By Maurie Cashman
There are several considerations when buying business real estate. In this case the real estate I am talking about is the real estate you are leasing (or could lease) to house your business. I recently completed an analysis on such a situation and came up with a solid â€œthat dependsâ€. Yes, I know you attorneys who know me and are reading this are guffawing at this!
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, Joeâ€™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.
My answer was, of course, that depends:
Return on Investment
The business was generating very strong cash flow and the returns on investment were high. Normally I would have counseled looking at the opportunity cost of investing in the real estate vs. investing more in the business. However, since this was a service business, the investments that must be made are mainly in human resources and so the new ownership could likely grow the business with minimal capital outlay, so in this case, this was not a huge concern.
However, the return on investment on commercial property is largely dependent on the future value of the property. This is much less certain and risk tolerance must be taken into account. Jason was also asking considerably more for the real estate than the appraised value, which would have significant impacts on the ROI and the ability of Joe to finance the property. At the right price, the ROI was attractive however.
Finally, it may be a very attractive time to invest in real estate. Interest rates are low and can be locked in for significant time-frames. And the ability to borrow against the equity may be important in some unforeseen future scenario. It will take time to build equity in a leveraged property however.
None of us likes to pay taxes. In this case, buying the real estate and being able to deduct depreciation from the ownerâ€™s taxes could be an advantage. Since Joe would be buying the building from Jason, it could have a strong impact on Joeâ€™s taxes. If Joe were to buy the building himself and lease it to the operating business he would be able to extract cash from the operating business with paying FICA taxes and have deductions to offset part of the income on his personal taxes. The IRS is increasingly scrutinizing these transactions however.
Next week we will look at some additional considerations and possible alternatives to consider.