Term Paper

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Case 2

In the Zone: Turning Residential Space into Commercial Office Space

OVERVIEW

(Read the following case and 4 Witnesses’ statements)

Mr. Terry Brown had been renting a single office from the Diva Group, which had been

renting a whole floor in an office building and subleasing to him. Unfortunately, the Diva

Group's business was failing, and they were giving up their lease, including Mr. Brown’s

space. He was going to have to find a new office.

Before Mr. Brown started looking for a new office, he wanted to make sure he found the

right space for himself. Although his personal needs were small, Mr. Brown decided to

explore the option of buying a building, making an office for himself, and renting out the

rest of the space to small businesses. He found such a building. It was a house that was

located about a block away from his current office. It had several points in its favor. It

was on a four lane highway, making for easy access. It was close to many public services,

such as a library, restaurants, banks, and other retail outlets. These amenities were not

very meaningful to him, but they were attractive points for possible tenants. The other

major amenity was that it was on a lake. Again, not much value to him but it could be a

drawing point for tenants.

The major obstacle to Mr. Brown's plan was that the property was a home and was in an

area that was zoned as residential. In order to use the property as a commercial business

office, he would have to get the City of Shoretown to change the zoning ordinance. This

issue presented an interesting challenge. Shoretown had already considered and turned

down an application to change the zoning. There had been another property owner who

wished to change this property into a bed-and-breakfast type of business. Because the

area residents wanted the property and their area to stay residential, the zoning ordinance

was not changed.

In reality, Shoretown had really wanted to see the area become a commercial area. The

four-lane highway, once a two-lane road, was expanded two years ago. When this

happened, it left the small neighborhood of eight homes separated from any other homes.

In essence, it had no future as a residential area. The subject house had been for sale for

almost one year, with no offers being made before Mr. Brown took an interest in the

house. It was unlikely that the house would be sold as a residence.

Although the house would not be good for a residence, it could be good for an office

building. The house was in a popular suburb, was twenty minutes away from two large

metropolitan areas, and was near several large corporations. The chalet-style building

was in very good shape, which boded well for its conversion to a commercial building.

And because it currently existed as a residential property, it could be purchased at a good

price. Further, it held the future possibility of being combined with the other lots in the

small neighborhood to make a fair-sized commercial strip.

Another consideration that Mr. Brown had was the adaptability of the home to an office

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building. He would need a contractor to determine the costs of making the space more

attractive as an office building, as well as determining the cost to bring the building up to

code requirements, including handicapped access. Once all of the governmental and

physical issues were resolved, Mr. Brown would have to face his biggest and most

ongoing issue--whether there was any demand for additional office space in this area and

whether this building would meet any of that demand.

WITNESS 1

Roger Kolstad, Real Estate Leasing Agent

Mr. Brown asked me to analyze and assess the rental potential of his property. I did, and I

uncovered some interesting information. How can I help you?

Relevant Facts

Items:

 Comparative and competitive office space in the area

 The appeal (or lack thereof) of converted properties

 The metropolitan economic situation

Relevant Facts:

Mr. Brown contacted me about finding him some renters for his future office building.

He thought that he would be able to get about six small offices out of the building with

potential for using the two garage stalls for some other purpose, either for very small

manufacturing or for a small business like a cabinet shop. My biggest concern was

whether the office would appeal to any commercial business.

The first step I took was to look at other office space in the area and to try to find an

office that had the same appearance. This proved to be rather difficult. While I was able

to find a few mixed-use buildings where individual people were working out of their

homes, I was only able to find two former homes that had been converted to commercial

businesses. In both cases, the business was a dental office. On a positive note, both of the

dental offices were in chalet-style houses, very similar to Mr. Brown's building.

All of the other office space in the area suburbs was standard office space, meaning that

the space was in a building that had been originally planned as an office. This fact could

work for or against Mr. Brown. The uniqueness of his property could be attractive to

some businesses. Alternatively, most people seeking offices have a stereotypical office in

mind, and a converted house is not within that stereotype.

My next step was to review the area around the building to determine its general office

stock and the existing need, if any. I found several area buildings with "For Lease" signs,

but when I called them for available space, there was little available. I was able to find

several spots with 5,000 or more square feet of office space available, but they would not

rent a smaller office. I found only six buildings that would rent space of 5,000 square feet

or less. And I found only one building that would rent a single office. This was

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encouraging because Mr. Brown's building would be made up of single offices and very

little competition existed in this arena. On the other hand, if there were no other single

offices, maybe there was no demand.

