Business Values - Part Deaux
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You’re reading this on Super Bowl Sunday. A celebration of a very long National Football League season that climaxes with the clash of the remaining titans - in this case our hometown Rams and rival Bengals. Enjoy the guac!
Two weeks ago, we discussed the circumstances under which a piece of commercial real estate housing a business becomes significantly more valuable than it’s resident. If you missed the column - you can quickly catch up here.
Follow the link below to view the article.
When Property Eclipses Business Inside
Mentioned was - so what? It’s all paper until I’m a seller. Today, it’s time to continue the conversation.
Becoming a seller creates two tough challenges for owner-occupied commercial real estate - increased expense to the operation and “what do we do with the money”?
Increased expense. Occupants of commercial real estate generally purchase their business homes for very different reasons than investors who strictly look at the cash production. By this I mean, the businessis the focus - and all efforts are made to enhance the enterprise’s value. Appreciation that occurs with the address is strictly a circumstantial benefit. Emphasis is placed upon machinery, equipment, and employees which drive revenue and in many cases provide a greater return on the company owner’s investment. Ask most proprietors and they’ll tell you - we purchased our building for our operation. Sure, collected is rent from the occupying company - an investment - but in many cases this payment is subsidized by the building owner.
What we’ve experienced locally is the operation clips along and produces its product or service - machine tooled parts, injection molded widgets, or storage and logistics for customers. Hopefully, sales increase and the enterprise’s worth is enhanced. Recall, this worth is a math problem that deducts expenses from revenue to form a net figure. A multiple applied and voila! Enterprise value.
Meanwhile, our real estate becomes more valuable simultaneously. Market conditions change, rent increases, capital becomes cheaper, investor appetites are voracious, supply contracts, demand for space increases and boom. So, if we look at the way commercial real estate appreciates (increase in comparable market value, replacement cost, or through a bump in rent and compressed cap rates) - by allowing the occupant to pay less than market rent actually devalues the premises.
Let’s take a look at a quick example. Assume rent paid by the enterprise is $8.40 per year. Market rent is $12.00 per year. If our return is 4%, the resulting values are $210 per square foot with the subsidy and $300 if the lease rate reflected market. On a 100,000 square foot box - that’s $9,000,000! But to reap the $9,000,000 and sell the building with our company inside suggests our resident must bear the added rent expense of $3.60 per year or $360,000. Reduced is the bottom line of our company. Unless an owner is exiting, reluctance in hopping an enterprise expense is assuaged.
What do we do with the money? If - and it’s a big if, an owner’s operation can swallow a big jump in rent, the next issue arises. Ok. I saddle my group with the $12.00 lease and take that unsolicited investor offer at $30,000,000 (from above, 100,000 square feet at $300 per square foot). After all, the interested party will allow the company to stay put, we avoid a costly move - and I pocket $30,000,000. Easy! Hmmm. Don’t forget. You’ll pay a bit of dowry for that gain. In some cases, up to 45%! Certainly, we can employ some tax deferral through a 1031 exchange, a Delaware Statutory Trust, or a partial exchange. But in the end - you’re trading the devil you know - your company is housed, they pay you each month, and you control the operation for the devil you don’t - another leased parcel of commercial real estate.
Many business owner opt to say “thanks for the free appraisal - but we’re not sellers.
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at email@example.com or 714.564.7104. His website is allencbuchanan.blogspot.com.