Businesses often use real estate that is owned by the business, directly or indirectly.
When it comes time to sell the business, for any reason, several choices emerge:
Sell the business with the real estate?
Sell the business and
keep the real estate?
Sell the business and sell the real estate separately?
The short answer? Every situation is different —
the rule of thumb, unfortunately, is that there is no rule of thumb. (Not very helpful, I know.)
So how does one decide what to do?
First, some important basics.
Conceptually, a business’s value or price is the current value of a future sum of the stream of expected cash flows given a specified rate of return. Simply put, that means that those cash flows are discounted to today based on the market cost of capital for that business. That market cost, conceptually, is the risk-free rate, (e.g., two-year treasuries) plus some sort of equity premium.
The size of the premium depends on the expected variability of the cash flows; that variability, in turn, is tied to business size, industry, etc. The premium is also a function of how public companies in your industry are evaluated.
When the business and building are sold together, that building is treated like just another piece of business equipment and not valued distinct from the business.
Academic research has shown that the returns from owning real estate are roughly similar to a 50/50 blend of stocks and bonds. The returns are less volatile so the cash flows from ownership are typically discounted in the market at a lower rate, resulting in a lower cost of capital for real estate than for a business.
Life insurance companies in particular like real estate, because they would rather earn a good return once over a 10 to 15 year period (or so), than try to earn a better return but have to do it several times in a row. As a result,
real estate with the same cash flows as a business will typically sell for a higher price (just as bond prices go up when interest rates go down). Many in commercial real estate think that along with local market conditions, variation in value is best explained by changes in the 5- and 10-year Treasury rates.
So, Real estate with a tenant is a different kind of asset than a business.
The market for real estate can also change for reasons different than the market for your business. That’s because the value of the real estate will vary based on which type of use will command the highest price, something that is very dependent on the immediate market surrounding your building.
For example, one client of mine operated out of a complex of inner-city buildings they owned. The location offered quick service times to their city customers. But when it came time to sell the business, the real estate was sold separately. That’s because the highest and best use for the property was as an apartment building. That client sold the real estate to an investor that will tear down the buildings and put up housing.
Sometimes the value goes the other way. During the Great Recession, many manufacturing buildings in small towns in the Midwest were leveled and sold as farmland.
Overall, it is quite conceivable that selling the real estate separate from the business can create more value for the owner of both.
That said, there are still good reasons to own the real estate a business uses. Just as you found value in owning both, so might the buyer of your business.
Controlling your own destiny — at least the real estate piece — might be one of them. My client in the example above was in a service/rental type of business, one that was easy and cheap to move. If you are in a manufacturing business, on the other hand, removing and re-installing equipment is expensive and ownership might make sense. (Would anyone really build an oil refinery on leased land? Would any landowner want an oil refinery as a tenant?)
Remember as well that the buyer of your business may be in a very different situation than you. The buyer may want to move your operation into his physical location — because he has space, because there are synergies to be realized, and so forth. In fact, the buyer of that service business had suburban facilities with excess capacity, and they moved the business into those buildings.
Perhaps, your current set of customers are in different locations than when the business started and a different location closer to these customers is better, closer to raw materials, labor supply, and more. In short, the buyer of your business will likely be facing a somewhat different set of circumstances than your business faces today.
So, what to do when selling a business that owns the real estate it uses? Two suggestions:
#1. Be prepared before the business sale process starts.
Have the real estate appraised. What is its highest and best use? What is a true market rent? What is the building worth to an investor with your buyer as tenant paying a market rent?
Have valuations done on your business. First, as if the real estate is included with the business. Second, as if the real estate is
not and the buyer pays market rent.
Also, think about whether you, the business owner, would like to be in the real estate business after the business sale. For many business owners, such as public companies and private equity owned businesses, the likely answer is no. But if the business is owned by you personally, your family or a small set of investors, the answer may be different.
Know going into the business sale process the pluses and minuses of retaining ownership of the real estate.
#2. Fine tune your assessment after the business sale starts.
As you narrow the list of potential buyers, start looking at their businesses and see if there are implications for the real estate.
Have they bought other businesses before and have they ever bought the real estate along with it? Do they own the real estate for their own facilities? Do they have excess capacity and want to put your products or services inside their existing facilities? Are there a lot of financial or institutional prospective buyers who likely don’t want to invest in real estate?
At some point in the business sale process, it will become clear that just a handful of possibilities are feasible. At that time, you can gather more detailed information, do more analysis, and so forth. For example, if the likely winning bidder doesn’t want to own the real estate, think through whether or not you want to continue holding it. If not, how will you sell it and what type of price might you get, given the likely lease arrangements?
Conclusions
When it comes to selling a business, whether or not any business-owned real estate is included as part of the transaction will depend – on the seller’s circumstances, the buyer’s circumstances, and the real estate market itself.
Make sure to take the considerations detailed above into account before and while moving forward.