My third step was to look at the whole metropolitan area. History had shown this area to

be marginally unaffected by wide swings in the economy. Neither of the surrounding

metropolitan areas was tied to a single business like auto manufacturing or mining. The

major industries were health care, banking, insurance, and education.

From my standpoint, I can see that there will be a growing need for office space as the

metro areas grow. I see a pinch in the small office supply market in the suburban area that

would be serviced by this building; however, I do have concerns with the ability of this

building to satisfy small office space needs. Its novelty may make the difference, either

pro or con.

Irrelevant Facts

Items:

 Building amenities and their role in attracting small businesses

 Location as it pertains to shipping and transportation outlets

 How the property relates to Mr. Brown's standing as a member of the twin metro business community

Irrelevant Facts:

I looked at the building itself and the small neighborhood around it. There were no other

commercial buildings on the block, only small residences. The house was a chalet-style

structure which would lend itself nicely to a conversion. I have seen other chalet-type

buildings used as commercial buildings. The building also allowed the tenants to use the

balance of the property for recreational purposes. The commercial industry is moving

toward a more worker-friendly work environment, and this house offers lakeside appeal.

Tenants can swim or boat or fish at their leisure. And it has a backyard, something that is

rarely found with commercial property. It allows for outdoor activities which could

include family events. All-in-all, it is an attractive property with plenty of amenities.

As for the location, while it's near a highway, it's rather inconvenient in other modes of

transportation. Being in the northern suburbs, it is easily 35 miles from the international

airport. Driving through either metro area during business hours would take a normal

driver an hour to reach the airport. Also, there is no train service that would ever get near

the property. Any manufacturing that would be done on the property would have to be

first trucked off the property, and then taken to a rail hub for transport. This is the same

problem that comes up any time a home is converted to commercial use. Residential

areas are always a significant distance from other commercial properties and businesses,

and thus, away from the normal carrier routes. This building would not be in the center of

commercial traffic lanes.

Finally, Mr. Brown, as owner of this building, would have to consider how the location

relates to his general standing in the general twin metro business community. Where this

office space is located, chances are he wouldn't fit in with owners of larger, higher-

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priced, better-maintained office buildings in the downtown areas. It is unlikely that Mr.

Brown, or any future owner of this building, would be invited to participate in a

downtown property owners association. This type of networking is essential for gauging

major business trends and setting rental fees. There's also a good chance that owners of

the metropolitan buildings are not going to want to hear from, or even respect the opinion

of, an owner of such a small property. This could cause this property to be "out of the

loop" in terms of advance warning of major leasing trends which could cause the rental

space to be leased below market value.

WITNESS 2

Ms. Janet Dean, Chief Lending Officer, Twin Town Bank

I am in charge of the loan for Mr. Brown's potential purchase. Being the chief lending

officer, I like to really dig deep and sink my teeth into each case. So I have plenty of

information, but what do you think would best serve you?

Relevant Facts

Items:

 Mr. Brown's risk factor Tenant stability for this property

 The bank's options if the endeavor fails: re-selling or re-converting to a house

 Single office space supply and demand

Relevant Facts:

On the subjects of lending risk, credit history, and collateral security, this is the

information I have. Mr. Brown is a long term customer of the bank's who has always

handled his affairs in a businesslike manner. Our concern with Mr. Brown, which we

have explained to him, is that he is a business consultant, not a property re-

developer/manager. There are people who do this type of thing as their profession--

people who are experienced and know the ins and outs of the business. It is obviously

risky for Mr. Brown to step outside of his known area of expertise and try to tackle this

type of project.

If Mr. Brown is able to obtain the approval of the city for his actions and then is able to

convert the property to commercial use, we would have continuing concerns about the

type of tenant that he would attract. Small businesses are often fairly unstable. If they do

a good business, they grow and move out. If they fail to grow, they close, sometimes

leaving a rental debt when they leave. This type of volatility is not conducive to good

lending practices. I am convinced that Mr. Brown has the personal financial ability to

maintain the building for a long time but things change. I am not sure that we want to

facilitate the potential demise of a good customer.

