When Commercial Real Estate Values Eclipse the Business Value
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As mentioned previously in this space - many business owners in SoCal have opted to own the premises from which they ply their trade. We refer to this as owner-occupied. Benefits of this structure are plentiful - tax advantages, appreciation, and facility cost stability - to name a few. The other alternative for an operation is to lease their business home. They become a tenant and the monthly rent they pay is sent to an unrelated landlord. Today, I’ll focus on owner occupied real estate.
In both circumstances, if properly nurtured and managed, the enterprise value grows. It’s quite common for that plastic injection molding operation or your neighbor who’s company tools aerospace parts to be worth several million dollars. I should mention here - the business valuation appreciates independently of the real estate’s worth. Sales generated by the company - top line revenue - is apportioned to account for expenses such as employees, raw materials, plant and equipment, etc. Resulting is a measurement called EBITDA - earnings before interest, taxes, depreciation, and amortization. Multiplied by the industry norm is this net figure. Generated is an estimate of valuation. There you go. I’ve just simplified the role of an investment banker into one paragraph. In practice, the process is much more complicated - but you get the idea.
Now, let’s dissect the ways in which commercial real estate becomes pricier. When considering a parcel of commercial real estate, we look at three metrics - income approach, comparable sales, and replacement cost.
Let’s start with the easy one first - replacement cost. You’ll need some land. Curbs, gutters, storm drains, maybe some demolition, and loss due to street widening are called off-sites. An architect will charge you to design, engineer, and process your new build through the city. A contractor will quote construction. Money may be borrowed which adds a layer of expense. Finally, to compare with an existing structure - depreciation is deducted. Now you properly have estimated replacement cost.
Comparable sales are a great gauge of commercial real estate value - normally. These simply view the market in the rear view mirror. In our over-heated industrial playground - if only the reverse is considered and not where the puck is going - you’ll miss a big chunk of equity. Therefore, in addition to COMPS, please contemplate what’s available and what those alternatives portend.
Finally, the most complex - Income approach. Regardless of the commercial real estate genre - apartments, industrial, office, retail, raw agricultural land - ALL can generate a dollar amount per month - rent. The amount and associated risk of said rent form a valuation labyrinth. Let’s say that manufacturing facility which bears your company’s name pays your LLC $12.00 per year in rent. Coupled with a risk defined return of 4.5% would suggest a value of $266 per square foot. Easy.
As you’ve gathered, two buckets of wealth are created - company plus brick and mortar. What’s uncanny today? How far the values of business homes have exceeded the company’s worth. This week I witnessed an example - six fold! Both figures were accurate as the owner recently paid a consultant to value the operation and we received an unsolicited offer to purchase his real estate.
Ok, so what? You may be wondering. It’s all paper until I’m a seller. That, dear readers is the topic for next week. So, stay tuned.
So, there they are - my 2022 predictions. Stay tuned this time next year to see how I did.
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.