 year after COVID-19. Buildings with elevators present a significant challenge due to limited capacity requirements. The premium rates the CBD’s currently experience could be difficult to continue. The greatest remote preference is a hy-bred of at home and at office. According to the CEO of Blackrock he feels a maximum of 60-70% of their employees will need to return to the office. This has to impact demand at some point. We are blessed to have the Medical Mile activity we do, which was recently improved even more with the announcement Perrigo was moving into a new facility they will build downtown just off Michigan. Medical offices currently lead the commercial real estate industry, with rent collections at 99.8%, in spite of some tenants having faced challenges amid the banning of elective procedures.
Bankers I talked to have stated the small guy, highly leveraged, may be in trouble, but the original panic seems to have diminished. In general, they stood back and watched for the first three months with no new loans, but are now back looking for business – lower interest rates have certainly helped.
Again, the reoccurring theme is ‘Property and Location Specific” regarding impact, with good locations and quality tenants not significantly impacted at this point.
Retail seems to be the most difficult area, although again “Property and Location Specific” is key. Nationally it has been hard hit – published sales data shows lower incomes but creeping up after July, primarily from on-line sales. E-commerce was approximately 13% prior to the pandemic and 18% now. E-commerce is growing quickly and taking demand away from on-site shopping.
Slower recovery from malls that are designed for crowds which is not good now. 50% of all closures are coming from malls even though they make up only 10% of all space. The expectation is mall vacancy will rise by at least 4% which will impact its value. Malls will also have a slower recovery while neighborhood and community centers should hold up.
Restaurants – could be tough going and 61% of the closures are likely permanent!
Quick Service Restaurants (OSR’s) has seen an increase of 30 basis points in cap rates nationally compared to past years, with corporate leases basically unchanged. Many OSR’s are looking to downsize their sit-down stores and look for drive-through sites. There will be a bifurcation between corporate/large franchisees and smaller franchisees as a flight to quality continues.
Bankers have mixed emotions about retail – many stated they are not seeing enough data yet and some appraisers are making 5-10% downward adjustments on some properties. Sit down restaurants are hardest hit and if they make a loan, they are looking at a 12-month period to stabilize the income. Another said retail was a flip of the coin – national tenant restaurant would be okay. Smaller mixed tenant facilities would depend a lot on the owner, local, amount of leverage, etc.
Most fast foods are still paying – PPP helped and deferments are good through 12/31/2020 with no consequences and no downgrade of the assets on their books. In March 40% asked for deferments and that is now down to 15%.
Industrial seems to be holding up fine and actually improving. The Grand Rapids area is growing pretty rapidly and our diversified industrial base has proven to be a very positive factor.
Multi-family continues to be a significant factor in new construction and resales are good, with some paired sales showing significant increases from previous years. The demand for these facilities is boosted by the lack of inventory of single-family homes and the builder’s inability to keep up with demand, especially in the lower, entry level price ranges.
We are blessed to be in the West Michigan area at this time, as the infection rate on this side of the state is substantially lower than the state as a whole. Let’s hope that continues and a vaccination is developed soon so we can move past this current situation.
John A. Meyer, SRA, GAA
John A. Meyer Appraisal Co.