Business Sold, Retain Real Estate?

The Background:
I provide location advice to owners and occupants of industrial real estate in Southern California. Frequently, this advice results in a company buying a building to occupy. With prices at historic lows and cheap financing, this in many cases can result in a "rental" rate cheaper than a market rental rate. The "rental rate" I am referencing is the debt service achieved when applying the purchase price financed at today's low interest rates. When an ownership structure involves the owners of the business that will occupy the real estate...a terrific union is formed. The "company" pays the rent (debt service), and the owners benefit from the appreciation, depreciation, and stability of facility costs. What happens if the owner decides to sell the company (tenant)? Should the real estate be retained?

The Misconception:
When the owner of the company and the occupant of the real estate are identical...but defined by entity...the owner of the real estate controls the decisions of the tenant...length of lease, annual increases in rent, tenant improvements considered, etc. When an owner of a company decides to sell the company (tenant) and retain ownership of the real estate some misconceptions occur.
The new tenant will run the business the same as the original owner
The new tenant will decide to stay in the real estate for many years
The new tenant will pay rent in a timely manner
The new tenant will care for the real estate the same way as the original "tenant"
While owning real estate and the company that occupies the real estate may prove to be a sound financial decision, owning real estate while not owning the company may not be as sound. As an example, I encountered a closely held company that purchased a 50,000 square foot building for their use. The company occupied the building for eight years until the owners decided to sell the company. The owners retained the real estate and signed a five year "leaseback" with the new owners of the company. The owners of the real estate enjoyed a nice cash flow for five years. At the end of the five years, however, the company decided to vacate the building and relocate to a facilty in another state. The owner of the real estate was now forced to compete with other owners of 50,000 square foot buildings...in many cases better capitalized...to secure a new tenant. The owner could not secure a tenant and the owner was forced to sell the building in an undesirable dip in the real estate cycle.

The Solution:
We advise many owners in this situation to sell the building as a leased investment upon the execution of the new lease to an owner whose core assets fit the criteria. We then suggest reinvesting the proceeds through a tax deferred exchange into an asset class with less risk...IE a multi tenant project OR simply paying the tax on the proceeds and investing in a non-real estate asset.

When is Commercial Real Estate a BAD Investment?

When risk outweighs return. Our neighbor has a tidy portfolio of single and multi tenant properties. The good news? Single tenant buildings are easy to manage - one tenant, one rent check. Multi-tenant - such as an apartment building or strip center don’t crush your cash flow if someone bolts - but you have several rent checks to chase. For our neighbor to eliminate her management and convert to single tenant - a risk greater than her tolerance, ensues. Thus her balanced portfolio. Think of single tenant assets as a share of stock and multi-tenant as a share of a mutual fund.
 
Good for business. We recently represented a family owned construction company. The company found its origins in the 1950s in a part of town that was booming. Owning the location from whence the business resided was a solid plan. Flash forward. A decision was made, by the next generation, to shutter the enterprise. Boom in the 1950’s was replaced by blight in this decade. Consequently, with no occupant to pay rent to the family - the construction company was closed - and little upside - selling and redeploying sale proceeds became the direction. Therefore, an investment good for the business evolved into one less favorable years later.
 
Metrics are skewed. Replacement costs, rent, capitalization rate and return, sustainability of the income stream, and exit plan are ALL considered by most investors of commercial real estate. Should one of these measures of an income property’s value need alignment a future problem may arise. As examples. If you buy a Starbuck’s location and pay $1000 per square foot for a building go that can be replaced for half that amount - your basis is artificially inflated. So long as Starbuck’s stays current, no harm. But if folks start brewing coffee at home and store sales wane - you see where I’m going. Finally, investors focus on a return on their money. If a check is written to acquire the asset then the return is the cap rate. Easy. Layer in some debt and the answer is a bit more complex. Simply. If the capitalization rate exceeds the interest rate on your mortgage - positive leverage occurs. This is magical - as the return on your invested down payment now is greater than the overall cap. Clearly the opposite occurs when a borrowing rate eclipses said capitalization.
 
