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Why banks overpay for real estate

Oct 6, 2015 / Consumer Banking

Banks frequently overpay by 15% to 20% or more on average for real estate compared to other retailers for comparable space. Over 10 or 20 years we’re talking a lot of money! For a bank that leases seven locations of its ten-branch network, with annual rents averaging $100,000 (triple net) while the market average is $85,000, over a ten-year period that translates into $1,207,500 (factoring in rent escalations). For this price, the bank could have built a new branch.

Landlords and developers have the mindset that they can charge banks more than other tenants. It is not uncommon for developers to have one rent schedule for retailers and a much higher schedule for banks. Why is this? Because they have been doing it for years and everyone has come to expect it. Bankers have put up very little, if any, resistance, primarily because they are not aware of market values or what other retailers pay. In addition, bankers typically fail to negotiate for free rent and “TI” (tenant improvement dollars), which most chain retailers ask for and usually receive.

Banks should not be paying higher rents because their credit is good, they are a “clean use” (meaning they do not generate much trash), nor do they attract a nuisance clientele. In addition, unlike some retailers such as restaurants and health clubs, banks do not require many parking spaces. Their faster turnover even contributes more parking spaces for customers of other tenants. Banks also tend to be closed in the evenings, weekends and holidays when most restaurants and retailers have higher customer traffic requiring even more parking. Lastly, because space leased to banks does not turn over nearly as frequently as other uses, landlords can avoid having to pay leasing and legal fees every five or ten years, do not lose income between tenancies, and do not incur expenses such as demolition and “TI” contributions, which is typical whenever there is a change in tenancy.

Given these considerations, bankers definitely have room to maneuver when seeking new space.  Here are some common real estate mistakes that can be avoided when planning for branch expansion:

Last-minute lease renewals. Most leases have a six- to 12-month lease renewal notice requirement. Failure to anticipate lease renewals and plan sufficiently in advance reduces a financial institution’s options. The lead time to open a new branch is typically more than 12 months, even longer. At minimum, two years prior to lease maturity, bankers should complete a comprehensive branch performance and trade area analysis in order to guide their decision to either renew or relocate.

Why a trade-area analysis? Simple! Shifts in market dynamics, infrastructure changes, daytime population shifts and increased competition have a direct impact on a branch’s loan and deposit performance. Better to understand the potential impact early in the process and leave sufficient time to change direction than to be forced to stay locked into an unprofitable branch for another several years.

Not treating properties as a portfolio. Trade areas and even communities can change and sometimes even deteriorate over a period of time. Given the cost of opening a new facility, a poorly performing branch, due to poor location and site constraints, can have a huge negative impact on the bottom line. Banks need not lock themselves into a property if their leases provide sufficient flexibility.

Customer pressure. “Do I have a property for you!” Sound familiar? The failure of bank management to utilize objective criteria in evaluating properties that are presented by good customers oftentimes puts management in an awkward position and is likely to send them down a wrong path. By allowing themselves to be boxed into a corner, bankers run the risk of losing a good customer’s business.

Insufficient research. Key to opening a successful branch is having a sound strategy. Understanding what will drive the success of a branch is critical. Is traffic retail-oriented or business-oriented? What are the target demographics? If retail-oriented, where are the primary outlets that generate the most traffic located in the trade area? What are consumers’ travel patterns? Understanding these and other factors will help to narrow the geographic search and reduce risk.

Poor site selection. Retail branch properties should have site characteristics comparable to those of the strongest retailers, such as McDonalds, Dunkin Donuts or CVS. The same property factors critical to those retailers – visibility, access, parking, signage, traffic patterns and retail synergy – are equally important to banks. In evaluating a location, consideration should be for both immediate and long-term success. If a customer cannot make a left turn in and out of a property, move on to another site.

Not understanding site value. Restaurants and other retailers know what they can pay for rent (or purchase) based on a percentage of sales; they do sales projections and then back into a rent number. Also, rents should not exceed what comparable space leases/sells for. Using a financial pro forma that factors in market conditions and facility costs as a percentage of a branch’s projected net interest income will take the emotion out of a “go vs. no go” decision. Given the cost of building, equipping, furnishing, branding and staffing a retail bank branch, there can be little room for error.

Unnecessarily disclosing the bank’s identity. In most situations, there is no need to let the market know that your bank is looking to expand. Once a site has been identified, establish the price and terms first before letting the owner know that a bank is the interested party.

Negotiating the deal, poorly. Real estate developers make their living understanding real estate transactions and market conditions and pride themselves on being shrewd negotiators. Bank management knows banking but often not retail real estate. It’s not a fair fight. So, level the playing field by retaining a professional who can get you the best deal possible.

Not getting professional advice. Most banks and other financial institutions are comfortable bringing in outside legal counsel and professional auditors for specialized financial transactions. However, for some reason there are bankers that believe they are sufficiently qualified to handle commercial real estate transactions. Wrong! This approach not only drives up acquisition costs, it can also extend the time it takes to actually open a branch, thus reducing profitability because of lost opportunities. In addition, the bank runs the risk of having its deal “shopped” and being “aced-out” by another tenant, and even worse, a competitor.

Own vs. lease. If a bank has the opportunity to purchase, more times than not, it should. However, leasing is not a bad alternative if there is a superior site in a desirable community that offers the greatest likelihood for success and is only available by lease. The argument that a bank wanting to control its destiny can only do so with a purchase is totally misguided. Depending on how a lease is negotiated, a bank can have as much or even more control of its destiny.

Failure to provide an exit strategy. Every business needs to have an exit strategy, today more than ever, primarily because of technology’s impact on how and where consumers make their purchases and also do their banking. Since crystal balls are hard to come by, the next best thing is for banks to hedge their bets by having as much flexibility as possible. Excellent real estate will always be in demand, whether it be another financial institution or another commercial user of space. Therefore, the location, the site, the layout as well as the building’s design, should factor into its utility and applicability and marketability in the event the bank vacates the premises.

While real estate is not a financial institution’s core business, by default banks are, in fact, in the real estate business whether they own or lease their facilities. Any business that requires bricks and mortar is in the real estate business and, when it overpays, takes a direct hit to the bottom line. Expanding one’s up-front due-diligence will help to ensure that your bank selects the right market, the most strategic location and a site where your institution will enjoy both immediate and long-term success.

Mr. Pilla is principal and founding member of Quincy, Mass.-based Paramount Partners, LLC. He can be reached at [email protected].