The building itself is currently a good risk in terms of securing the bank's loan--assuming

Mr. Brown wanted to purchase this as a residential property. We would be very happy to

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lend Mr. Brown the necessary funds to buy the property as a home, but what happens

when he takes a perfectly good home and changes its use in an untested market? If the

commercial venture fails and based on no fault of his own, we end up with the structure,

we would get back a failed commercial building in a residential area. We would either

have to sell it as commercial property, which may not make us whole on the original

loan, or we would have to convert the building back to residential use at a price.

Working in Mr. Brown's favor is the general office demand in the north metro area.

Single office space has been very hard to find for many of our customers throughout the

metro area. When there is a good demand for a product, like office space, we like to

support those who will satisfy that demand. We know that it will be a risk, but we feel

that the building will find a niche in the northern suburbs, so we are prepared to lend to

Mr. Brown; however, we will still do our best to limit the losses that could occur because

of this loan.

Irrelevant Facts

Items:

 Mr. Brown's risk factor Mr. Brown's clientele and the corresponding cyclical cash flow

 Rental values of area, residential lakeshore property

 The bank's options if the endeavor fails: tearing down the property, selling the lot

Irrelevant Facts:

First, I'd like to say that we have had Mr. Brown’s accounts for some time, and he has

always handled his affairs in a businesslike manner. I have no concerns for his credit.

Most of Mr. Brown's business clients are generally in the produce or food service

industry and supply other businesses and restaurants with their products. Businesses in

this industry are notorious for having low capital. They are also notorious for being

cyclical. Their cash flow goes up and down, depending on their market. For example,

high priced restaurants do well during the holiday seasons but fare poorly in the summer.

This is the core of Mr. Brown's business.

I have research on rental values in the area and have found that a single family dwelling

on a lake in the metro area rents for $2,500 to $4,000 per month. Due to the corporate

nature of the northern suburbs, new business executives are coming with their families

into the area all the time, keeping the residential rental value high.

If the whole project goes bad and we end up with the property, that could be a concern.

Sure, the old adage about real estate, "they aren't making any more of it," applies

especially to lakefront property. If we had to take the property back, one option would be

to remove the house and sell the vacant lot to a commercial developer who could then

make better use of the space. I'm not sure this is the best option, but it is an option.

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WITNESS 3

Jim Shews, City Employee, Community Development Director

I'm the Community Development Director for the area where Mr. Brown is considering

purchasing property. Rezoning is such a pain because the city has so many things to

consider, but hey, it's my job. So what can I do for you today?

Relevant Facts

Items:

 Description of the property and the neighborhood

 The future "highest and best use" of this property

 The city's comprehensive plans for the zoning of this area

Relevant Facts:

Regarding the application for a zoning change from residential to commercial, I have to

say that these applications are reviewed with an eye both to the specific property and also

to the city as a whole. We have a comprehensive plan, like most communities, that lays

out our expectation for our city in the coming years. We have to consider both issues

before approving a zoning change. On the smaller scale, we can actually see the house

from our offices across the street. It is located on our recently upgraded four-lane

highway. The house is the second house from the end in a string of eight houses on that

side of the street. On the west end of the property, there is a nature area that comes up to

the highway. On the east end, there is a large church, then office buildings. These eight

houses make up their own mini-neighborhood. I seriously consider this to be a declining

neighborhood. The block is no longer suited for residences.

Another factor when considering rezoning concerns the concept of "highest and best use."

With the decline in its neighborhood status combined with the influx of office space and

the new access caused by the highway, we would have to consider this to be ripe for a

zoning change. We do not expect all of the neighbors to agree to a zoning change, but we

can see that, long range, it would be best for that area and for the city. We no longer see

this house, used as a residence, as the highest and best use of the property. We think it

would serve the city best as a commercial property. Hence, though this property once was

denied a zoning change, conditions in the area have changed, and I would now favor a

change in zoning. If the residents again opposed a change in zoning, we would do

whatever we could--perhaps even overrule the residents--to change this property to

commercial.

From the position of our comprehensive plan, we have not formally planned for a change

in zoning in this area. We do, however, recognize that as the metro areas expand, we will

have more businesses pushing out to this area. More office space will be required. This

single building does not necessarily meet the exact spirit of our comprehensive plan

because the property is too small, but since we might be able to use this property to set

the stage for the rezoning of the balance of the homes, changing the zoning on this

property might indirectly pave the way for our comprehensive plan.

