Business Brokers and Business Real Estate

We often encounter business owners that ask about the wisdom of buying the real estate their business is in or buying real estate that they can move their business to, especially when their business is expanding. The decisions made about the acquisition or ownership of business real estate will impact the business owners when it is time to sell their business.

If you’re a business broker – or aspiring to become one – this is a topic that you are guaranteed to encounter a couple of times every year. If you’re a buyer, you might consider the wisdom of buying the business’ real estate and, if you do, how it should be bought.

A small business owner can take two approaches to investing in real estate: 1) invest independently of the business as the owner would invest in other assets such as stocks or bonds, and, 2) invest as part of the business. Because the first approach is no different from anyone else investing in real estate, I’ll focus on the second.

Almost every business has a “nexus”; its place of business. The only exceptions might be internet-based service businesses in which a bunch of propeller-heads work out of their respective homes which could be miles – or continents – apart. But for most businesses that you will be tasked with selling, real estate is guaranteed to be involved to one degree or another.  If you’re speaking to a potential client about selling their business, you need to know how the real estate is involved.

Here’s a couple of examples of how the real estate might be related to the business.

1. The business leases its real estate from a third-party landlord in an arm’s-length transaction, a very common situation. One of the best examples of this is any chain of retail outlets such as bookstores, healthcare clinics or submarine sandwich shops. They might lease a free-standing building or locate in strip malls but they generally lease from an unrelated landlord. (McDonald’s has for decades bought excellent real estate and then leased that real estate to its franchisees. McDonald’s Corporation is, in fact, more of a real estate company than a franchisor.) If you were to represent the owners of a chain of 15 sub shops, there’s a good chance that 15 leases with 15 different landlords are involved.
2. The business leases its space from a party related to the owners of the business. This is the optimal case from the business owners’ standpoint.
3. The business owns the real estate it operates in. This is not the most ideal situation as it can unnecessarily limit the owners’ options when it comes time to sell the business. (To see why, I offer this case study of when real estate was a problem in a transaction one of our lead brokers was handling.)

Why Lease?

Most businesses lease the space they operate in. They do so because leasing preserves capital to grow the business and eliminates certain of the more onerous aspects of ownership such as some maintenance issues and other upkeep or real estate operating expenses. But, if a business is profitable, we advise the owners to consider personally investing in real estate and then lease that real estate to their business. This is a particularly effective strategy when the owner’s business is throwing off a handsome profit because it allows the owners to get money out of the business essentially tax free buy charging the business rent. For this strategy to be effective, however, it is critical that the real estate be owned by an entity other than the entity that owns the business.

By way of example, John and Mary Smith own Miami Widgets, LLC. Miami Widgets leases space from Abbott and Costello Enterprises, a real estate investment firm located in Daytona Beach. Each month Miami Widgets sends a $5,000 check to Abbott and Costello guaranteeing Bud and Lou a handsome retirement.

But if Miami Widgets is showing handsome profits, the Smiths might be wise to consider forming a real estate investment vehicle and buy the building they are in from Abbott and Costello – or another, perhaps larger, building to accommodate the expected fabulous growth! – and leasing that space to Miami Widgets. But the key to this strategy is for the Smiths to form a separate entity – let’s call it Smith RE, LLC – to buy the real estate and Smith RE would lease the real estate to Miami Widgets.

Why? Well, to borrow from Elizabeth Barrett Browning’s Sonnet 43, “let me count the ways”!

Benefit #1: All rent paid by Miami Widgets would be to the benefit of Smith RE allowing Smith RE to pay off the note used to acquire the property with profits from Miami Widget.

Benefit #2 If Miami Widgets was generating healthy profits, the rent could be structured so that Miami Widgets was paying a rental rate that was somewhat higher than the market rate thereby allowing the Smiths to pull more cash out of the business. (Attention should be paid to assure that the rental rate is not grossly inappropriate. Even though they are understaffed, a red flag might pop up on the third floor of the IRS building. The axiom that might be most appropriate here is, “Pigs get fat; hogs get slaughtered.”)

