You are reading this on Super Bowl Sunday. A celebration of a very long National Football League season that culminates in the clash of the remaining titans – in this case, our native Rams and rival Bengals. Enjoy the guac!
Two weeks ago, I discussed the circumstances in which commercial real estate housing a business becomes far more valuable than its resident.
Why is that important, right? It’s paper until you’re a salesperson. Now is the time to continue the conversation.
Going to sell creates two difficult challenges for owner-occupied commercial real estate: increased operating expenses and “what do we do with the money?” »
Increase in expenses
Occupants of commercial real estate typically purchase their commercial homes for very different reasons than investors who are limited to cash generation. By this I mean that the business is at the center of our concerns and that every effort is made to increase the value of the business.
The appreciation that occurs from this address is strictly circumstantial benefit. The focus is on machinery, equipment and employees which all generate revenue and in many cases provide a better return on the business owner’s investment.
Ask most landlords and they’ll say, “we bought our building for our operation.” Of course, collecting rent from the occupying company is an investment, but in many cases this payment is subsidized by the building owner.
What we’ve experienced locally is that the operation hangs on and produces its product or service — machined parts, injection molded widgets, or storage and logistics for customers. Hopefully the sales will increase and the value of the business will improve. Remember, this value is a math problem that deducts expenses from income to form a net figure. A multiple applied and voila! Business value.
Meanwhile, our real estate simultaneously becomes more valuable. Market conditions are changing, rents are rising, capital is getting cheaper, investor appetites are voracious, supply contracts, demand for space are increasing and exploding.
So if we look at how commercial real estate appreciates (increase in comparable market value, replacement cost, or via increased rents and squeezed cap rates) – it allows the occupier to pay less that the market rent actually devalues the premises.
Let’s take a look at a quick example.
Suppose the rent paid by the company is $8.40 per year. Market rent is $12 per year. If our return is 4%, the resulting values are $210 per square foot with the subsidy and $300 if the rental rate reflects the market. On a 100,000 square foot box, that’s $9 million!
But to raise the $9 million and sell the building with our business inside, that suggests our resident has to bear the additional rent costs of $3.60 per year or $360,000. Reduced is our company’s bottom line.
What do we do with the money? If – and this is a big if – a landlord’s operation can swallow a large rent increase, the following problem arises.
So, I saddle up my group with the $12 lease and take this unsolicited investor offer at $30 million (from above, 100,000 square feet at $300 per square foot). After all, the interested party will allow the company to remain in place, we avoid a costly move and I pocket 30 million dollars. Easy!
Hmm, don’t forget. You will pay a little dowry for this gain. In some cases, up to 45%! Certainly, we can resort to tax deferral through a 1031 exchange, Delaware Statutory Trust, or partial exchange. But in the end – you trade the heck you know – your business is housed, they pay you monthly, and you control the operation for the heck you don’t – another leased parcel of commercial real estate.
Many business owners choose to say “thank you for the free assessment, but we’re not sellers”.
Allen C. Buchanan, SIOR, is a principal at Lee & Associates Commercial Real Estate Services in Orange. He can be reached at email@example.com or 714.564.7104.