Businesses Owning Real Estate: 3 Examples
5 December 2022: Businesses Owning Real Estate: 3 Examples
Last week’s post was an overview of some of the issues surrounding the sale of a business when real estate is involved. At the end of that post, I mentioned that I planned to provide two examples from our client files to illustrate some of those issues – as well as some of the benefits to sellers if the ownership of the real estate is structured properly.
Well, I’m going to give you three.
But before we get started, I want to make sure that last week’s post did not leave anyone with the mistaken impression that, if neither the business nor the business’ owner owns the real estate used by the business that real estate is not involved. In almost every case, to some extent it is.
Most businesses – especially those in urban and suburban areas – lease the space they operate in. Sometimes, the business leases it from the owner of the business who also owns the real estate either personally or through a different entity. Such situations are the subject of last week’s post and this one, as well.
But usually, the business leases the real estate from an unrelated third-party landlord. Examples are shopping centers, malls, office buildings, business and industrial parks, urban pedestrian retail areas and on and on. (This is the main reason that the most ideal candidates for learning how to value and sell businesses are real estate agents; particularly, commercial ones.) So, real estate is still involved but it has a completely different relationship to the sale of the business and to us as professional business brokers. The lease, after all, governs. But leasing is not the topic of this post, ownership structure is. So let’s get to our examples.
“Ninety percent of all millionaires become so by owning real estate.”
– Andrew Carnegie
Owning Real Estate: A Manufacturer
This first example is a small, 12-employee, U.S-based plastics manufacturer. The business was owned by a husband and wife who approached us to get advice on how to start preparing their business for an eventual sale (which in and of itself was amazing given that far too many small business owners wait until they’re ready to list their business before they contact us.)
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This couple was leasing the building their business was in – a stand-alone structure with good truck access – and had no intention of moving. Their lease payment at the time was roughly $80,000/annually, a rate their business could easily afford.
As we talked through their business’ operations and their plans, the couple – both in their mid-40s – stated that they planned to own their business for at least another five years. We suggested that they consider setting up a separate entity to own the real estate, buy it and lease it to their business.
This would have the immediate effect of giving them, via the new entity, the benefit of $80,000 in cash flow – much of which could be sheltered from taxation through depreciation – rather than giving that benefit to someone they weren’t particularly happy with to begin with; their current landlord.
In the longer term, it gave them several benefits:
- The first is appreciation, the gradual increase in the value of the real estate. It’s a rare piece of property doesn’t become more valuable over time.
- It allows them to adjust their lease to the business environment. As their business grows, they can, within reason, increase the rent paid by the business allowing them get more of the business’ profits into a tax-advantaged entity. (But you’ve got to be careful here and heed one of business’ most important philosophical warnings: “Pigs get fat. Hogs get slaughtered.”)
- By creating a separate entity with which to own the real estate, they’re able to sell their business at some point but keep the real estate thus providing a very handsome retirement income for years to come – even as the real estate continues to increase in value.
We consulted with them throughout the process, including helping with the financing, and the deal was done. Their business has been making lease payments to their “real estate company” for the past four years Those payments are paying down the note for the acquisition funding as well as all ongoing costs of ownership. Their real estate company is making a profit every month and the property is worth roughly 15% more than it was when they acquired it.
Owning Real Estate: A Restaurant
Our second example is one that I’ve used in several earlier posts about valuations.
The business was owned for more than 15 years by two partners. The real estate was also a free-standing building but with the added attraction of being on a small body of water. When I wrote about this previously, it was to describe a disastrous, multi-year effort by a real estate agent to sell the business. It was “disastrous” because no one involved knew how to value it.
As it happened, the business was not doing as well as the owners let on – but notwithstanding that fact, it was showing a fairly handsome profit. How could that be possible?
It was possible only because the owners, who also owned the real estate (although in a separate entity), had the business paying their real estate entity a rental rate that was less than 40% of the true market rate: $22,000 versus $60,000. This, of course allowed the business to show a profit but it did nothing for the value of the real estate.
Yes, they could have sold the business separately but then they’d own an investment property that might qualify as one of the worst performing assets outside of a hole-in-the-wall space on a small alley in Sil-Li, North Korea. Needless to say, they wanted to sell the real estate with the business. They knew they had the proverbial pig-in-a-poke and they wanted to make that problem somebody else’s.
This example illustrates that the real estate was perhaps not being put to its highest and best use. It might be better to close the restaurant, sell the physical assets and restructure the building for a different use. But no one explained the problem or the solution to the owners – until the real estate agent eventually contacted us.
But it does illustrate that, by owning the real estate in an entity that is separate from the business entity, a business owner can adjust the business’ occupancy costs and, thus, value. But sometimes, as in this example, doing so comes at a cost to the real estate’s value.
Owning Real Estate: A Service Provider
The final example is that of a service business that leased office space – and it will show the reverse of the previous example..
The business was seven or eight years old at the time we got involved and we’d helped the owner buy it about four years earlier. It was growing nicely and enjoyed a healthy profit each of the previous four years. In fact, due to that growth it had relocated three times over its eight years in existence.
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The owner and her husband decided to take the leap and buy a building that could be modified to fill the specific needs of the business and that was located as close to the center point of the business’ geographical market as possible.
Our broker, who was involved in the owner’s acquisition of the company several years earlier, happened to also be a commercial real estate broker and assisted the couple in locating and acquiring a property that suited the needs of the business, provided room for expansion and could be acquired on reasonable terms.
This was a small U.S.-based business and the couple established a limited liability company (LLC) to acquire the property. Via this new LLC, they leased the property to the business at a rate that covered the costs of owning the property and paying off the acquisition note.
As it happened, the business continued growing which enabled the business to pay higher rents every year – allowing the owner to get more profit out of the business into a tax-advantaged business – the real estate LLC – that she and her husband owned. We continue to advise them and, based on the latest lease, the business is paying a premium to market rent of roughly 20%. But the business’ owner is paying that premium to herself.
They currently plan to sell the business in about five years. To assure that the business enjoys its highest value at the time of sale, we are advising them to begin reducing the business’ rent to market level over the three-year period leading up to the sale which should lower the occupancy cost, thus increasing the business’ discretionary earnings and, therefore, value.
We’re also advising them to create a new long-term lease with the business prior to bringing it to market. That lease will do two very important things:
- It will provide a sense of stability to the buyer of the business, and;
- It will provide the couple that continues to own the property with years of steady income, even after the business is sold.
“Landlords grow rich in their sleep” – John Stuart Mill
The Bottom Line
Owning real estate has been one of the best investment vehicles since time immemorial. But as it pertains to a business, how the owner of the business owns the real estate is extremely important. Properly-structured ownership can determine:
- The owner’s immediate ability to enjoy more of the business’ profits on a tax-advantaged basis;
- The increase in value over time of the owner’s real estate asset;
- The real estate and ownership costs being absorbed – and expensed – by the business;
- the owner’s options and flexibility when it comes time to sell the business;
- And the opportunity for the business owner to enjoy many years of cash flow from the business even after the business is sold via the rent the business will continue to pay to the owner’s “real estate company”.
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.
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
Searching For…
We’ve been contacted by an investment group seeking family-owned businesses in the healthcare, life sciences, laboratories and infrastructure testing (wellhead, sampling, etc.) with a minimum of US$4 million adjusted net located in North America
If any of you know of something that might fit, please let me know.
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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 500 in the world. He can be reached at jo*@Wo*******************.com