Summary:

Income derived from many commercial properties depends on occupancy by operating businesses.  Some may be tenants; others may be property owners who own a company operating on the property.  The operation of these businesses requires lengthy governmental approvals, occupancy permits, conditional use permits, and, in some cases, individual professional licenses before they can open.   Any permits, licenses, and approvals must be renewed annually, accompanied by the payment of the required fees.

Article:

The Impact of government regulations on commercial properties is significant.  Federal, state, and local government employees, mostly labor union members, are involved—the U.S. devotes a substantial portion of its gross domestic product and public expenditures to public-sector employees.  When the state collects more taxes, those resources primarily expand the state’s size.  The expansion of government continues.  Some argue that this growth is necessary for public welfare.  In contrast, others view it as government overreach. This debate is ongoing, with the implications of and regulations on America’s business economic engine and corresponding efficiencies being complex and multifaceted.

Government permissions and licensing are necessary for generating stabilized income and maintaining high occupancy levels in commercial properties.  While serving a regulatory purpose, these requirements also have significant financial and operational implications.  Seeking permission for all actions can be seen as a necessary step to ensure compliance with the law.  Still, it replaces free will, personal property rights, and the rule of Law with a more regulated and controlled environment.

Pushback against prohibitive permissions, such as strict zoning ordinances or high licensing fees, or adverse consequences, like environmental violations or safety hazards, can lead to more rules and regulations.  These additional regulations often require more public employees to enforce them, further complicating the regulatory landscape.  The process of seeking and maintaining these permissions can be exhaustive and punitive, extending the vacancy period and transferring wealth from the private to the public sectors through taxation (fees).

During periods of vacancy, property owners and lenders are burdened with ongoing expenses, including monthly debt service payments, property taxes, insurance, utilities, maintenance, upkeep, capital improvements, and marketing costs.  These financial burdens underscore the importance of maintaining high occupancy levels, emphasizing the financial risk involved in commercial property management.

The income stream from a property is a crucial factor in real estate purchasers’ and lenders’ lending decisions.  Vacancies of any duration can significantly Impact this income stream, underscoring the financial risk associated with commercial property management.  Government regulations, such as zoning ordinances and conditional use permits, can delay the occupancy of a property, thereby affecting the income stream.  This underscores the importance of understanding and navigating these regulations to maintain economic stability and make informed business decisions.

Properties likely to experience extended vacancies:

• Congregate care
• Hospitals
• Hotels/motels
• Restaurants
• Veterinary clinics
• Animal hospitals
• Daycare centers
• Private schools
• Liquor stores
• Gas stations
• Car washes

Understanding the lender’s underwriting considerations is not only important, but vital.  This knowledge empowers you to make informed decisions confidently and navigate the complexities of commercial property regulations with a sense of control and assurance.

When a multi-tenant commercial property unit becomes vacant, finding a new tenant with a long-term lease can test patience and preparedness.  The capital required and regulatory approvals can lead to potential delays that could extend for months or even years.  Knowing this can help you plan and manage your expectations, fostering a sense of preparedness.

Even after finding a new tenant, regulatory approvals may delay business openings and the realization of rental income.  Additional capital costs related to the regulations could further reduce profits; therefore, factoring these potential expenses into your financial planning is necessary for maintaining economic stability and making informed business decisions.

Defining terms:

• Land use and zoning ordinances:
• Zoning ordinances are written regulations and laws that define how properties in specific geographic zones can be used.  They specify whether the properties can be used for residential, multi-tenant, industrial, or commercial purposes.  They may also regulate building and lot size, physical placement, bulk (or density), parking requirements, and the height of structures.
• Zoning ordinances are lengthy documents that describe the acceptable uses for specified areas of land and outline the procedures for handling infractions (including any penalties), granting variances, and hearing appeals. They apply to all property uses.  Most interactions with municipalities require payment of fees.
• Variances from current zoning standards:

Zoning variances, a common aspect of commercial property regulations, are intended to provide equitable relief or deviation from existing requirements.  The property owner or representative must demonstrate that the variance would not conflict with the public interest and that undue hardship or loss of financial return would occur should the variance not be granted.  Building code variances may include exceptions to height restrictions, setbacks, moving demising walls, and noise attenuation, providing flexibility within the regulatory framework.