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Irrelevant Facts

Items:

 Extra tax revenue generated for the city through commercial properties

 The alleviated fiscal demand if this were a commercial property

 Residential districts vs. commercial districts: where our district ideally fits in

Irrelevant Facts:

Regarding the application for a zoning change from residential to commercial, I have to

say that these applications are reviewed with an eye both to the specific property and also

to the city as a whole. We have a comprehensive plan, like most communities, that lays

out our expectations for our city in the coming years.

Regarding your inquiry about taxes, it is true that commercial property often brings in

more tax revenue than residential property. Making this property commercial would

definitely increase the contribution to the tax base for the city. A single family dwelling

brings in little money compared to a commercial building. By changing the zoning

designation on this house, we would quite nearly double our tax receipts from the

property. Furthermore, we could revalue the property to take into account the fact that the

commercial property is on a lake and is therefore more valuable than other similar,

surrounding commercial properties.

Also, from a fiscal standpoint, a commercial property lowers fiscal demands. With a

lower residential base, we would have less demand for our largest budget expense--

schools.

Additionally, commercial buildings are usually vacant on nights and weekends, the peak

time for city services like police and fire departments. We would be saving money by not

having to pay for schools or several other city services.

From an idealistic standpoint, it would be nice if other communities provided the

residential districts so we could focus on the commercial, industrial, and retail properties,

especially with this particular property whose neighborhood consists of eight houses.

WITNESS 4

David Walters, Accountant, Potential Office Tenant

Mr. Brown has asked me to consider renting an office in a property he intends to buy. I've

surveyed the property. Sweet little place on a lake. Not bad. But, as with all decisions,

there are many things to consider. What would you like to know about?

Relevant Facts

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Items:

 Office space Accessibility for my clients as well as myself

 The office's conduciveness to productivity

Relevant Facts:

While looking for some office space in an office complex, I ran into Mr. Brown, who was

a tenant in the building. He said that he was looking into converting a house into

commercial offices and would like me to consider the building for an office. I was

finding very little office space, so I agreed to look at his building.

When I started looking, I decided on the most important attributes of an office. It came

down to a few basic issues: the traffic in the area, the usability of the office space,

whether the space was conducive to productivity, and how it suited my client's needs in

terms of their access to me. Since four-fifths of my clients never see my office, I am

about 80% interested in how it suits me personally and about 20% interested in how my

clients would perceive it.

For me, the office has to be fairly close to my home and have easy access. This office is

satisfactory on those points. It is less than five miles from my home, and the place is

located on a good highway with good driveway access. As far as space goes, the building

suits my needs there, too. There is plenty of work space area, plus there are several rooms

that will not be offices, so I would have sufficient storage area for my files. Then, it

comes the question of productivity. I fear that my attention might wander while I look out

the window at the lake; however, I know of several other office buildings located on

water, and I have not heard that the water is a big distraction. I think that I will be okay.

The access to the building by my clients is another issue that seems to be satisfied by this

building. It is centrally located in the northern suburbs where most of my clients have

their businesses. I do not foresee them having any more difficulty in finding and driving

to my office than I would. I expect that the business community in the area is increasing,

which could mean more business for me in the future -- another big plus to the property.

I recognize that the property is not a typical office building, but its differences are a part

of its charm. I hope that Mr. Brown gets his building in order in time for me to be a

tenant. I think that I would like to office there.

Irrelevant Facts

Items:

 Building amenities: how they would help me and how they might attract clients

 How I could use the garage space in a side-business

Irrelevant Facts:

While looking for some office space in an office complex, I ran into Mr. Brown, who was

a tenant in the building. He said that he was looking into converting a house into

commercial offices and would like me to consider the building for an office. I was

finding very little office space, so I agreed to look at his building.

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The amenities of the building were incredible! And this building definitely set itself apart

from the other buildings. Mr. Brown's project looked like it would fit that bill and more.

The building was formerly used as a home, which meant that it would have a kitchen,

bathrooms with showers, a basement, and a garage. This home was also on a lake. I could

go boating, swimming, or fishing without having to load up the car. Heck, I might even

catch a fish and be able to freeze it and have it for lunch a few days later. Also, I like to

work out before work, and sometimes I like to workout at lunch. This building will allow

me to bring my treadmill and weight bench to the office. I can exercise, then shower and

be back to work. Other offices simply do not offer these luxuries, and I think clients

would be impressed if I had such a laidback office.