Tax laws change. When Ronald Reagan was President. Yes. I was around the industry then. But I digress. At the end of 1986 - a tectonic shift happened with our Federal tax laws. Lower marginal rates of taxation were swapped by eliminating certain write-offs. I believe our present depreciation rules - 39 years - were examples. Real estate bought with certain tax shelters in mind were no longer great investments.
 
Improvements are specialized. We toured a building last week with a client. Our occupant processes food but does so in an ambient environment - no specialized freezers or coolers are required. The vacancy we walked was complete with tons of cooler space. Our premise was some of the cooler infrastructure would translate to our use. For those who need these special purpose goodies - rent is not an object. As the cost to create them is astronomical. But for those who don’t - which is a much greater universe of tenants - they won’t pay for the extras.
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.

Location Advice for Transitioning Companies

Recently, I described several changes that occur during the life of a family operated business - specifically, manufacturing and logistics interests. These outfits are owned by your neighbors next door and employ millions around the United States. To review - a transition could be; acquiring a competitor, the death of a matriarch, exponential growth, loss of a key customer, sale of the operating unit via stock or asset purchase, or a move out-of-state. Sadly, it could also be the end of the road because of a changing market.

 This week alone - I met with three such companies. Yep! All experiencing a change. Below is the commercial real estate advice I gave them. You see - whenever a transition occurs - a commercial real estate requirement soon follows.

 Better returns out-of-state. In 2014 a family owned aerospace tooling entity was sold and the real estate that housed the company retained. A couple of years later, it was time to sell the buildings. Concern was - the new owner of the business ran the day-to-day differently. Could the rent be replaced if the group bolted? Sale of the real estate and the purchase of three investments through a tax deferred exchange quickly followed. Then, as 2020 dawned, a decision to sell was made on one of three 2016 buys. After all, activity was robust, pricing was at an all time high, and belief was - higher returns and reduced taxes could be garnered out of California. Meanwhile, all of the partners had vacated the Golden State. In addition, there was uncertainty with near term roll over of half the tenancy. And if that wasn’t enough - after launching in February and just in time to receive a great offer - the Novel Coronavirus ravaged the national economy! The buyer paused and then cancelled. After the buyer exited - due to the uncertainty - guidance was sought on which direction was best. We were able to provide clarity, create best in class collateral, and re-launch the offering. Closing happened on time! The net proceeds of the sale allowed a 1031 tax deferred exchange into properties in tax friendly states and with a greater overall return and reduction of risk. The last of the four upleg purchases closed this week.

 Structuring for the future. Maybe one of my favorite stories of owner occupied commercial real estate enjoyed a new chapter this week. Two of my dear manufacturing clients purchased their business home in 1995. In the ensuing twenty-five years exponential appreciation has occurred. By their admission - the address is worth three times the value of the business it houses. Finally, a suitor for the company has gained favor. A sale of the assets may occur soon. The terms and conditions of the leaseback are critical. Potential investors for their real estate holdings will look at the lease rate in comparison to market, the length of the lease, and the maintenance expected of the owner. Even if there is no interest in spinning the parcel today - these issues need discussion.

 Everyone is agreeable - until they aren’t. One of my clients was approached by his neighbor. They struck a handshake deal. Unfortunately - the agreed upon rate, term of lease, and extension rights don’t provide my client with a lot of latitude. He’s bound to dealing with the expanding neighbor if he wants or has to sell - at a pre-determined price and time.

 Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.

 

Is Your Building Ownership a Mirror Image?

Commercial real estate ownership is a beautiful thing! What other investment can you own and experience the tax advantages of depreciation, passive income treatment, and capital gains - all while the asset is appreciating.

If you own a business that occupies your commercial real estate - even better! Now, you have the occupant (tenant) paying you (landlord) rent. I’ve witnessed this structure numerous times over the years - and it works the majority of the time.

Today’s column is centered around those few occasions when the structure hits a snag.

First a bit of background:

Common among commercial real estate ownership is an entity known as an LLC - Limited Liability Company. An LLC may have one or a number of “members” each with a percentage of the stake. The LLC owns and operates the real estate - collects rent, pays the bills, is registered with the state, and files a tax return. Generally the taxes owed are passed down to the members via a K-1. Great!

Common among operating business ownership is the corporation - generally a C or S Corp. Each have different rules of taxation - which is a topic for another day. Suffice to say this entity pays rent to the building ownership - LLC. Cool!