City-issued variances from zoning ordinances run with the land, not the applicant, and may be passed on to future property owners.  However, they may also be revoked for many reasons.  Please don’t feel like a city council Member, city planner, inspector, or a friend of the bureaucracy (FOB).

Conditional use permits:

A conditional use permit is issued at the local level.  It is a permit, with conditions set by the municipality, that allows some deviation from current standards.  An applicant for a license must submit a set of plans and a statement of purpose to the proper municipal authority.  Once granted by the municipality, the conditional use permit is typically non-transferable and subject to revocation by the city.  Conditional use permits do not run with the land but are temporary approvals that can be terminated.

The process always requires the municipality to pay various fees.  Relying on a conditional use permit is a significant factor in a credit decision or value conclusion and could substantially reduce the property value should the permit be revoked.

State licensing of the business operator:

Some properties, such as a senior care facility in an R-1 single-family zoned neighborhood, may require a state license for the operator and a conditional use permit by the municipality to operate the facility.  State licensing may require operators to undergo special training and testing to demonstrate competency.  The purpose is partly to ensure that the operator is qualified.  The process also results in governmental entities collecting fees, holding power, and issuing monopoly directives.

Suppose the property is sold or a lender is underwriting it to make a loan.  There will be concerns about property conformity, permitting, state licensing of the operator, and the Impact on the value of a going concern.  ‘Going concern’ refers to a property currently operating and generating income.  The value of a going concern is often higher than that of a property that is not yet operational.  Can the growing business generate sufficient revenue to cover expenses and make debt payments?  The common practice is to use an income approach, comparing lease rates of similar properties.

Underwriting may be problematic when performing a capitalization rate analysis if the property types differ significantly, even though the going concern business is the same.  An example of an underwriting deviation would be comparing a congregate care business, one that operates out of a single-family home, with one that operates out of a building zoned for commercial use and designed for that purpose.  Both are licensed and meet all the regulatory requirements.  Still, only the commercially zoned property can be valued using a capitalization rate analysis based on market rents and expenses to determine its net operating income.  The single-family home has only alternative uses as an owner-occupied or rental home.

Most practitioners are required to obtain an individual state license to practice in their chosen field.  Licensing is nothing more than a tax imposed by state governments, which use force as a mandate to enforce their monopoly.  Government agencies are motivated by different efficiencies than private enterprises.

State licensing usually runs with the business operator and will terminate when the title of the property changes.

Zoning, Variances, Licensing, Use Permits, and Conditional Use Permits:

Interpreting land use and zoning, variances, conditional use permits, and municipal and state licensing for business operators can become a complex maze.  For those trying to start a business, the process becomes one of time, frustration, and navigating the bureaucratic governmental maze with continuous fees to sustain it.

Government agencies require different and sometimes redundant fees for lawfully running a business.  They consider allowing the public the temporary privilege or license to operate rather than the natura,l lawful right to use, as would otherwise occur in a free countr.  The process is about control, redundant fees, or taxation.

Lawful, only is subject to agreeing to pay the fees that government agencies demand.  Breakdowns of these approvals may rear their ugly heads for the lender on two occasions.  During processing and underwriting, one is on the frontline to ensure the business operates legally.  Multiple challenges can arise after a default occurs, and the lender takes the property through a successful trustee sale.  At that point, the property becomes lender-owned, and various difficulties can arise.

Many businesses, such as restaurants, senior care facilities, medical care providers, daycares, gas stations, and laboratories, require a complex overlay of land-use regulations to ensure that individual licensing and business operation licensing functions are successful.  Many businesses and operators of these companies must seek approval from 20 or more separate government approval processes before opening.  Each level of the government bureaucracy has its own application and waiting period, dealing with a bureaucrat who rarely prioritizes time and efficiency, and demands fees for the temporary privilege.  The result is usually a bureaucratic quagmire as a prerequisite to owning and operating a potentially profitable enterprise.

