What About My Business’ Real Estate?
When you also own the real estate in which your business operates, it can be confusing to understand how the value of the real estate interacts with the value of your business when you are selling the business.
First, a quick note about virtual and 3rd party lease situations:
Virtual
If your business is run virtually, you may be off the hook on this topic. However, a buyer may believe yours is a business that should be, or that they plan to run, in a non-virtual manner. In the main sense, that’s not your problem, but such a buyer may impute theoretical rent against your cash flow in their valuation approach.
3rd Party Landlord
If you don’t own your real estate and lease from an unrelated 3rd party landlord, a few different things can happen. Typically, the buyer of your business will either take over your existing lease or negotiate a new one. Your lease will likely require notice, acknowledgement, or permission from the landlord if the business is going to change hands. The landlord may have a qualification process, and there may be advance notice timelines, so review your lease for provisions about “change of control” or a sale of the business. It’s also possible the buyer’s lender will have requirements for the lease so they know their borrower will always have a place to do business and be able to pay them back. For example, an SBA loan may require a total of a ten-year term to be in place, including options, so their ten-year loan term matches the (potential) term of the lease.
You Own the Real Estate
Typically, when the business owner owns the real estate their business occupies, they own it separately from the business. Limited Liability Companies, “LLC’s,” are the most common form of entity for such ownership, but they may also own it as an individual. If your real estate is owned within the same entity as the business, consult with your CPA. You may be at a disadvantage tax-wise. This is particularly true at the time of sale if you own the real estate in a corporation.
For the rest of this paper, we’ll assume you own the real estate separately from the business.
Market Rent—What are you paying?
Your business is likely paying some amount of monthly rent to you or your entity that owns the real estate. Sometimes people simply set this to equal the amount of any mortgage payments. The best approach is to research the amount you’d have to pay a 3rd party to use the space. You may be able to get a feel for lease rates in your area on www.loopnet.com.
A quick rule of thumb to verify whether or not your lease is at or close to market rates is by using a “cap rate.” If you know the approximate value of your property, take 6% times the value of your property. The result should generally reflect what “base” rent you should be paying. Please understand the proper percentage to use in such a calculation will vary by market and over time. “Cap rate” means capitalization rate. To use a cap rate, you divide the net income of the property (total rent less building expenses) by the cap rate—this should roughly correspond with the value of your building—basically the inverse math of starting with the value of the real estate and multiplying it times the cap rate. It doesn’t have to be perfect, and you may even want to pay extra rent above market rates-consult your CPA.
[Sidenote: Even though you’re “paying yourself,” consider putting a written lease in place, even if it’s very basic.]
Cash Flow Adjustments—Scenario 1: Leasing your real estate to the buyer of the business.
Scenario: Your business has Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) of $500,000. You own your business property in an LLC and estimate its value at $2,500,000. A survey of properties in the area supports that belief.
| Simplified Business P&L | Estimated Market Rent |
| Sales | $4,000,000 | Assumed Building Value | $2,500,000 | |
| Implied Market Base Rent
($2,500,000 X .06 = $150,000) |
$150,000
6% Cap Rate |
|||
| Rent Paid | 100,000 | Rent compared to market
(100,000 rent -150,000 market rent = (50,000) underpaid rent) |
$ (50,000) | |
| + Interest
+ Depreciation |
100,000
50,000 |
Cap rates are applied to the net income of the real estate. This example assumes the business is paying the taxes, insurance and maintenance already, making the base rent effectively the net income of the real estate. | ||
| + Other Costs
= Total Costs |
3,400,000
3,650,000 |
|||
| = Net Income | 350,000 | |||
| + Interest & Depreciation | 150,000 | |||
| = EBITDA | 500,000 | |||
| +Adjustment for Rent
= Adjusted EBITDA |
(50,000)
450,000 |
|||
| Assumed Business Value at 4X EBITDA | $1,800,000 |
In the above scenario, at a cap rate of 6%, it’s estimated that annual rent currently paid of $100,000 is $50,000 less than estimate market rent of $150,000 (.06 X $2,500,000 = $150,000 market rent estimate). Both the business and the real estate have to support their economic value independent of each other.