Here’s where things can get dicey.

The LLC and Corporation have different owners. More than once recently we’ve seen this. What starts as an LLC with members whose ownership percentages mirror the shares of the business corporation can morph over time. In one extreme example - we had a building ownership comprised of a church, an ex-wife, two of the original owner’s children, a non-profit, and a former health care taker. By the way - initially the LLC had one member - the proprietor of the company! Death of the original owner caused all manner of chaos - as you can imagine. The result? An eviction of the business and a forced sale of the real estate. Ugly!

The operating business changes hands. With the spate of merger and acquisition activity these days - this is quite common. Typically, the company is acquired, a lease is struck with the LLC and things proceed. Over time however, a disconnect can occur - a smaller footprint is needed, sales decline, expensive improvements are required, the business goes bust. All easy when the building and business are identical twins. Not so easy when the twins are fraternal.

The commercial real estate is sold. No problem if you’re happy to fork over close to half the gain the commercial real estate has enjoyed. Sell it and pay Uncle Sam and Cousin Gavin. Done! If, however, the LLC chooses to defer the gain through the use of a 1031 tax deferred exchange - the LLC - all of the members - must be in lock step. What if an LLC member wants to take his cash and move to Cabo? A complicated buyout must follow. We’ve witnessed what’s called a “swap and drop” in these instances. Simply, the LLC is disbanded and replaced with a Tenants in Common vesting. Now the “tenants” - upon the sale - can self direct their percentage of the sale proceeds. In practice, this is much more complex. Please seek tax and legal counsel before employing this strategy!

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.com.

Six Tough Commercial Real Estate Conversations - Cooperation Can Help!

Cooperation is a reality in commercial real estate deals. Meaning - a buyer and seller or landlord and tenant - must reach an agreement. Simple. But there are other layers of cooperation which factor in - the professionals representing each side - brokers, lawyers, lenders, CPAs, and the like. All must genuflect at the alter of a deal for it to close. Generally, the level of cooperation is enhanced when the advisors do their jobs. That is - conduct the tough conversations which should precede any transaction. Indulge me while I describe a few of my favorites.

The disruption of a move. Sure. Moving to save a few dollars may seem like a good idea. But, a move is expensive! Once physical moving expenses, the potential loss of key employees, downtime, fixturization of the new facility, and customer confusion are weighed - are you really saving? Have you considered things such as internet speed, a new phone number, website changes to reflect the new address, revised marketing collateral? Add any sort of complexity to the use with which you utilize the building and a costly use permit may be needed. Someone must consider the true cost of a move before you wander into the market.

Taxes, taxes, taxes. Uncle Sam, the state of California, and the Affordable Care Act will all want a major taste of your sale proceeds. The time to understand the impact is before you plant that “for sale” sign. Easy math. You can plan on approximately 40% of your gain to be consumed by taxes. Whaaaat? That’s correct. A tax professional can run the numbers for your specific situation. Sure. You can employ certain tax deferral strategies - a 1031 tax deferred exchange, a charitable remainder trust, or an installment sale - but all come with complexities which should be fully vetted.

Market realities. Small business owners that buy or lease commercial real estate are smart. They read. They listen to their customers. They’re informed. In today’s market - unrealistic owners get crushed. The halcyon days of crazy asking prices, waves of buyer interest, and feeding frenzies have vanished like La Niña. Sure. Deals are transacting - but, at a more normal pace.

Condition of the building. During the go-go days of 2016 and 2017 - a buyer would overlook repair necessities such as the roof, air conditioning, paving or exterior condition. Not anymore. We recommend a pre-sale inspection to identity any issues and an assigning a cost estimate. Even if you opt to wait on the fixes - you know what they will run.

Limited availabilities. The weird thing is demand still exceeds supply - there are fewer buildings on the market than buyers. What’s changed since last year? Buyers are proceeding more cautiously, offers well below asking prices are the norm, and market times have increased.

Complete information. Access to scaled drawings, an office layout, a building inspection highlighting the condition and needed repairs, a current title report, copies of leases, expenses, maintenance contracts, and utility bills - all can hasten the timing of a transaction. Buyers will ask. Have them ready.

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.com.