Many businesses own the real estate they use, directly or indirectly. The building types range from offices to warehouses to factories. Some are single tenant (i.e., the business is the only tenant), while others are multi-tenant. Today’s newsletter addresses the issues and opportunities that arise when the real estate used by a business is also owned by the business or a related party.
Two Important Differences
From an economic standpoint, it’s important to understand that real estate and businesses — particularly privately owned businesses — are quite different. Academics and investment pros know that commercial real estate has a return and risk profile similar to a 50% stock / 50% bond portfolio. But, because rents increase over time with inflation (unlike most bonds), the risk profile is a bit different than owning just stocks and bonds.
Because of all this, investors will accept a lower return from owning commercial real estate than from businesses — particularly private businesses and (even more so) small, entrepreneur-owned businesses.
A second difference between real estate and businesses is that lenders will lend more on real estate than on a business.
For example, consider that most residential mortgages are for 80% of the value of the home. For a business, that is leverage
of 4 to 1! Interest rates can be lower on a mortgage as well. For example, I recently received a notice for real estate loans (SBA 504a) with 25-year rates at 3.80%.
Own or Sell?
Taken together, these two real estate attributes necessitate a decision: Own the real estate and use it as collateral to lower borrowing costs for the business? Or sell the real estate to a third party and lease it back, investing those funds into the business itself, which should earn a higher return than from the real estate (this is known as a sale/lease-back transaction).
Investors will pay up for the real estate because when many leases are pooled together, the risk resulting from the failure of any individual tenant is tiny, and the cash flow from rent payments on the pool of such leases is steady, predictable, and inflation-hedged (assuming there are inflation adjustments embedded in the lease).
I recently spoke with a private equity investor who bought a specialty chemical business I helped sell several years ago.
He had hired a real estate broker to shop the real estate for a sale/lease-back transaction. He sees lots of investment opportunities in the business he bought with potential returns much higher than what real estate investors will accept. The opportunity cost
of owning the real estate is the foregone higher returns from these business investment opportunities. Sale/leaseback transactions are a standard trick for private equity investors in manufacturing businesses.
This business and its owner are willing to make some tradeoffs to do the sale/lease-back:
- The business is committing to not move for a long period of time.
- The business is in high-cost Massachusetts. So if the business buys a plant with excess capacity in a cheaper part of the country, it can’t roll in the Massachusetts business for lower costs and better capacity utilization.
- The business is located on a large site, so there is room for expansion if needed. However, an expansion will require a lease renegotiation, with the landlord having the leverage.
Also, because this investor recently bought the business with the real estate, he won’t have a large gain on the sale. Typically, when real estate is sold, capital gains taxes are paid on the difference between the sale price and the tax basis of the building. Tax basis is simply what was paid for the building and any improvements, less accumulated depreciation. But accumulated depreciation is taxed at the higher ordinary income rate (in tax speak, the depreciation is “recaptured”). When my client who owned the business for 30+ years sold it, he paid a lot of taxes on sale of that real estate.
Sale/lease-back transactions are only for single tenant businesses (like this one). But, if the business is just one of many tenants in a building that is owned by the same party as the business owner, a similar set of decisions should be periodically evaluated. The building can be sold to an investor in multi-tenant buildings. The proceeds can then be reinvested in the business for higher returns. As rent increases, the value of the building will increase too, so more can be borrowed using the building as collateral and put back in the business.
An Illustrative Example
A former client of mine is in the IT services business. During the great recession, this company needed more space, so it leased space at a low rate in an up-and-coming area. It even got an option to purchase the building for a low price. This was back in 2009. The landlord lost the building to a lender that imploded from too many bad real estate loans, so they were able to get a great deal. Before long, they purchased the building with help from outside investors that fronted the equity.
The business owners were the borrowers for the loan to purchase the building (the equity source was not a borrower). One of the owners kept increasing the rent roll which allowed the building owners to keep borrowing more to invest in the IT services business.
They could borrow more because the building was worth more and they could service more debt from the increased rent. The area became super-hot for real estate developers so the building value skyrocketed. So much so, that the borrowing constraint was not the value of the building, but the rent role that constrained the fixed charge coverage ratio
. Ultimately, they sold the building, agreed to a two-year lease, paid off all debt, bought out a founder, and bought a competitor!
Note, these individuals made a conscious decision to be in both the IT services business and the real estate development business. This is not an option for the private equity investor I mentioned previously. His investors pay him to invest in manufacturing businesses and they pay different firms to invest in real estate.
Lowering the Risk Profile
One other factor for entrepreneurs to consider is that an owner-occupied, multi-tenant building can lower the owner’s overall risk profile. How? The entrepreneur’s wealth is tied up in an illiquid business, but the multi-tenant real estate is a lower risk business and more liquid.
For example, a client of mine owns a good-sized industrial services business that operates out of many small offices across the country. He owns many of the office buildings where his industrial service business is a tenant. For the most part, he just collects rent and doesn’t develop real estate. That way, the considerable wealth he has in the high-risk industrial services business is balanced with a lower risk, steady-return real estate business. And the ability to sell individual buildings provides flexibility.
There are only two constants when considering real estate owned or controlled by the business:
- Evaluate the situation from time to time.
- Make sure that evaluation is fact specific.
Neither of these amounts to a universal recommendation, as none is possible.