If you’re leasing the building yourself/your LLC, you will likely want to lease it at the market rate of $150,000/year + TIM (Taxes, Insurance, Maintenance). This raises the businesses expenses by $50,000/yr, dropping EBITDA and the business value, but supports the real estate value more properly.
| EBITDA | $500,000 |
| + Adjustment for Rent | (50,000) |
| = Adjusted EBITDA | 450,000 |
| Assumed Business Value at 4x EBITDA | $1,800,000 |
Cash Flow Adjustments—Scenario 2: Selling your real estate to the buyer of the business.
The adjustments here are essentially the same. The real estate itself has to support the economic value of the real estate.
The combined value is $2,500,000 (Business) + $1,800,000 (Real estate) = $4,300,000.
$2,500,000 for the real estate AND $2,000,000 for the business = $4,500,000. Essentially, the buyer is paying an extra $200,000 for a cash flow stream that doesn’t really exist in the business—because it is needed to properly support the value of the real estate.
An important note to understand on the “Net Income” of the real estate above is that it assumes ALL Taxes, Insurance, and Maintenance (TIM) are paid out of the business. If those things are only paid from the real estate owner without charging them to the business, then those expenses would have to be deducted from the business EBITDA as well so you can then charge them to the business as a tenant under the new ownership.
For example, if the real estate entity paid $50,000 in Taxes, Insurance, and Maintenance and you want the buyer of the business to pay those things out of the business, which you likely will in a true “triple net” lease where the tenant pays building expenses, then the adjustment to EBITDA is really $100,000 in adjustments: $50,000 for the rent increase and $50,000 for the TIM (if the business wasn’t paying TIM previously).
$500,000 – $100,000 = $400,000 in EBITDA X 4 = $1,600,000 in business value. If TIM is already paid by the business, this is not an issue.
So, which is better, sell or lease to the buyer of the business?
It’s not a simple answer. For you personally:
- What are your preferences? Do you want to be a landlord and continue to earn the income, or would you rather receive a lump sum for the real estate as well?
- What are the potential extraordinary expenses of the building the tenant may not be responsible for under the lease such as roofing, structural concerns, etc.
- Tax considerations?
And as it relates to selling your business:
- Buyers often have a preference to own the real estate they operate in
- Banks prefer it when real estate is involved.
- Real estate may improve financing terms for the buyer (a longer term on the loan at lower interest rate).
- You may be able to negotiate a higher price for the business.
- Despite scenario 2, above, having the real estate packed up with the business can muddy the cash flow water a little bit in terms of the buyer’s tolerances for a higher overall price. The real estate is perceived as a more tangible, less risky investment and improves financing terms, i.e., they might accept a little lower return on Investment on the real estate which can add value to the business side of the deal.
Our recommendations:
- Assess if you are paying market rent and consider making an adjustment.
- Have your business pay the Taxes Insurance and Maintenance on the building; we find this is beneficial in the debate over rent, expenses and how a lease should work for the buyer.
- Be flexible about how real estate will be included in the deal. Generally, it’s best to package the business and the real estate together. If you are really committed to owning the real estate, but a buyer on great deal wants the real estate too, consider a 1031 Exchange—the buyer gets the real estate and you roll the proceeds into another property so you don’t take a tax hit on the sale of the real estate, and still enjoy lease income.
NOTE: Nothing herein should be construed as tax or legal advice. It is educational based on what we have experienced and observed in transactions. Please consult the appropriate tax and legal advisors.
Don Beezley is President of Proforma Partners, LLC and a Business Certified Appraiser (BCA) with over three decades of M&A, banking, and business operations experience.