Herein lies a problem for the real estate lender: they must understand all the regulations and licensing approvals required by the business occupant.  Which authorizations and permits run with the land, meaning they still exist after the transfer of ownership, and which will terminate upon the property transfer?  These barriers must be understood to close a loan successfully.  In the unfortunate circumstance of a Borrower default and a subsequent successful foreclosure, can the lender be confident that the protective equity remains intact and cannot be compromised by the loss of previously obtained approvals?

Example:

Restaurant start-up: A partial list of approvals, licenses, and annual inspections is required.

Opening a restaurant business is challenging and requires getting started, breaking even, and maintaining a profit over time.  The breakdown may average 40% in infrastructure costs, including labor, 20% in food and liquor costs, and a 40% gross profit markup.

Developing a business plan and marketing strategy, creating a food and drink menu, ensuring consistent quality, adhering to continuous regulations, hiring and retaining employees, addressing internal theft, and managing liability all put pressure on the operator.

Food markups and related costs vary significantly in privately owned and chain restaurants.  If a coffee lover buys a 20-ounce cup daily from a cult-like national chain, they will spend $700 to $1,100 per year ($3 X 365 = $1,095), plus the wait and, in many cases, the wasted gas while idling in line for the coveted prize   The same cup brewed at home by the consumer macost $ 0.15 to $0.20ts or $75 per year.

Due to the stress, many restaurants have introduced additional charges and reduced portions.  Liquor has a markup of 200 to 575p.  When drink portions go down, you may now trade in your old martini for an iced down (martini) and a glass of wine for a glass, but pay for a full glass.  Paying a corkage fee for your premium wine becomes preferable.  A short-poured martini (1.5 oz) with tax and tip could cost $20 to $25.  At home, assuming a 1/2 gallon of Ketel One costs $30 and has 64 ounces, 2.5 oz of vodka, dry vermouth, and two green olives may cost less than $2—the $10 draft beer includes sales tax and pouring.  The same beer may be purchased and consumed at home for $1.50 to $2.00.

Failure rates range from American Express’s estimate that 90% of start-up restaurants will close within the first year.  The National Restaurant Association estimates a failure rate of 30% in the first three years.  Requirements imposed by labor unions, such as the Service Employees International Union (SEIU), add to the pressure and increase the failure rate.

Getting started can cost anywhere from $250,000 to $2,000,000 or higher, depending on the inclusion of fancy tenant improvements (TIs), furniture, fixtures, and equipment (FF&E), as well as start-up expenses.   There are many sources of estimates.

Consultants are necessary to chart the approvals flow and expedite it when possible.

Fictitious Business Name, Doing Business As

The Statement will be filed with the County Clerk-Recorder Fictitious Business Filing Division.

Municipal Business License-

This license is required for all entities within city limits or unincorporated areas of the county. For a restaurant, fees may be up to $7,000.

Obtain a business license from the local government.  Pay a fee.

Obtain a business license from the county government and pay the required fee.

https://www.uschamber.com/co/start/startup/business-licenses-and-permit-guide

The California Department of Tax and Fee Administration administers various taxes under the U.S. Small Business Administration (SBA) to determine the state and city-specific rules for obtaining a business license.

Franchise State Tax Board:

State income tax registration requires filing appropriate forms to notify the state of incoming tax receipts.  File with the State Franchise Tax Board within 40 days of starting the business.

https://www.ca.gov/agency/?item=Franchise-Tax-Board

Federal Employer Identification Number (EIN) filed with the IRS.

Employers, business partnerships, and corporations with employees are also required to obtain an EIN.  An EIN is similar to an individual’s Social Security number.  The EIN must open a bank account, apply for a business license, and file a business tax return.

• https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online
• Air Quality Management permit to operate- inspect and permit process for installation according to new emissions standards:

https://www.aqmd.gov/home/permits/permit-application-forms

Building permits, plans for new buildings, renovations, and tenant improvements must be submitted to a long and arduous approval process in advance to obtain a building permit.   Multiple fees are charged.

