On Leasing to Unconventional Tenants

SAN DIEGO—Unconventional industrial tenants are a boon for landlords with difficult-to-lease buildings. As commercial real estate vacancy in San Diego County—as well as many other markets—continues to decrease, Lee & Associates' Peter Merz and Daniel Knoke tell GlobeSt.com they are seeing a surge in industrial leases form anomalous tenants whose uses deviate from the industrial industry's conventional warehouse, manufacturing and distribution tenants. These include church and worship centers, active-lifestyle and recreational facilities, charter schools and event venues. We spoke exclusively with Merz and Knoke about what landlords should know when negotiating with these tenants and dealing with the conditional-use permits they must obtain to comply with zoning codes.

GlobeSt.com: What is the cause of unconventional tenants flocking toward industrial space?

Merz and Knoke: The progression of these tenants toward industrial space is mainly caused by the rise in rates across all commercial real estate sectors. As rates continue to climb, these users are finding affordable opportunities in industrial properties, and because they are able to pay higher rents, these tenants are driving rental rates upward, displacing standard manufacturers and warehouse tenants.

GlobeSt.com: What type of space should landlords try to lease to these tenants?

Merz and Knoke: Landlords with unique, difficult-to-lease buildings can find benefits in pursuing these tenants. Because of zoning codes, these progressive occupants are required to obtain a conditional-use permit or special-use permit to occupy traditional industrial spaces. With the difficulty these tenants are facing in finding space, we are seeing a trend in buildings with functional obsolescence getting leased and tenants willing to pay higher rental rates. If done correctly, it can be a win-win scenario for both the landlord and the tenant. Conversely, if it is not handled carefully, landlords can be in for a long and unpleasant journey without an end in sight.

GlobeSt.com: What are some practical steps landlords can use to evaluate whether a leasing proposal from one of these unconventional tenants makes sense?

Merz and Knoke: When it comes to leasing to these tenants, it's best to be prepared. My father taught me early in life to learn as little by experience as possible. Hopefully, the following tips from our experience will help save landlords some expensively learned lessons.

1. Hire a qualified broker. Anexperienced broker understands how the process works, can see the potential pitfalls and write a lease that protects your interests.
2. Thoroughly review tenants' financial information. Some of these tenants are franchisees that have undergone a rigorous vetting process and have a corporate headquarters that will take over the lease if the franchisee gets into trouble. Many, however, are start-ups with little experience and lack of financial resources to get through the first year of building a business. It is better to have a vacant building than a bad tenant.
3. Require that the tenant hire a planning consultant. As a landlord, you can write your lease to require prospective tenants to hire a consultant who specializes in guiding tenants through the CUP process. Many of these consultants have previously worked in the city-planning department, know the process and have the necessary contacts. If the tenant is truly serious, he will spend the money to hire a consultant. If he thinks he is smart enough to handle it himself, then you may want to look for another tenant.
4. Set performance benchmarks. The lease document should spell out benchmarks that the tenant must pass and subsequent termination options for the landlord if he does not meet these milestones. For example, the lease should set deadlines to provide a signed contract between the tenant and planning consultant, the formal submittal of the CUP package to the City, an initial feedback letter from the City and, of course, for the issuance of the CUP. If the tenant doesn't meet a benchmark deadline, you should be able to exercise the option to terminate the lease. Recently, this clause in a lease allowed one of our landlords to terminate an executed lease and move forward with a more-favorable lease with one of his existing tenants. In our experience, this process will take longer and is more involved than you may expect.

5. Know your responsibilities vs. the tenant's responsibilities. We are not attorneys, and therefore we need to emphasize that this is not legal advice. With that noted, however, Paragraph 2 of the AIR standard lease makes it very clear that gaining any governmental approvals is solely the tenant's responsibility. Sometimes the tenant's description of their use will have a huge impact on how the City views it. We recently represented a tenant that grinds plastic parts and resells them for commercial use. The city in which he was located viewed him as a “recycling facility,” which opens Pandora's Box of hoops to jump through to receive approval. Although he was a manufacturer that should easily fit within standard industrial zoning, the difficult path ahead paved by the recycling label made him opt to look for space in another city. Certain words carry powerful meanings. Does the tenants' use really require a CUP if it is described accurately? While this is not your responsibility as a landlord, it certainly simplifies the process for a tenant's business-license application to be written in such a way that matches the wording in the zoning description. Also, a smart tenant will do their homework before they stroll into the city-planning department and start asking questions. If there is any uncertainty, the city bureaucrats will always play it safe and say “no.” They would prefer to “check the box” without the risk of making any judgment calls. Again, this is solely the tenant's responsibility, but it will benefit you to ensure they understand this concept.

GlobeSt.com: What else should our readers know about CUPs and SUPs?

Merz and Knoke: Tenants in need of CUPs or SUPs can be a great fit and provide above-market rents, but it is imperative for landlords to understand the process and its pros and cons to prevent any difficult situations. The next time you visit Fidel's Mexican Restaurant in Solana Beach, CA, take a stroll across the street and look at the tenants in the multi-tenant industrial buildings. Predominantly occupied by ballet/dance studios, fitness gyms and fashion-related tenants, these buildings are great examples of landlords who have taken advantage of this current market trend and understand the benefits of these unconventional tenants.