Is your property worth more than your business? – Pasadena Star News
Owning the building your business operates from can be a great deal. After all, the business needs an address from which to transact. The rent has to be paid to someone. Why shouldn’t that someone be you?
It usually works like this. A suitable location is identified and negotiations for its purchase begin. Funding for homeowners comes from the Small Business Administration. Banks love it, BTW. Why, you might wonder? Under an SBA 504 program, banks lend only 50% of the purchase price. The other half is made up of a second 40% government trust deed and a 10% deposit. A lender’s risk is minimized and protected by Fed involvement.
From a buyer’s perspective, you own for a pittance – just 10% plus points and closing costs. If the resulting mortgage payment – called debt service in a commercial purchase – is close to market rent, you’re golden!
Don’t forget the tax advantages. If structured correctly, the owning entity leases the building to the company. The rent is paid by the occupant to the property. The bank debt is paid by the owner. Bingo! The amortization of the building fittings over 39 years provides tax relief. Expenses related to the operation of the property are deducted from the rent. And remember, real estate appreciates over time.
During this time, the resident – your company – enjoys a stable payment and is protected from fluctuations in market rates. It’s a nice arrangement.
I have many manufacturing and logistics providers owned and operated by a family whose real estate value far eclipses the value of the business that lives there. How is that possible, you might be wondering? Let me walk you through an example.
Let’s talk about real estate first.
Let’s say your business needed a 50,000 square foot building. If you purchased between 2000 and 2010, an investment of around $4 million was typical. Back then, interest rates were a bit higher than they are today. You could borrow a 30-year fixed home loan for around 6.25% and 10-year Treasury bills weighed between 4% and 4.5%. On the other hand, today’s rates look very good!
But in 2005, if you financed 90% of your $4 million acquisition at 6%, your payment was $27,031 per month. If we add $3,300 per month for property taxes, $750 for insurance, and $1,000 per month for miscellaneous expenses, your overall figure was $32,081.
If we divide that by square footage, your cost was 65 cents per square foot. Today, that rental figure is $2! Even if you establish the occupant, your business, with a lease that increases 3% per year, that rent today would be $53,025, or just over $1 per square foot. So, because of your smart move in 2005, your business enjoyed below-market rent for 17 years. Presumably, this delta allowed the operation to run profitably.
Now let’s move on to enterprise value.
Remember that the value of a company is a multiple of the profit generated. Sometimes this profit is given a fancy formula called EBITDA or EBIDA and defined more precisely this way by Investopedia:
“EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, is a measure of a company’s overall financial performance and is used as an alternative to net income in certain circumstances. EBITDA, however, can be misleading because it does not reflect the cost of capital investments such as property, plant and equipment.This measure also excludes expenses associated with debt by adding interest expense and taxes back to profits. a more accurate measure of business performance since it is able to show profits before the influence of accounting and financial deductions.
Thus, a business paying rent in an owner-occupied scenario would underestimate its construction expenses by almost half. Remember, he pays $1 a square foot against $2 market rent. When the profit of the company reflects a market amount, the profit is less and the EBIDTA suffers, which also reduces the value of the company.
On the commercial real estate front, values have largely eclipsed a 3% annual kicker in rents. Today, a 50,000 square foot building – if you can find one – would cost around $22 million. That’s a whopping 450% increase over 17 years!
Next week, I will describe the enigma created by this imbalance.
Allen C. Buchanan, SIOR, is a principal at Lee & Associates Commercial Real Estate Services in Orange. He can be reached at [email protected] or 714.564.7104.