What to do with your company’s real estate when preparing for a sale can pose a difficult question for some business owners. Should it be included in the transaction, or would you rather retain the property and generate rental income for a period of time? What is the value of the real estate and the tax liabilities associated with it? All of the above are fair questions that you may, and should, ask when preparing to sell your business.
Prior to deciding as to whether the real estate should be included in the transaction or retained for a period of time, you should determine what the property is worth.
If the real estate is owned by a separate entity, determining the valuation will be much easier. As the property is owned by a separate entity, all revenues and expenses should be recorded on that entity’s income statement. This will make it easier to value the building and/or land separate from the company you are trying to sell.
Additional work will be required if the company you are attempting to sell owns the real estate. If this is the case, it will be necessary to determine which revenue and expense items are separate from the company. As the owner you will want to engage a third-party real estate appraiser to determine the value of the property. You will also want to discuss how the real estate will be taxed with your tax advisor. Different entity structures come with different tax implications.
A general rule of thumb that can provide a starting point with valuation is to apply a capitalization (“cap”) rate to market rent. Let’s assume you pay $150,000 per year in rent and you apply a 7% cap rate. You are estimating that the real estate is valued around $2.1 million ($150,000/7%). It is important to remember that multiple factors, such as location and the building condition, will impact your cap rate. This is where a local real estate specialist can be of great value.
Once you know the fair market value of your real estate, it is time to consider selling as part of the transaction vs. retaining. Naturally, both options have pros and cons.
Including the real estate in the transaction provides immediate liquidity. However, retaining the property will result in rental income while you are the owner and the potential to benefit from any appreciation by the time you do decide to sell. It is worth mentioning that the final point concerning appreciation may not always play out as planned. As many people have learned the hard way, real estate prices do not always go up.
The buyer’s preferences should also be considered. Some buyers don’t want to own property and would prefer a lease. If they are forced to take the real estate, this could be a point of contention in the negotiations. If a situation arises where you want to sell the property, but the buyer doesn’t want it, then think outside the box for solutions. One possible outcome may be that you sell the property to a third-party who then leases the property back to the buyer. Win-win scenarios can usually be found with a bit of creative thinking on both sides of the table.
Should you decide to retain the building and lease to the buyer it is critical to have a strong lease agreement in place. If your business owned the real estate, it is probable that a detailed lease wasn’t in place as any expenses and repairs were easily run through the company. When the buyer takes over it is important to ensure it is clearly understood who is responsible for what expenses and what changes, if any, the buyer can make to the building.
When drafting the lease agreement with the buyer be sure a fair market rental rate is used. Offering a below market rate will likely cause a real estate investor to value the property lower when it eventually comes time to sell.
If your business was paying a higher than market rental rate you may be able to benefit by providing the new tenant a fair market rate. Providing a market rate could allow you to take an add-back to EBITDA. When the valuation multiple, typically applied to EBITDA, is multiplied by this additional amount from the add-back you may be pleased with the higher valuation. For example, a valuation multiple of 4.5x applied to an amount of $50K that is added back results in a $225,000 boost to the valuation!
If you follow our blog on any consistent basis, you know our team stresses the importance of early planning in any M&A scenario. This is for good reason. The earlier that you plan, the more scenarios you can consider and the better deal you will be able to structure. Last minute and hasty strategy discussions, whether concerning real estate or any other company asset, may result in good options being overlooked in an effort to get a deal done.
Real estate can be tricky in a transaction. In addition to determining a fair valuation, you must also consider environmental analysis and other analysis that may be required that can take one month or more. Early and thoughtful planning ensures that you maximize the value of your asset and reach a deal that is satisfactory to both parties.