What To Do With Real Estate Related To A Selling Business

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By Dan Weinmann,
Managing Director

When a business owner decides to sell their Company, an important decision must be made regarding real estate owned in the business or by a related entity. Selling business owners typically face three options:

  1. Sell the real estate as part of business transaction;
  2. Consummate a real estate sale with a third party real estate investor unassociated with the business transaction (Sale-Leaseback); or
  3. Maintain ownership of the real estate and enter into a lease with acquirer of the business (Buyer)

Whether a business owner decides to sell the real estate at the time of their business sale depends on several factors:

  • Is the business owner a real estate investor outside of the owner-occupied property associated with their business?
  • Can a non-owner occupied (investment real estate) mortgage be secured at acceptable interest rates and loan terms if the real estate is retained?
  • Do market conditions make it favorable to sell the property now or wait if the market is depressed?
  • Does the Buyer have a preference or aversion to buying the real estate?
  • What is the Seller’s investment horizon?

The Seller’s risk assessment and risk appetite are important initial considerations. If a Seller determines to divest the real estate with the business transaction, they may reallocate and diversify the proceeds into new market-based investments that may be more suitable, since the real estate asset may make up a larger allocation of their net worth than appropriate. Diversification is preferred by many Sellers as the perceived risk increases after they cease to have full control over the business which is usually the single tenant. Being reliant upon a single tenant, where business failure or facility migration may initiate an unknown period without lease revenue (depending on the lease or ability to secure a new tenant), may exceed a Seller’s risk appetite. Additionally, the value of the building at the time of the business transaction may be one of the highest because the Seller can use the business transaction to extract favorable lease terms or values from the business buyer, and the original lease term is generally the longest at the point of the original signing of the lease - which generally leads to a higher value.

Sellers preferring to maintain ownership of the real estate must consider the ability to procure a mortgage with interest rates and terms that may be different than an owner-occupied mortgage. If a Seller reduces their ownership in the business below 50%, the real estate generally becomes an “investment property”, and may be subject to higher interest rates and more restrictive terms, and some banks don’t offer those mortgages.  Owner-occupied mortgages typically feature lower interest rates and more favorable terms (length of amortization, loan to value, etc.).

Sellers must determine whether market timing is optimal. Oftentimes, simultaneously selling the business and real estate is the most advantageous time to sell because a new longer-term lease can be negotiated as part of the business transaction. Even if the business buyer is not purchasing the real estate, the new lease that is negotiated during the business transaction can provide a third party sale-leaseback investor group with a longer lease with which to value the real estate.  Because a longer lease term provides more certain and longer cashflows, banks will give these real estate buyers longer amortization (and sometimes higher loan to value) for their mortgages in order to purchase the real estate. Higher low-cost leverage and better cashflow due to the longer terms, allow real estate buyers to pay more for a building because the bank leverage increases their equity returns.  Since the lease term will probably never be longer than when the lease is originally signed, this may be the best opportunity for an owner to sell its real estate.

Inversely, if a Seller determines that the timing is not yielding the desired value, they may opt to keep the property and collect rental income or sell to a third party in the future. This scenario presents potential risks to future value because lease terms and future cash flows, which Real Estate Investors use to generate values, may not align with financing secured to purchase the property. Most lease extensions are not as long as the original lease, which may make longer-term financing more challenging for a future buyer.  Market timing must be considered in conjunction with the financing options that may be available currently that would also influence value.

A third-party sale-leaseback arrangement, which can be arranged by a commercial realtor, investment banker, or, sometimes the business buyer, can represent the best opportunity if the business buyer is not open to buying the real estate themselves. A sale-leaseback is a real estate transaction consummated with an unrelated third-party (real estate investor), preferably concurrently with the business transaction. The real estate investor enters into a lease agreement with the new tenant (business buyer). A real estate investor can maximize the value received by the Seller, and both of the transactions are completed for the Seller. The real estate investor benefits from the favorable terms (discussed previously) negotiated into the new lease, and the business buyer has an agreeable lease and is not required to own real estate, as may be their preference.

Deciding between a real estate sale or lease/own arrangement may depend on the Seller’s investment horizon. The Seller must determine whether they would maintain the investment long enough to realize an advantageous return over an acceptable time period versus an immediate sale with reinvestment of the proceeds. Shorter to intermediate-term investment horizons typically provide an advantageous return if the real estate is sold concurrently with the business. Sellers must also consider the liquidity of real estate compared to other market-based forms of investments as it relates to their risk profile and retirement income needs.

Common to every transaction, tax consequences should be considered carefully. If the real estate is sold at the time of the transaction, the Seller will likely incur tax at the capital gains rate, which is currently at 20% federal. Additionally, the Seller can reinvest the post-tax gain into other assets immediately. Inversely, if real estate ownership is maintained and leased to the Buyer, rental income is treated as ordinary income, and the tax rate is currently around 40% (highest income tax rate for individuals is 39.6%), with no deduction for principal payments on mortgages.

The investment horizon and tax consequences are best demonstrated in the example below with the following assumptions:

First, calculate total net proceeds if the Seller chooses to divest the real estate concurrently with the business. In this example, the net after tax and debt proceeds are $500 thousand if the property is sold for $2.0 million with capital gains tax treatment, a state income tax rate of five percent, and $1.0 million remaining on the existing mortgage.

Alternatively, if the real estate is held post-transaction and leased to the Buyer using a triple net lease (tenant agrees to pay all real estate taxes, building insurance and maintenance expense), the Seller will receive cash flow after tax and mortgage payments of approximately $27k annually.

From the two calculations above, the estimated payback period of the net proceeds can be compared for an immediate real estate sale versus the lease model by dividing the real estate sale proceeds by the annual rental net cash flow, which is illustrated below:

As illustrated above, the Seller would break even on cashflow after 18.5 years. Reinvesting sale proceeds at a 4-5% conservative market return would extend the payback period to well more than 20 years on a.  Of course, holding real estate indefinitely can return a higher overall value, so long as the real estate continues to appreciate. Otherwise, selling is still generally the best financial conclusion over the short and intermediate term.

The decision to sell or maintain and lease real estate after a business sale can be complicated depending on the Seller’s financial goals, investment risk tolerances and timeframes, and post-transaction roles in the business. However, careful analysis of the above considerations and input from trusted advisors can help a Seller determine the optimal course of action for real estate in a business transaction.

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