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A piece of the action: investing in your property.

The Campeau debacle and other widely publicized failures may have discouraged some developers from investing in tenant businesses. But more and more, property owners and managers-large and small-are seeking a piece of the action. More and more property owners are opting for a double stake in tenants' growth by acquiring equity in their businesses.

David Cox is president of Jacksonbased Cox & Associates, one of Mississippi's largest and fastest-growing property development companies. So it comes as no small surprise that Cox has been working nights of late, slaving over a hot stove and flipping burgers at a popular local restaurant. He has cheerfully been waiting tables, too, while wife Leslie has helped out behind the cash register.

Sweat equity

Are the poor Coxes victims of a sudden cash crunch? "Nothing so drastic," laughs David. He and his wife are simply keeping an eye on an important investment. Since 1989, Cox has held a 50 percent equity share in the restaurant, which is located in one of his company's shopping centers in a Jackson suburb. The restaurateur, a young man who had made a success of two other Jackson eateries, "really loved this location;' reports Cox. "But he was over-leveraged and depleted of capital. We weren't."

In return for a cash infusion of about $50,000, Cox acquired half of the business, as well as a long-term tenant for his center. Open less than a year, the hamburger place is already in the black. Cox hopes to hold on to his investment in the eatery for many years. "I made sure of my ability to retain an equity interest was specified in our agreement because of an earlier experience;' he explains. In a 1987 foray into retailing entrepreneurship, Cox had invested in a drug store, located in the same shopping center. "I had commissioned various demographic studies, all of which predicted that a pharmacy would do fabulously in this location," he relates. "But we couldn't interest any drug store chain in setting up shop.'

Finally, one well-known national chain, impressed by Cox's enthusiasm, said to him, "O.K., if you feel so strongly about it, put your money where your mouth is. We'll sign the lease, but you have to become our franchisee and stock the store. When it pulls its own weight, we'll buy it back from you."

Cox agreed to this arrangement and eventually invested a considerable amount-over 200,000-in the project, becoming the store's temporary owner.

"The chain cautioned me that it would probably take three to five years before the outlet began to turn a profit;' Cox says. "It actually took less than two years. The unit has proved to be one of the chain's best-performing locations ever."

Although proud that his original judgment about the location had been correct, Cox had to sell the store back to the chain in 1989. He did make a small profit on the transaction. "I'm sorry I no longer own the store, though. I'm discussing opening another unit for the chain. But this time, I'll demand to keep my equity stake as long as I want to."

David Cox is part of a nationwide trend, which some experts believe will become more and more visible and important in the decade of the 1990s. Impressed by their tenants' prospects for growth-and realizing that such growth will benefit them-an increasing number of property owners and developers are choosing to take a double stake in tenant companies by buying into these businesses. Some are acquiring equity through direct cash investments. Others are forging creative arrangements, foregoing or reducing short-term rents in exchange for long-term pieces of the action.

Income in a real estate slump

One expert who thinks that such arrangements will absolutely boom" in the coming decade is M.I.T. professor and real estate consultant Dr. David Birch, who is president of Cognetics Inc., in Cambridge, Massachusetts.

Why does Birch think that many property owners will choose to invest in their tenants' businesses? "In order to make more money," he replies bluntly. "Real estate is stagnant and producing small returns in numerous markets," he explains. At the same time, the small-business sector is exploding.'

Cognetics maintains an extensive database of small and medium-sized American businesses. "More than 700,000 companies have been growing at a rate of 20 percent or better annually over the past five years;' reports Birch. "To maintain this growth, many of them will choose to seek outside capital, providing opportunities for savvy investors'"

And who better to provide that financial lifeblood than property owners? "It's a matter of knowledge perfectly jibing with need;' believes Birch. Few can know a tenant company more intimately than its landlord, who will already have carefully kept track of its finances, its requirements for space, its employees, and its general prospects'

Garnering direct stakes in tenant businesses also may help owners diversify their portfolios and protect their long-term real property investments. For all of these reasons, Birch, who frequently travels around the country making presentations, reports that he has talked to "several dozen' developers and owners who are either already investing in tenant companies or hoping to do so soon.

