What are the Pros and Cons of Buying the Real Estate with the Business?
If you’re buying a business, should you buy any real estate that the business owns? Well, that depends. Let’s look at some of the upsides and downsides.
For starters, most business owners would prefer to lease the real estate needed to run their business. Leasing has two immediately evident pluses. First, leasing does not tie up the business’ or owners’ capital that could otherwise be used to grow the business. The business may need capital for new equipment to fulfill a significant order it just received from a new and sought-after client or to expand its inventory.
Second, if the business outgrows the real estate, owning the real estate may make relocating difficult from a financial standpoint simply because the acquisition of additional space, be it through a lease or additional purchase, will negatively impact the business’ financial position. Real estate is an asset that is not easily converted to cash. Additionally, the needs of most businesses are likely to change over time. Real estate is, for the most part, a “static” asset, i.e., it is not easily reconfigured.
Let’s look at a couple of examples from deals that we’ve done.
The first one involves a legal industry business that had been renting space for more than 10 years. It was the only tenant in a one-tenant older building. The space was not very efficient and was a bit larger than was needed. But the geographical location was ideal for the business’ market. When the owners sold the business, the new owners took over the lease but thought the business could be run more efficiently in a smaller space but they knew that to maintain continuity with their clients and maintain the geographic coverage that the business already had, they needed to stay very close to where they were.
There were no suitable options – ideal size, location, rental rates, etc. – in the market but they knew they needed to relocate and eventually an opportunity presented itself. Unfortunately, this opportunity was for sale, not for lease.
We have licensed commercial real estate brokers in our network, so the new owners became our clients after they bought the business. In the event, we acted as non-paid advisors on the belief that the new owners would be selling in five or 10 years and we wanted them to have a favorable impression of our good will and expertise.
We sat down with the new owners to analyze the financial impact and discuss the possibility of buying. What was revealed were five conditions that strongly suggested that the business owners should consider buying the real estate:
- The real estate was priced below market value
- There was enough room to expand the building as needed, eliminating any need to move in future;
- Because the building was newer and smaller, utility and insurance costs would be lower than at the existing location thus decreasing the business’ operating costs;
- The business was showing a handsome profit allowing it to pay rent at a rate higher than market, thereby allowing the owners to get more tax-favored cash out of the business, and;
- As part of their long-term personal planning, the owners wanted to invest in real estate at a personal level.
With all of these issues lining up (admittedly a rare event), it began to seem that a purchase might be appropriate. In the event, the business owners decided to buy the real estate after identifying the following attributes:
- They would buy it personally or in an entity separate from the business allowing them to sell either the real estate or the business down the road.
- They were able to get tax-favored revenue out of the business;
- Because of lower operating costs and improved cash flow, they, as the owners of the real estate, were able to charge the business an above-market rental rate increasing the amount of tax-favored revenue that they were able to get out of the business.
- Because the property was large enough to expand on, they knew that the business would not outgrow the real estate. They would be there for the long term.
An opposite example is from another deal we were involved in, in which the business owner also owned the real estate. This one was a specialty metal fabricator.
The owner of this business had started it about 20 years earlier. It was heavy on equipment and raw inventory and located on more than two acres on a highway with significant frontage, much of which was unused. The owner wanted to sell his business but most buyers balked. The reasons?
- The highway-frontage land was fairly valuable thereby increasing the investment needed to buy the business and property;
- Most buyers saw a need to upgrade the tools and equipment, a significant capital expense;
- Most buyers realized that the business did not need highway exposure and could be relocated to a lower cost facility; a leased facility in an industrial park, for example.
The solution in this case was for the owner to form a separate entity into which he could transfer ownership of the real estate and lease the real estate to the business. We could then sell the business and the buyer could invest his additional capital in upgraded equipment. As well, subject to the lease, the buyer could move the business to a more appropriate locale and the seller of the business could then sell the property separately.
These are but two examples of how real estate impacts or factors into business ownership decisions and the options available to the owners and buyers when it comes to to sell or buy. In most cases, it does not make sense for the business to own the real estate or for the owner to try to sell both assets together. There are FAR more buyers that can afford the business than there are that can afford both the business and the real estate.
Real estate plays a large part in almost every business and, therefor, almost every business transfer. The ideal situation – for both the business seller and the business buyer – is if the business occupies leased real estate. We’ve put together a check list of items that must be addressed or considered if you’re considering buying a business which you can download here.
The key, again, is planning. If you’re a buyer, do you need to own the real estate? It’s unlikely. If you are a business owner and your business owns the real estate, when it comes time to sell – and it will – you are likely to find a much smaller pool of buyers which would generally translate into a much longer sale cycle. If you’d like to learn more about strategies on how to avoid, these problems, leave a comment below.