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As Long as We Remember...

November 29, 2011

Charting Solutions To Charter School Problems

Earl 'Rocky' Mackintosh

There are creative ways in which tenants and charter school start-ups can reduce their annual rental payments by employing innovative financing and longer term leases.


During the past couple of weeks, The MacRo Report has provided an overview of the challenging market for commercial office and warehouse/flex real estate in Frederick County.


It has touched on high vacancy rates, shadow space, and the glut of properties that entered the market just as the real estate recession became evident. Among many other circumstances, all are putting pressure on prices and lease rates.


This economy has put both developers/owners and buyers of commercial real estate in a tough spot. Prices for commercial space are flat and dropping; however, many businesses aren’t in a position to take advantage of these opportunities as they are struggling with the “buyers market.”


Those that could buy aren’t sure the market has bottomed out.


Leasing is the safe bet right now.


Many, if not most, commercial spaces require some type of tenant improvement (TI) in order to customize or modify the space to the needs of a particular business. This can include walls, cubicles, paint, carpeting, doors, rest rooms, and much more.


Landlords typically provide a tenant improvement allowance that pays for some of these necessities. The tenants – or buyers of commercial space – are financially responsible for the remaining costs; when property is leased, these costs are paid up front or amortized over the initial lease term. The terms of the allowance for, and financing of, improvements are covered in the cost of the lease.


In order to mitigate the risk of a tenant default, landlords typically seek some sort of personal guarantee or additional collateral beyond the limited liability of a corporation or LLC.


In recessionary real estate markets, landlords will very often offer reduced rental rates as a concession to attract tenants to their vacant space, but rarely compromise on the guarantees when significant customized tenant improvements are involved.


Take for example a lease transaction that is being facilitated by MacRo, Ltd. for the Frederick Classical Charter School that has sought about 30,000 square feet of space.


The Frederick County Public School system provides operating funds on a per-pupil basis for approved public charter schools, but Maryland state law does not allow public funding to be awarded to charter school groups for securing their facility or capital improvements therein.


Therefore, beyond a state grant of about $500,000 for furniture and equipment, the typical charter school must find a way to manipulate their operating budget so as to “rob” the necessary funds for facility rental and maintenance. These often come from such line items as curriculum and operations. In the case of the Frederick Classical Charter School, the founders are confident that they can scratch together around $350,000 per year (just under $12 per square foot) to pay the base rent and approximately $1.4 million in tenant improvements, which the landlord is willing to amortize over the initial term of the lease.


This is where the length of a lease becomes critical for any tenant who receives landlord funded tenant improvements.


For example, if a landlord were to finance the $1.4 million over a four-year period and include an annual base rental rate for the shell of say $120,000, the combined annual rental rate for the school would exceed $535,000 or nearly $18 per square foot.


Simply put, such a rate is unaffordable for a start-up charter school entity.


If the initial term of the lease was extended to eight years, the amortization of the tenant improvements would spread over the same period, which would allow the annual lease rate to fall to $360,000 in the first year. Put another way, the per-square-foot rent would drop by 33.3% to $12.


A 16-year initial term could reduce the first year's rent by nearly 50% from that of a four-year-initial term. With a first year rent of $273,000 ($9.10 per square foot), Frederick Classical Charter School would have that much more of their operating budget to put toward student education.


The risk for a landlord who is willing to finance the tenant improvements over the initial term of a lease for a public charter school is that it is very unusual to obtain any kind of outside guarantees from the school founders or the Board of Education. On top of that, the school board always retains the right to terminate a charter school's charter at any time with just cause.


Therefore, any landlord willing to provide $1.4 million in customized tenant improvements without guarantees of some sort is taking a significant risk to the point that it becomes philanthropic, as they are aiding a worthy not-for-profit cause.


The challenge for the Frederick County Board of Education is to be willing to take a leap in breaking with their tradition of only granting initial charters of four years to these start ups. Extending the initial charter term will result in a more realistic risk profile for private investors and real estate developers while allowing the school to have an affordable rent.


In the end, since the school board has the ability to terminate a school's charter at any time with just cause, there is no reason that the initial term cannot be set for terms as long as 15 or more years, as is the case in states such as Nevada and Arizona where public school charter programs are flourishing.


Frederick Classical Charter School is the first of the three Frederick County charter schools to find a developer who will provide a customized build-out of the school's needed space.


The only thing standing in the way of moving forward is the willingness of the Board of Education to recognize the dilemma facing the real estate developer, their investors and the start-up public charter school.


Rocky Mackintosh is the owner of a land and commercial real estate firm based in Frederick. He is also the editor of the MacRo Report Blog.


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