From retail developer to retailer

That does not surprise prominent Washington-state developer Basil D. Vyzis, president of Vyzis Company, in Bellevue. In retailing, he quips, taking equity in tenant companies "has been going on since the Corinthians and Athenians sailed the Mediterranean." The Greek-born Vyzis is justifiably proud of his heritage. The D" stands for Demetrius;' so he may just possibly be indulging in a bit of hyperbole.

His own company first chose to invest in a tenant enterprise in 198,3, when he acquired a small stake in a women's apparel chain. The following year he made an investment of over $2 million, which bought him between 15 and 20 percent of the shares of a mid-sized regional drug store chain, which operates units in two Vyzis shopping malls. Vyzis not only still ho investment, which he ports is doing quite well;' he also serves as a member of the company's board of directors. "I abstain from any decisions involving leases or rents on my projects, though;, he adds.

Spurred on by such earlier successes Vyzis Company made a multimillion-dollar tenant investment in 1986, when it coacquired 50 percent of an upscale department store chain. One of his partners was the former head of the women's apparel chain he had bought in 1983. The chain was doing poorly and losing money rapidly, but Vyzis and his co-investors managed to improve performance. The company was sold last August at a very good profit;' says Vyzis, and a unit of the department store is still a big-draw anchor tenant in one of Vyzis' shopping centers.

Profit and fun

Not all retail investments need be quite this mammoth, of course. Southern Californian John Phelps, CPM[trade mark] CSM, who is a past president of Orange County IREM Chapter 91, was looking for a suitable restaurant tenant last year for his Fullerton Metro Center, which recently won an award for design from the National Mall Monitor,

I wanted something upscale and fun, which would attract attention;' recalls Phelps, a partner in Anaton Associates of Orange, California. He thought that a new restaurant venture, which capitalizes on the nostalgia craze by mimicking the decor and atmosphere of a 30s diner, would fill the bill admirably.

"I approached the owners;' says Phelps. "But they felt they were too financially stretched and would need some extra help to swing it." For about $200,000, Anaton gained 50 percent ownership in the eatery, which seems to be prospering so far. When asked if he would consider a similar investment again, Phelps jokes that "wearing one of my hats, as a cautious, conservative property manager, I might not be too enthusiastic. But wearing my other hat, as a bold, risk-taking entrepreneur, I'd say full steam ahead!"

Risk mixed with caution

Indeed, most experts believe that enthusiasm must be tempered by caution when owners think of investing in tenant businesses, particularly in the volatile retail sector. "You have to look at each opportunity objectively," says IREM senior instructor and consultant Richard E Muhlebach, CPM, who is president of TRF Management Corporation, in Bellevue, Washington.

"The developer's perspective is different from the merchant's," he warns. A property owner tends to think of a shopping center as a universe that's proper for 1,000 different uses. The retailer is only focused on whether or not the center's trade area serves a large enough customer base in his or her field of endeavor."

Never, says Muhlebach, should an owner think of investing in a tenant store "just to fill up the space. You will only be successful if the business is promising as a business-if it is a profitable, ongoing enterprise, rather than just a pipe dream."

Averting a disaster

That is the ideal, to be sure. But sometimes, it can make sense to help out a long-time tenant which is faltering or even to sponsor a new tenant, if it can prevent having to swallow a substantial loss on unused space.

Such was the situation that Jim A. Watkins, CPM, president of Capital Properties Inc., in Louisville, Kentucky, faced recently In September 1988, Watkins signed a lease with a well-known regional furniture chain, with 20 or so units in the Kentucky, Tennessee, and Mississippi markets. The firm had previously operated stores in the 5,000square-foot range, but the space it contracted for with Capital was a mammoth 16,000-square-foot property, to be converted into a furniture superstore."

In order to prepare for his new tenant, Watkins sunk more than 150,000 into leasehold improvements. "To make a long story short;' he sighs, "the company took possession of its space on July 4, 1989. On August 1, it filed for bankruptcy." Within weeks, the regional company was sold to a big national outfit, and Watkins was hopeful that he had been given a reprieve: "No such luck. Under bankruptcy rules, the acquiring company can accept or reject leases at its discretion. This firm generally operated in large metropolitan markets and considered Louisville a secondary market. They opted out."

