If you own real estate in your business, you should give some thought to how you would liquidate it.
To be clear, if you own buildings that are used by
tenants — office buildings and warehouses in particular – that is something different. Here, I am referring to businesses that make something in a factory, distribute a product from a warehouse, and so forth, all of which they own.
Why is this important?
Because “liquidation value” is not the same as fair market value.
Most of the time, when thinking of real estate, we have a number in our heads of what the land and building are worth. There might be a legitimate basis for this number, such as sales of comparable buildings. But those buildings were probably marketed extensively for an extended period of time.
That is called fair market value.
But there are many times where it doesn’t make sense to take so long to sell real estate. In these cases, the building will most likely sell for
less than fair market value.
That is liquidation value.
But why would a business sell real estate quickly and accept a lower price? If the business defaults on a loan and the lender can’t sell the real estate with the business as a going concern, the lender will be looking to get paid quickly. With that in mind, lenders look at liquidation value when assessing real estate as collateral for a loan.
Your business might also look to sell quickly if you need the cash for liquidity purposes. Or, if your business simply wants to redeploy assets when consolidating plants, for example. It might happen as well in those instances when holding costs are high and/or the time to sell at fair market value is long.
The following factors need to be taken into consideration when properly valuing your business real estate…
Highest and Best Use
In many cases, commercial buildings are not utilized in a way that maximizes their value. For example, a client of mine used one of its buildings as a small office and another as a warehouse and processing facility. The buildings were sold to a developer who builds apartment buildings for a high price. The high real estate value was good for the lenders because it helped them get paid, and it allowed my client to borrow far more than it should have: secured debt as a percent of revenue was 40%!
In other cases, such as during the Great Recession, idle factories in parts of the rural Midwest were often torn down and sold as farmland. Why? Farmland was hot, the sale time of a factory would have been lengthy, and the carrying costs of an empty building were high. Farmland was the best, most liquid option.
Time to Sell
The time it takes to sell a building will always come into play. In the example above, where the buildings were sold to a developer putting up apartments, the property was located in an up and coming section of Boston – an urban market with lots of real estate activity. The lenders knew the building would sell relatively quickly, so they lent quite a bit of the building’s value. In the Midwest market, by contrast, the buyers are often few and far between.
What does it cost to carry an empty building and land? It can be considerable. Insurance for vacant buildings, for example, is much more expensive than for occupied buildings (the facilities must still be maintained, and perhaps more fencing and security is needed). When you multiply carrying costs by time to sell, the number can be frighteningly large! That’s another reason why few lenders can wait to receive “fair market value,” and why a business might have urgency if the real estate in question is no longer needed.
Unless it is being sold as part of an ongoing operation, buyers don’t want your stuff in the building. Sometimes this is not a big deal, such as for a warehouse: sell the goods, leave the racking for the next tenant, and move on.
Much more typical, though, is the need to remove equipment and then repair the resulting damage to roofs and floors. Worse case, money must be spent to process the remaining goods on the premises. For example, a former client of mine was in the business of taking recycled materials from municipal trash picks ups, sorting it and then selling it. The company was horribly run and shut down. But, the lender had to pay for an additional six months of continued operations to clear out the backlog of recycled materials on the property.
Another example, where the lender didn’t even bother to mortgage the property, was a scrap metal company. There, after the huge piles of inventory were sold, we found stream beds, WWII big gun live shells and more. Fortunately for the creditors, the company was sold to its largest customer, a steel mill that thought these sorts of environmental problems were minor compared to those of a steel mill!
“Hair” On Real Estate
In this context, “hair” refers to the oddball problems that may show up when attempting to liquidate real estate. Some common examples:
Problems with the title. In the Boston example cited above, the owners purchased the property over 30 years ago with a loan secured by a mortgage from a bank that itself died in the nineties. Unfortunately, that lien was never formally removed, a problem that was solved with somewhat more expensive title insurance. When selling real estate, do a title search early in the process. Yes, the buyer will do their own and pay for it, but it’s best to spot problems before the buyer does.
Environmental problems. These are quite common and manifest themselves in all sorts of ways. In the scrap metal company example above, just four days before the forbearance agreement required a signed Asset Purchase Agreement (APA), the crown jewel property was declared a Superfund site. The Mayor’s election platform had a plank devoted to shutting down my client’s business and he was successful. Today, that property still sits vacant as land abandoned by a bankruptcy estate.
Less onerous, but still painful, a client of mine recently sold his healthy business for a nice price, including the building and land. After the Letter of Intent was signed, however, the owner’s neighbor contacted him about a problem. Apparently, an abutter had an old leak of toxic stuff that may have migrated onto my client’s property. While State laws provide lots of protection, the out of state buyer insisted on an escrow amount set aside at closing to cover potential costs.
Neighbors and politicians. In the recycling example above, this may have been the only permitted site in New Jersey that was
not owned by a mobster, making it worth a premium! Unfortunately, the city built an elementary school just three blocks away. Clearly, the new owner is going to have a hard time renewing the permit to operate.
Without question, real estate can be valuable collateral for a loan, or as a source of cash for a business that is restructuring its operation. But there are many things to consider and more than a few pitfalls to beware of.
Do your homework, enlist the help of experienced professionals as necessary, and plan early for what the future may bring.