We have often spoken about the importance of keeping any real estate connected to your business in another entity so that you have more options when you’re looking at an exit. In this article we’re going to take a closer look at the interactions between those entities.
It’s Hard to Buy Early On
When businesses are young, there’s not a lot of free cash to spend on acquiring the real estate associated with the business. Also, sometimes the first location is a “good enough” location as opposed to an ideal one, and that young business may very well outgrow that original space. In the early years, many business owners are reasonably just concerned with making the rent, not in being a landlord too.
If You Can, Buy
Once a business has matured and there’s capital and a willing seller, a business owner should almost always consider buying the real estate associated with his/her primary business.
The simplest advantage is the changing of a liability — rent you are paying to a landlord — into income into another business entity you own. You’ve taken money that was going out the door to someone else and redirected it into a door that you are benefitting from.
More importantly, when it comes time to sell, you have two businesses to sell, creating more options for how a transaction can happen.
That said, things continue to shift in the new world of work post-pandemic, and businesses are continuing to evaluate how much office space makes sense for their operations. This is yet another thing to consider.
Charge Appropriate Rent
Now, if you are your own landlord, there’s a fair amount of flexibility that you now have. But you must wield that flexibility wisely.
Scenario 1: Undercharge
A business owner may want to, for whatever reason, take more money out of his primary business, so he/she fixes a rent that covers the mortgage for the real estate business, but is below market rates for his primary business. This creates a number of problems:
- A future valuation of the business will have to take into account the true market rent
- The real estate business is not benefitting as much as it could
- A buyer will wonder what other irregularities are under the hood
Undercharging your business rent when you are the landlord may be a good short-term solution for various personal reasons, but it’s clearly a poor long-term solution.
Scenario 2: Charge Aggressively
Part of owning the real estate business is creating another vehicle with its own tax advantages. As such, you may want to “stress” your primary business a bit in order to reach some goals in your real estate business.
This doesn’t have to be anything extravagant. It could be something like 10% above market prices. Or it could be as high as 25-30% above market prices. You can choose an amount that makes sense for your own goals.
But, to make sure that you have the best price for your primary business, you will want to ramp that price down to market rates 12-24 months before selling it. This will maximize seller discretionary earnings (SDE) and the valuation of your business.
Many of our brokers have real estate licenses precisely because we often have to deal with transactions that have real estate attached. Give us a call to see how we can help you prepare for a future transaction.