Owning a building your company operates is a big deal. After all, businesses need an address to conduct transactions. Someone has to pay the rent. Why shouldn’t that someone be you?
Generally it works like this. A suitable location is identified and purchase negotiations commence. Owner-occupied loans originate from the Small Business Administration. By the way, banks love this. You may wonder. Under the SBA 504 program, the bank will only finance him 50% of the purchase price. The other half consists of a 40% government second trust deed and a 10% down payment. Lender risk is minimized and isolated by the Fed’s involvement.
From a buyer’s perspective, you can own it for just 10% plus points and closing costs. If the resulting mortgage payment (called debt service in commercial purchases) is close to market rent, you are rich!
Don’t forget the tax savings. If properly structured, the owner entity leases the building to the business. Rent is paid by the tenant to the owner. The bank debt is paid by the owner. bingo! Depreciation of building improvements over 39 years allows for tax relief. The cost of running the property is deducted from the rent. Remember, real estate appreciates over time.
Residents (your company), on the other hand, enjoy stable payments and are protected from fluctuations in market interest rates. It’s a beautiful arrangement.
I have many family owned manufacturers and distributors whose real estate value far exceeds the value of the companies that live there. You may be wondering, how is this possible? Let’s look at an example.
First, let’s talk about real estate.
Let’s say your company needed a 50,000 square foot building. An investment of about $4 million was typical when purchased between 2000 and 2010. At the time, interest rates were slightly higher than they are now. You can get a 30 year fixed mortgage at around 6.25% and a 10 year government bond weighs between 4% and 4.5%. In contrast, today’s rates look very good!
But in 2005, if you financed 90% of a $4 million acquisition at 6%, your payments were $27,031 per month. Add in monthly property taxes of $3,300, insurance of $750, and miscellaneous expenses of $1,000 for a total of $32,081.
Divided by square feet, the cost was 65 cents per square foot. Today, its rental price is $2. Even if you set up your company of tenants with a 3% annual rent increase, your current rent would be $53,025, or just over $1 per square foot. So, thanks to a smart move in 2005, your company has benefited from below-market rents for his 17 years. Presumably, this delta allowed the operation to work profitably.
Now let’s pivot to company values.
Recall that the value of a business is the multiple of the profit generated. Sometimes this profit is given a fancy formula called EBITDA or EBIDA and is further defined by Investopedia as follows:
“EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, is a measure of a company’s overall financial performance and is used in some circumstances as a proxy for net income. , is misleading as it does not reflect the cost of capital investments such as equipment, etc. This measure also excludes liability-related costs by adding interest costs and taxes to earnings. Nonetheless, it is a more accurate measure of company performance because it shows earnings before they are affected by accounting and financial deductions.”
Therefore, a company paying rent in an owner-occupied scenario would underestimate the cost of the building by almost half. Remember, you’re paying $1 per square foot versus $2 market rent. If a company’s profit reflects the market value, it will have less profit and EBIDTA will likewise devalue the company.
On the commercial real estate front, rents have far outpaced the 3% annual rate increase. Today, the 50,000-square-foot building (if it can be found) would be his $22 million range. That’s a whopping 450% increase in 17 years.
Next week, we’ll discuss the conundrum created by this imbalance.
Allen C. Buchanan (SIOR) is a Principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at his [email protected] or 714.564.7104.