Buying a Building With Space to Lease Out

Sometimes the extra space is a choice. A company wants to grow into a building over time and would like someone else to help pay for the floors it does not need yet. Sometimes it is not a choice at all. The location is right, but the only available building is bigger than the requirement.

Either way, the appeal is straightforward. Rent from tenants can offset some of your costs. The spare space stays under your control for later. Truist lists potential rental income for unused space among the benefits of buying. The harder question is whether the income is worth what comes with it, and whether your financing allows it.

Check this before you run any numbers, since it can decide the deal.

• SBA financing on an existing building. Under 13 CFR 120.131, which covers both 7(a) and 504 loans, a borrower may permanently lease up to 49 percent of the rentable property if it permanently occupies and uses no less than 51 percent.
• SBA financing on new construction. The borrower may permanently lease up to 20 percent if it permanently occupies and uses no less than 60 percent. It must also plan to occupy some of the remaining space within three years, and all of the space not permanently leased within ten years.
• The 504 program’s purpose. The SBA’s 504 page says a loan cannot be used for speculation or investment in rental real estate.
• Conventional bank loans. Banks set their own standards. The OCC’s handbook for bank examiners says that when a property is partly leased to an unaffiliated tenant, classification turns on the primary source of repayment. If half or more comes from third-party income, the property should be considered non-owner-occupied, which may change how the loan is analyzed.

These figures come from the regulation and handbook as published at the time of writing. They can change, and details such as how rentable property is measured matter, so confirm with a lender or Certified Development Company before you make an offer. CDC Small Business Finance also advises raising a plan to lease out part of a building with the lender early.

Here is a hypothetical, for illustration. All figures are invented and are not market data. A company buys a 20,000 square foot building, occupies 12,000 square feet (60 percent) and leases 8,000 square feet (40 percent). The tenant pays $120,000 a year in gross rent, and the building’s annual operating costs of $150,000 are not passed through.

• Fully leased: the leased share of operating costs is 40 percent of $150,000, or $60,000. Rent of $120,000 less $60,000 leaves $60,000 a year toward debt service and profit.
• Tenant leaves and the space sits empty for nine months of the year: rent falls to $30,000 for the three leased months. Against the same $60,000 cost share, the result is a $30,000 shortfall, before any commission or improvements to attract the next tenant.

The swing in this example is $90,000 in one year. What matters is the test, not the numbers: run your loan with the leased space empty for a long stretch, and see whether the company can carry it. Lenders may do the same. If the purchase only works with the tenant in place, the risk you are taking is larger than it looks.

Your company becomes the party it used to call about a broken air conditioner. Plan for these duties.

• Finding tenants, including marketing, commissions and sometimes improvements to the space.
• Screening credit, and accepting that a small tenant may not be able to pay through a downturn.
• Drafting and enforcing leases with an attorney, including who pays which costs.
• Billing, collecting, reconciling expenses and handling defaults.
• Maintaining shared areas and systems, and responding to complaints.
• Sharing the building with someone else’s employees, customers, deliveries and parking needs.
• Compliance. Under the ADA Title III regulations, both the landlord of a building housing a place of public accommodation and the tenant operating it are subject to the rules. As between them, the lease can allocate responsibility.

You can hire a property manager for much of this. That cost reduces your income, and someone in the company still has to supervise the manager and make decisions.

If the building comes with tenants, ask your attorney how their leases carry through the sale. The California Lawyers Association’s overview lists the transfer of existing leases among the issues a purchase agreement may address, and the lease terms can determine when you can use the space yourself. A lease with years left and no landlord right to take the space back can block your occupancy plans. It may also affect any occupancy test your lender applies.

Maynard Nexsen’s overview of the purchase process recommends inspecting each lease for term, rent and landlord obligations, and obtaining tenant estoppel certificates, in which a tenant typically confirms its lease is valid and that neither side is in default. If you need space vacated by closing, the same overview notes that buyers may ask the seller for that assurance in the contract.

• ✓What share of the rentable space will we occupy at closing, and does that meet each lender’s test?
• ✓Does the purchase still work if the leasable space is empty for a long period?
• ✓Can the building be divided, with separate entries, restrooms and utilities, without a costly rebuild?
• ✓Would a tenant actually want this space, in this location, at the rent we are assuming?
• ✓When will we need the space ourselves, and do the lease expirations line up with that date?
• ✓Can our leases include a right to relocate a tenant or take space back, and what would that do to the rent?
• ✓Who will manage tenants, and what will that cost in money or staff time?
• ✓Has our CPA reviewed how rental income will be treated, and has our attorney reviewed the entity holding the building?

The cleanest version of this strategy treats tenants as a temporary way to carry future expansion space, with lease terms built around your growth plan. Tenant Advisory Group represents occupiers, not landlords or sellers of investment property, so in this kind of purchase our job is on your side as the buyer and occupier: testing whether the building fits your own needs first and whether the extra space is an asset or a distraction.