28 October 2024: Buying a Business: Understand the Lease.
If you’re buying a business, what should you look for in the lease? Several things, actually, as the performance of the business depends in no small part on the terms and conditions of the lease through which the business has a right to the space it occupies.
Though most businesses lease the real estate they occupy, that is not always the case. Many times, the individual(s) who owns the business also owns the real estate separately and may wish to sell it with the business. But in such a case, the business is still subject to a lease, albeit not exactly in an “arm’s length” relationship.
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But if a lease is involved (likely) arm’s length or not, multiple terms and conditions of the lease must be understood with an eye toward how they might change if the business changes hands and, if so, how such changes will impact the business’ performance.
Let’s look at some of the most impactful issues.
Rental Rate
The most obvious issue is the rental rate. If the business you’re buying leases its location from an unrelated party – usually the case when the business is located in a mall, strip shopping center, industrial park, central business district, multi-tenant office building and similar real estate – the business’ financials should clearly show the amount of rent and related fees paid by the business in any given year. The business’ financial performance reflects these expenses and you might be able to assume that the future financial performance of the business will be similar if the rent does not change appreciably.
That said, most commercial leases include an escalation clause that describes the periodic increase in rent. In addition, many retail leases, especially in shopping centers, include a percentage rent clause which means that the “minimum” rent is just that: the minimum. If you are a savant in business and the one you buy is wildly successful, you are likely to end up paying more than the minimum rent – not necessarily a bad thing. More on that in a moment.
The next aspect to examine is to determine if the lease is transferable. Many landlords and property management firms do not allow a tenant to transfer the lease to a successor tenant, at least without the written approval of the landlord. And even if the landlord approves, it will very likely charge a transfer fee and possibly alter the lease terms.
And speaking of the lease term, this is one of the most crucial considerations as it can have a huge impact on how much money the business you buy will eventually find its way into your pocket. How? Because one of the most important aspects of a business you acquires is how long will it take for that business to pay for itself.
How much time is left on the lease term? Is there an option to renew? Is the rental rate for any renewal period described in the lease? If so, do you think the business you’re buying can absorb that increase, pay itself off, provide a reasonable income for you and a return on your cash invested in the acquisition?
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There are many other aspects of an existing lease that will impact the profitability of the business, all of which should be reflected in the business’ financial statements, but these three are most likely to be impacted by a transfer of the business to new owners and any modifications are likely to impact the business’ profitability.
Let’s look at each more closely.
- Rental Rate – First, you must determine if the existing lease has an escalation clause, a provision that stipulates a rental increase at certain dates, usually every year, or upon certain events, such as extending the lease for another term. If such a clause exists, it must be factored into your projections to see how it will impact the profitability of the business after you buy it.
- Is the lease transferable and, if so, at what cost? Most leases are not transferable without the express written consent of the landlord. In our experience, it would be unlikely that a landlord would not approve a lease transfer if the transferee (the business buyer) was at least as credit-worthy and reliable as the transferor (the business seller). This is particularly true if the business you’re acquiring is paying the current market rent and has a history of profitability. But if the lease is not transferable for any reason, your contract to purchase the business must be contingent on your ability to enter into a new lease with the landlord on terms that are acceptable to you.
- Remaining Term – This is a big one. How much time is left on the existing lease. This depends on a number of factors but the most important is the type of business you’re buying and the ease with which it can be re-located. You want to make sure that you have enough time to get a return on your investment. As a hypothetical example, one that we use in our Course, consider the transfer of a child care business in which the value of the real estate was low because the rental income was below market. But to increase the value of the real estate, the rent charged to the business would have to increase to a level that would not give the buyer even a modest return on its investment in the business within any reasonable period of time.
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Minimum Rent vs Percentage Rent
I mentioned minimum rent above. Minimum Rent is generally paired with Percentage Rent. This is a common situation in malls and some shopping centers and mostly impacts retail businesses.
Professional landlords and property management firms are generally run by smart people (Mom and Pops are completely different story) and will likely have some idea as to what revenue a particular business can generate in their property.
Their object for their own revenue is twofold: they want a minimum rent that reflects what they believe the business can support and still stay in business (i.e., provide a profit that keeps the owner(s) motivated). But, if the business does spectacularly well, the landlord feels, not unjustifiably, that the business’ success is due in no small part to its location and the amount of traffic the landlord drove to the property. As such, the landlord will probably want a share of the “excess revenue”. (If you want more information on how this is computed join The Brokers Roundtable℠ and post your question in the Ask An Expert space.)
The Bottom Line
Buying a business ain’t for sissies. And it’s important to realize that buying a business is completely different from actually running a business. Unless you’ve been through this process in the past, most people will be on unfamiliar ground.
And while there are many issues to consider when buying a business, the lease is as important as any of them.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at
jo*@Wo*******************.com
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If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
Joe
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 600 in the world. He can be reached at
jo*@Wo*******************.com