Faced with a 150,000 loss and with no other tenant in sight who wanted such a large space in a depressed local retail market, Watkins decided very reluctantly," he says--to accept an arrangement suggested by a former officer of the bankrupt regional chain. In return for the money it had already spent for leasehold improvements, Capital was granted 49 percent of a new entity formed to operate the superstore, which would be managed by the exofficer. While it was not necessary for Watkins to make any further cash outlay, he was required to co-sign a bank loan for 300,000, needed to stock the new store and meet its initial payroll.

At least we're receiving rent on a three-year lease;' says Watkins. But he emphasizes adamantly that if he had his druthers, he would certainly rather not be a retailing entrepreneur. "You can compare our situation to being the passengers on an airplane when the pilot suffers a sudden heart attack;' says Watkins. "You're not a professional pilot. You've never taken flying lessons. But somehow, you've got to bring that airplane down safely. No matter what, you don't want to crash."

Propping up a faltering tenant

Crisis conditions can force an owner to take an interest in a manufacturing or service company, too. Andrew R. Gallina, president of Gallina Development Corporation, a small industrial and commercial firm in Rochester, New York, was faced with such a situation in the early 1980s.

"There was an extremely old firm in town, founded in 1890, which manufactured metal emblems and cloisonne, mostly for the automobile industry," Gallina relates. "They always had lots of work to do, but they were experiencing severe cash flow problems'

In 1982 Gallina and three developer partners arranged a sale leaseback of the venerable company's building, at the same time increasing its manufacturing space from 100,000 to 300,000 square feet. In short, the firm became his tenant.

For awhile, things looked brighter. But by the third year of their occupancy, the company was in trouble again, Their banks were shutting them off, and suppliers were sending materials on a C.O.D. basis. Ironically, the firm had landed a couple of big new contracts, but it did not have the necessary working capital to fulfill them

Again with his partners, Gallina agreed to purchase a bit under 10 percent of the struggling company's shares, in exchange for $30,000 or so of desperately needed cash. Under continued severe pressure from suppliers, the emblem maker eventually had to seek protection under Chapter 11. But it is now reorganized, stronger, and getting back on its feet, reports Gallina.

"We're optimistic that we'll someday make a profit on the deal;' he ventures gamely. "In the meantime, we've been collecting substantial rent for almost eight years'"

Gallina felt satisfied enough with this first investment, in fact, that he made a new one recently-this time in a service business. Just a few weeks ago, he agreed to buy a 20 percent share in a small, two-year-old commercial tenant, a distributor of advertising specialties like tee-shirts and visors. Again, the investment was prompted by business problems, although this time of a minor nature.

"They were slightly overextended and slightly behind in their rent;' explains Gallina. "On the other hand, they have a solid long-term contract with a big-name national retailer. I read through that contract and also examined their books very thoroughly."

In return for his share of the business, Gallina has co-signed a bank line of credit for the company and reduced their rent. "Neither this situation nor my previous manufacturing investment could be called particularly exciting," Gallina laughs. "But at least I've tried to do something a bit creative." Seizing the brass ring While adversity may prompt some investments, at other times a property owner may be faced with a deal that is just too good not to take a flier on. Jon Walker, CPM, president of Walker Asset Management Corporation, in Colorado Springs, Colorado, and the immediate past president of Southern Colorado IREM Chapter 53, was lucky enough to face just such a situation very recently,

Since the merger several years ago of the city's two daily papers, Colorado Springs has been a one-newspaper town, aside from a handful of neighborhood "shopper" journals. just a few months ago, however, a new weekly paper, with an issues-oriented, long-article format, was launched.

"The publisher approached me before the first issue was printed;' recounts Walker. "Because of the number of buildings we own or manage, as well as our participation in residential real estate, our company is a major local advertiser. We're also fairly prominent citizens in town. I think that's why I was approached initially."

