Considerations in Buying Business Real Estate (Part II)

By Maurie Cashman

Last week we began a discussion of considerations in buying real estate you are leasing for your business. Last week I described the following situation and we talked about some tax and return on investment analysis. Let’s review the situation and then look at a couple of additional considerations.

Joe had recently purchased his half of a business from his partner, Jason, and was beginning the sale of stock in the business to a key employee, Sandee. Joe and Jason had been partners for years and the business had grown steadily and was in very good financial condition. It was poised for more growth should the new ownership desired to head in that direction. The business was a service business and did not require much capital to grow on its current platform.

The real estate housing the business was fairly unique on a great location in a thriving community near a large metropolitan area. The real estate was owned by Jason, Joe’s former business partner. It had been appraised recently by a firm that I have dealt with in the past and Jason was asking considerably more than the appraisal. The terms of the business buyout involve a three year continuing relationship between the two former partners in order to insure a smooth transition. Jason has significant relationships with several important clients. My job was to advise the Joe on the advisability of buying the real estate from Jason, who was a motivated seller.

“Surplus wealth is a sacred trust which its possessor is bound to administer in his lifetime for the good of the community.”–Andrew Carnegie, Scottish-American industrialist, entrepreneur and philanthropist

Cash Flow

One of the key risks to buying any business property is the ongoing cash-flow required to generate the projected returns. This particularly property was nearly 100% occupied and had been by the same tenants for several years. However, if a main tenant, most likely Joe’s business moved out at some time in the future the tenant for a significant portion of the building may have to be replaced. This can be difficult given economic conditions or factors that may be out of the owner’s control, as in the regional impact of the 2008 flood in Eastern Iowa: “By 2013, downtown office vacancies will edge up from current levels of around 12 percent to about 15 percent for older buildings, and around 5 percent for newer Class-A office space.” An economic slowdown could have an impact of the cash flow of the business and its ability to pay the anticipated rental rate.

There may be ways to tie the lease amount to the performance of the business which could be considered, but these may be difficult as the real estate may have little to no effect on the performance of the business. In effect, you are mixing apples and oranges, but it is done.

Strategic Fit

This is probably the most important point to consider. Does the real estate fit with the strategic plan of the business? Several factors should be considered:

• Will the physical space meet the needs of a growing business? It may be just fine if growth will involve adding satellite offices in other geographies with the current site as either the hub or a significant business center. If expansion may require closer proximity to airports or customers, it may be better to invest in real estate in another area.
• Is the quality of life in the community such that it helps attract key employees who will be needed to grow the business or would another location give you an advantage?
• Does Joe have confidence that he can replace the business as a tenant at the same rate should he decide to move the business? Does Joe have the appetite to be a potentially absentee landlord?

What About Jason?

• Jason started the business and brought Joe in as a partner. There is a long-term relationship involved here that can cloud judgement, but at the same time, must be recognized and honored.
• Jason will have meaningful impact on the performance of the business for the next few years. What risk is involved if Jason becomes upset and dis-engages from the business?
• Jason has significant relationships in the industry. These relationship are critical to maintain.

Alternatives

• Joe may be able to postpone the decision by buying an option on the property, giving him time to sort out the strategic fit.
• Joe may be able to find an alternative buyer who would be friendly to the business and may allow him an option to buy after a period of time. There may also be a put or call option that could be negotiated.
• Joe may be able to negotiate a long-term lease with Jason that would make Jason comfortable continuing to own the real estate. However, don’t forget that Jason is a motivated seller and could sell to a less than desirable lessor.
• Joe may be able to purchase the property and negotiate an option to sell to a third party should he decide to vacate. I believe this is known in hockey circles as “the Hat Trick”.

Real estate is often touted as a great investment for tax purposes. My experience has been that the best decisions are made for strategic reasons and not for tax purposes. If faced with such a decision, please be sure to consult with qualified advisors who can help you reach the best conclusion.