Every phase of building construction and tenant improvements requires a separate permit process and inspection for every completed component, and multiple fees are charged.

https://ocds.ocpublicworks.com/service-areas/oc-development-services/building-safety/building-grading-information/building-permit

https://ocds.ocpublicworks.com/service-areas/oc-development-services/planning-development/applications-and-forms

Wastewater Discharge Permit Connection: The sewer system must exist or be established, and high volumes or unusual wastewater content require a permit, accompanied by a corresponding fee.

https://www.epa.gov/npdes/npdes-permit-basics

https://www.waterboards.ca.gov/water_issues/programs/waste_discharge_requirements/

Dumpster Placement Permit: This is required to place dumpsters outside the kitchen area.

https://www.dumpsters.com/resources/dumpster-permits

https://ocds.ocpublicworks.com/service-areas/oc-development-services/permitting-services

Fire Prevention Permit: Each jurisdiction has a separate governing body.  Orange County, California, has the Orange County Fire Authority.

Fire Prevention and Code Enforcement

Fire inspectors who work under the supervision of the fire marshal are authorized to enforce specific codes.

Facility fire inspection- annual inspection

Fire extinguishers-annual inspection

Fire alarm permit- yearly inspection.

The fire sprinkler system permit is for annual inspection and testing.

https://ocfa.org/AboutUs/Departments/CommunityRiskReductionDirectory/PreventionFieldServices.aspx

https://ocfa.org/AboutUs/Departments/CommunityRiskReductionDirectory/PlanningAndDevelopment.aspx

Certificate of Occupancy - After the commercial space has been constructed, a final building inspection is conducted to obtain the coveted Certificate of Occupancy.  You may pass after several inspections, including plumbing, electrical, fire safety, and building inspections.

Food Service License

An operator can expect regular health department inspections once this permit is obtained.

Please review the U.S. Food and Drug Administration’s food vendor application and your state’s requirements.

https://www.cdph.ca.gov/Programs/CEH/DFDCS/Pages/CertificatesandLicenses.aspx

https://www.calrest.org/food-safety/california-food-handler-card

Food Handler’s permit

Referred to as an Employee Health Permit

The permit ensures that the facility meets regulations for food sanitation, storage, protection, and preparation.

ServSafe is an online source for learning about the requirements.

https://pos.toasttab.com/blog/on-the-line/food-licenses-and-permits-in-california

Building Health Permit Businesses preparing and selling food must have approved building plans and equipment, and pass a facility inspection before commencing business with the Environmental Health Division, Food Program Division.

Federal Bureau of Alcohol, Tobacco, and Firearms and County Liquor License Level II: Any person or entity seeking to sell alcoholic beverages must be licensed.

Each state has its own Alcohol Beverage Control Board (ABC)

On-premises license, off-premises, all-liquor license, or beer and wine only.

You can apply for the license in person, and it will be processed in 45-60 days at a minimum.  However, the Law precludes issuance in less than 30 days.

Alcoholic Beverage Tax- entities selling, manufacturing, importing, or distributing alcoholic beverages must register to collect taxes.

A resale permit that allows your restaurant to make certain nontaxable purchases of food products.

https://www.cdtfa.ca.gov/formspubs/cdtfa230.pdf

https://www.taxes.ca.gov/Sales_and_Use_Tax/Forms.html

Weights and Measures - Businesses using scales, fuel pumps, electronic or manual price lookup scanner devices, or other measuring devices must ensure proper calibration and pass inspections with the Public Facilities and Resources Department, as directed by the Commissioner of Agriculture.

• https://www.cdfa.ca.gov/dms/
• https://www.cdfa.ca.gov/exec/county/Exam_Weights_Measures_Inspector.html

Signage permit:

Traffic Study:

Live entertainment and music license:

Noise attenuation:

Valet Parking Permit:

Pool Table License:

Food truck permit, if applicable:

Workers’ compensation files with the Department of Industrial Relations.  Businesses with employees are required to maintain workers’ compensation insurance, typically through the State Workers Compensation Insurance Fund or a private insurance carrier.

Why is this imperative? Commercial properties containing operating businesses can be an excellent long-term investment strategy.  However, the lenders’ level of sophistication requires a much higher understanding of the lengthy process.