The available garage is also an attractive point. For a small increase in rent, I could have

a shop to work on my car. I do all of my own simple auto maintenance. It becomes fairly

inconvenient in the winter to be outside changing oil, so the added garage would be

helpful and worth the added cost. Also, I have some friends who don't trust mechanics, so

I would have occasional income doing oil changes and simple maintenance for them.

I look forward to seeing the completed project in the next couple of months. I believe that

the office building will suit me just fine.

HANDLING THE CASE

(Answer the following 8 problems and provide comments)

1. What is the main reason that Mr. Brown is looking to change the home into a

commercial building?

A. The rules of supply and demand have left him with few alternatives for office

space, and he is forced to look at options other than standard office space.

B. His previous office, which he was losing due to no fault of his own, was insufficient

for his needs.

C. His client base had moved to a more relaxed, casual form of business, and he

needed to become less formal in order to remain competitive.

D. He would be able to reap financial benefits by becoming a property owner, benefits

which would include free rent for him.

2. What is likely to be the building's best attribute if Mr. Brown is allowed to change the

building into commercial space?

A. The availability of the extra space within the building in terms of the basement and

garage B. The proximity to the lake

C. The location on the highway and its nearness to two metro areas

D. The uniqueness and the small size

3. What makes real estate different from all other commodities (things that you can buy)?

A. Its price. Taken individually, the cost of real estate is higher than any other

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commodity in the marketplace.

B. It cannot move.

C. It serves two purposes. It is both ground, which allows space for movement, and

can include a building, like a house, with its inherent advantages.

D. It can change uses, as in this case, from a residence to a commercial building.

4. What is the term that is used nationally to describe the placement of a property at its

most advantageous use in its market?

A. Price and distance usage

B. Interim to permanent usage

C. Highest and best usage

D. Supply and demand usage

5. The supply of real estate improvements is characterized by several factors. Which of

the following is not one of those factors?

A. The supply is fixed in the short run.

B. The additions to supply in any one year usually are a relatively small proportion of

the total inventory.

C. Additions to the supply are based largely on anticipation of future demand.

D. Supply must constantly exceed demand so that the available space makes for a

broader market to pick from for the potential tenant.

6. Which of the following growth factors may have contributed the most to the demand

for office space in this building in this suburb?

A. The availability of natural resources

B. The regular climate

C. The ready availability of a good labor force here as opposed to in the metro areas

D. The relative ease of transportation

7. There are four life cycles used when describing the nature of a property. Which of the

stages would you say that this property is in, considering its current residential status?

A. Gestation, youth, and maturity

B. Incipient decline

C. Clear decline

D. Accelerating decline and abandonment

8. From the facts of this matter, what do you see as the biggest challenge to Mr. Brown's

chances of ending up with an office building on the lake?

A. The neighbor's opposition

B. Obtaining a building permit

C. Borrowing sufficient funds for the project

D. Finding tenants

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CASE CONCLUSION

(Choose one witness role and make a concluding remark)

Through the details of this case, it becomes easy to see why real estate developers can

make and lose so much money so fast. You can count up the major considerations that

Mr. Brown will have before he can expect to take in his first dollar of rent. He will have

to buy the house, or at least have an agreement to buy the house, apply to the city for a

zoning change, have his contractor estimate the cost of improvements that would be

needed to make the property rentable to office tenants, get building permits, satisfy code

requirements, obtain both long and short term financing, deal with the neighbors, review

the tax picture for residential and commercial properties, and find good tenants. If he

addresses all of his considerations correctly, he stands to get a fair return on his

investment. Or if he doesn't get the answers he expects, he could decide to decline on the

investment entirely. But what happens if he pays cash for the house, then finds that he

cannot get financing or his zoning change? He would be stuck with a house he doesn't

want in a declining neighborhood. A failure in any of his considerations would make this

whole deal fail.

You will also note that he must address all of these considerations without any income

from the property. Earnest money cash, zoning and code application fees, financial

review fees from either his bank or his accountant, the actual construction fees, and a

leasing agent's fees must all be paid before he takes in a dollar in rent.

Mr. Brown has also picked a property that is different from the area properties. It is in a

residential district instead of a commercial district, so he is taking a chance as a market

pioneer. He also has no obvious history as a landlord. On the job training is an expensive

proposition when dealing in the real estate market. We can wish him well. Property

development is not for the faint of heart.