Walker and the publisher hit it off famously, and soon they were discussing other kinds of collaboration. The new paper needed an office, and Walker convinced the publisher that the downtown building in which he has his own office, built 17 years ago by his father James R. Walker, would be an excellent location.

"Since the fellow is just starting out, and the Colorado Springs office market is badly overbuilt and basically stagnant, I offered him a very good rent to begin with, about $7 a square foot," Walker relates. "But we got to bargaining and came up with the idea that If I would knock off another 5,000 from the first year's rent, he'd give me a piece of his paper, plus some preferential rates on advertising."

Few building owners, we believe, would turn down a deal with so little downside risk and so much upside potential. Walker is now a proud owner of a one-tenth share of the fledgling paper-and he has a new tenant as well.

Although his financial exposure is tiny, Walker has offered other kinds of help as a landlord-investor. He has let the newspaper use meeting rooms in his office for solicitation meetings to attract new investors. He has also talked up the venture around town. And because of his firm's local prominence, his advertising in the journal should attract other advertisers.

Indeed, several investor-owners we talked with say they give extra help of various kinds to tenant businesses in which they have a stake. "It's almost inevitable;' says Andrew Gallina, who acts as his own property manager. "You might help out with maintenance problems or make sure the space is especially well maintained.'

John Phelps reports that the managers of the eatery his company partially owns are very knowledgeable in the restaurant business, so we haven't had to assist them with suppliers, introductions, or anything like that.' But John!s brother and partner, Jim Phelps, has helped the business organize their accounting systems better and get their books in order. Caught in the middle In those cases where the owner-investor does not manage tenant premises, but rather relies on an independent property manager, the situation gets a bit more complicated, with some potential for conflict.

Mississippi developer David Cox gives all kinds of personal help and advice to the restaurant tenant in which he has a share. But the independent property manager in charge of the restaurant's shopping center, Clarence Evans, Jr., CPM, who is vice president of H.C. Bailey Management Company, in Jackson, is careful to treat the eatery just like any other tenant.

"I can't show favoritism to one tenant because the others would be bound to notice and resent it;' says Evans. "Of course," he adds modestly, "I like to think that I am helpful to all of the tenants I deal with."

Property manager Audrey Williams, CPM, CSM, vice president of D.W.A. Smith & Company, in Newport Beach, manages space for owners and developers in Southern California. She also tries to treat every tenant the same, regardless of whether the owner involved has equity in the business or not.

In one recent incident, a retail tenant which was partially owned by the developer of its mall lobbied hard for permission to install coin-operated newspaper racks in front of its premises. Williams stood firm and refused. "It's the policy of the mall not to allow that, and I couldn't make an exception for this one business."

Consultant David Birch acknowledges that it may be difficult for some independent property managers to gauge exactly how to attract tenant businesses in which building owner/ clients have invested.

"One can visualize a situation in which the property manager wishes to maintain a neutral, arlds-length relationship, while the investor-owner expects partially owned tenants to receive special help or favors;' admits Birch. "In a worst-case scenario, the property manager might want to get rid of the tenant-because they were behind in their rent, for example. The investor-owner might step in and forbid it. You could end up with a real clash."

To prevent this kind of situation, Birch suggests that the property manager could become a party to the deal." The manager might be given some tenant equity of his or her own or receive some sort of special compensation for managing the partly owned tenant. Know their business first The possibility of conflicts with independent property managers is just one reason that potential owner-investors should be cautious. Audrey Williams is skeptical about owners' chances for success if they invest in tenant businesses far from their areas of expertise. "I've seen too many people fail badly," she says. "They have plunged into investments without adequate understanding or sufficient background in the tenant's field of endeavor."

