Many business owners aren’t sure what options are available to handle their business real estate when they sell their company. It is important to understand the value of the real estate and the tax liabilities associated with it. It's also important to consider your goals as the owner of the property — immediate liquidity or retaining the rental income for some period of time going forward.
Real Estate Valuation
If you own the real estate in a separate entity, you have a clearer path to valuation. Any revenues or costs associated with the real estate are recorded on a separate income statement, thus making it easier to value the building/land separately from the business.
On the other hand, if your company owns the real estate, additional diligence is required to delineate which expenses and/or revenues should be considered separate from the business. Prior to a business sale, it is important to get a third-party appraisal of the real estate so all parties have an understanding of value. Also, if you are a C-Corp and your company owns the real estate, then your real estate will be taxed differently. You should consult with your tax advisor to understand these implications.
A general proxy when valuing real estate is to apply a capitalization rate to market rent. For example, if you pay $200K/year in rent and you apply a 10% cap rate, then you’re pegging your real estate value at $2M ($200,000/10%). Know that cap rates vary based on location, building type and condition.
Options of Leasing vs. Selling
Like all real estate transactions, you have the option to sell or lease the building. Selling provides immediate liquidity while leasing your facility provides a longer stream of income, plus all the upside of selling the real estate down the road. Some buyers prefer to purchase the real estate with the business and others elect to enter into a long-term lease. If you want to sell the real estate and the buyer prefers a lease (many buyers do not want the hassle of real estate assets), another option is to sell the real estate to a third-party who will hold the lease with the business. You get liquidity and the buyer doesn’t have to worry about a real estate investment — win-win.
It’s important to consider lease rates when your business transaction occurs. If you have plans to retain the building and lease it to the new owner of your business, you need to have a strong lease in place. You may not have had a detailed lease in place when you were the owner of both the real estate and business and any real estate expense or repair was easily run through the company. With a new business owner in place, you’ll want a strong lease to delineate responsibility for the property as landlord. Don’t forget that, at some point, you’ll want to sell the property and the better the lease is the easier it is to find a real estate investor and get a great price. If you offer a below-market lease rate, a real estate investor will value the property lower based on the lower-than-market income that it generates.
Alternately, if your business paid a higher-than-market rental rate during your business ownership, it may be advantageous to offer a 'market’ rate to the new business owner and take an add-back to EBITDA (earnings before interest, taxes, depreciation and amortization) so that you get credit for the lower rental rate going forward. As you are likely getting paid on a multiple of EBITDA, a reduction of $100k in annual rental expense going forward gets multiplied by 4, 5, 6 — whatever your valuation multiple is — resulting in a valuation that can be $400k, $500k, $600k higher — in this example.
Early Planning is Key
Give thought to your goals for the real estate whenever you start discussing a business sale. There are a lot of variables that can affect your decision — tax liabilities, generation of income — and if you are adamant that your real estate must sell at the same time as your business, you’ll want to have that outlined from the beginning with your investment banker. This way your business sale can be packaged appropriately and potential owners understand the ultimate goal for the real estate. You don’t want to be stuck at the eleventh hour trying to renegotiate a transaction to include purchase of real estate. It’s not a 48-hour turnaround request — there are appraisals, environmental reports and other analysis that are done which can take a month or more to complete.
Recognize that you have a number of options from 1) selling or leasing to the buyer of your business, 2) selling or leasing to a third party or 3) holding on to the real estate and selling down the road. Plan ahead to identify which of these options provides the most value to you and ultimately achieves the goals you desire in a transaction.