Benefit #3: Using depreciation, maintenance, management and other fees, Smith RE would likely show a loss for many years which would pass through to the Smiths thus reducing their personal taxable income.

Benefit #4: Over the years, the asset(s) of Smith RE would increase in value to the benefit of the Smiths. (This is an excellent IRA investment because of…)

Benefit #5: When it comes time to sell the business – and it will – the business can be sold independently of the real estate (because of separate ownership) and Smith RE can continue to collect rent for years to come. (When the Smiths begin planning to sell Miami Widgets, they should, among the many other issues to focus on, make sure that the lease with the landlord – themselves as Smith RE – is renewed or extended so there are five or more years remaining when the sale of the business closes. A side benefit to this is that business buyers will generally want the stability that comes with a longer lease and the elimination of the immediate hassle of finding a new location or negotiating a new lease from the buyer’s already extensive “to do” list.)

Benefit #6: This benefit follows from the decision to own the real estate in a separate entity. When it comes to to sell the business – and it will – there are more buyers financially able to buy one of the assets (business or real estate) than there are that are able – or willing – to buy both, thus increasing the pool of buyers, a condition that would generally mean a higher value for the business; the greater the demand, the higher the price.

Case Study

Want to hear how this worked in action? Though the following is the true story of a very small business, the principles apply to any privately-owned company.

Here’s how I did it.

My lovely bride owns a small, six-person company that handles real estate closings.

(By way of a little sidebar here, she was actually an employee when we met about 12 years ago but I soon realized that she was the ONLY employee and none of the six owners ever showed up. She was doing all the work.

About a year later I started lobbying her about buying the business (that is, after all, what I do!). She resisted at first but by showing her how she could do it financially, I was finally able to convince her to take the plunge. Not long after, though she was still the only employee and doing all the work, now she owned the joint! And for the happy ending, not long after that, she started to think “Hummm, this guy might actually know what the heck he’s doing!” – and agreed to become my wife. [Sound of audience applause.])

During the ensuing years she relocated her business four times and added an employee here and an employee there. Finally, about two years ago, a building near her office became available. It was slightly larger than the office she was renting – which would allow for additional growth – and handsomely appointed. With little more than a paint job, a kitchenette and new carpeting, it would exhibit the level of professionalism that her business requires. We decided to buy it.

As explained above, we formed a limited liability company (“LLC”) for the sole purpose of buying this property. She and I own the LLC, the LLC owns the property and leases it to her company. Her business has grown steadily and, because it generates a handsome profit, the lease calls for a rental rate that is somewhat higher than the market rate – and significantly higher than the mortgage payments. This allows her to get more cash out of her business and by using the tax authorities’ generous allowance for depreciation, we are able to shelter pretty much all of that excess cash and use it for maintenance, upgrades, management fees (me) and a lavish Christmas party for the team and their spouses. And even though there is no legal requirement for an LLC to hold an annual meeting, we established such a requirement in the original organizational documents. We’re thinking about St. Barts every February.

The Bottom Line

A business owner that also owns the business’ real estate has two distinct assets – the business and the real estate – and they can be sold separately. One consideration that I’ve not touched on here is that the real estate can be sold while the owner continues to grow the business. This strategy can be used to generate cash needed for expansion or to perform the proverbial once-in-a-lifetime contract that will bring the business to a new level – and make it even more valuable.

So, if you’re a business broker advising a client – or a business owner wisely preparing ahead of time for the sale of your business and you want handsome monthly payments destined to support your lavish retirement lifestyle to keep flowing after the sale – start thinking about how best to deploy the two assets that the best-situated owner enjoys dominion over: his or her business and the business’ real estate.

If you have any questions, comments or feedback on this topic – or any topic related to business – I want 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 profitable week!

Joe

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