Bernard Van Til, CPM, a past president of West Michigan IREM Chapter 62, has heard other arguments against investing in tenant companies. "The financial basics of certain businesses, particularly in manufacturing, may be difficult for real property owners to understand or to evaluate properly," asserts Van Til, who is the commercial leasing manager for the Network Property Group in Grand Rapids. "These companies may use different procedures for valuation and for determining the cash flow'"

The shifting compositions of some large legal firms-with new partners or affiliates joining or leaving fairly frequently-may also I a problem. "I know of sever owners who turned down good deals for this very reason;' Van' reports. "They say things like, What if I were to take in an associate? Would I have to cut him in on my tenant investments? How could we structure that year's profit into the investment? And what is today's value of the ownership interest?' They're basically afraid that taking equity in tenant companies will make their own businesses too complicated and create unnecessary internal hassles."

That doesn't mean Van Til is against tenant investments himself. On the contrary, he very much regrets one particular investment that his company chose not to make, despite his urging. "In 1983, we discussed the opportunity to gain a stake in a tiny, struggling tenant, a service company which was just starting out;' he recalls. "They were having their problems, and I think we could have picked up a sizable chunk of equity in exchange for waiving the rent for awhile Van Til's bosses vetoed the deal. "I had to use a great deal of persuasion just to convince them to keep the company as a tenant;' he reports.

But his hunch about the company's promise turned out to be right on the mark. Today, the tenant has income of over $3 million a month in gross revenues. "If only we could turn back the clock;' Van Til says ruefully.

Chance for a big payoff

The chance of hitting some financial home runs-even if most investments turn out to be far less lucrative-has inspired some property owners to invest in tenant businesses consistently. One regular investor with an excellent track record is Rochester, New York, owner and property manager Elliott Landsman, CPM, president of both Landsman Development Corporation and its wholly owned subsidiary Mayzon Management Company.

Landsman, who controls over 3 million square feet of industrial and commercial space alone or with various partners, is one of the largest building owners in Monroe County, so he has the financial clout to pursue investments which appeal to him. Beyond that, though, he says that backing tenant companies financially is not unusual for me. It's something that I believe in very strongly."

Landsman has invested in 10 tenant businesses over the past 15 years. If the firm involved looks like it has a promising future, but is merely a marginal tenant today, he believes that his taking an equity stake can really encourage them and give them an incentive to do better. It demonstrates that I feel they have promise, that they're on the right track, and that we're fellow entrepreneurs who are in this thing together."

All of Landsmar's investments to date have been in manufacturing businesses, several of them high-technology firms. While not all of his fliers have been successful, he has reaped big rewards from some, both as an investor and as a landlord.

For instance, in 1985, he backed a laser technology firm, virtually a startup, with $200,000 in venture capital. Originally this tenant leased less than 10,000 square feet of R&D and manufacturing space. Five years later, it has expanded enough to occupy 35,000 square feet of space. "It looks pretty good as a pure investment, too," says Landsman.

In another case, Landsman put up about $300,000 for a minority interest in a firm which produces subassemblies for business copier manufacturers. "They became a tenant at the time of the deal, which was fairly creative," he explains. Landsman, investment consisted only partially of money spent for company stock. Subordinated debentures, leased equipment, and leasehold improvements comprised the rest. The copier subcontractor is now one of his major, long-term industrial tenants, with over 70,000 square feet of occupied space.

At one time, Landsman accepted seats on the boards of his tenant investments. He has recently stopped doing this, on the advice of his attorneys, who are wary of conflicts of interest. But he is still willing to help these companies in any way he can. "I view my role as that of a friend of the corporation; " he says. "I'm glad to help them make contacts, to inform them of supplier or vendor opportunities, or to give them advice if asked."

An investment relationship between property owner and tenant can become "highly synergistic," Landsman asserts. "It's often a case of two and two equaling five;' he says. "The tenant is strengthened by your support. And you are strengthened by the tenant's subsequent growth."

Moreover, Landsman believes that backing promising small and medium-sized businesses is a near essential duty for property owners with clout-and a big stake-in their communities. We're as committed as we can be to the Rochester area;' he says. "We're committed to its growth, to its success, and to its general prosperity.

"Part of that commitment is sponsoring young companies with bright hopes and bright prospects;' continues Landsman. As these businesses flourish, so will the community flourish. And-not so incidentally-so will we."
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Author:Brandt, Ellen
Publication:Journal of Property Management
Date:Sep 1, 1990
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