Understanding Real Estate as a Financial Asset

Real estate plays an important role in any business. As a significant long term asset, real estate represents a major financial investment. Whether it is owned or leased, real estate is one of the largest fixed expenses for many businesses.

Unfortunately many owners do not give enough thought to the role that real estate plays in their business strategy. Whether your plan is to stand pat, buy, or sell, the financial management of real estate plays a significant part in that strategy.

But many owners do not understand how outside parties view real estate and the implications that may have financially and strategically. Many owners I speak with are surprised when they learn that a potential acquirer has no interest in buying real estate. Depending on your individual location, sometimes real estate can be valued as much as the existing businesses, if not more. For an owner who has acquired a multi-million dollar asset by allowing a business to pay off the note on the property over time, the idea that a multi-million dollar institution would not be interested in acquiring this asset seems outright strange.

There are a number of factors that preclude a larger organization from acquiring real estate in a transaction. In an industry that is rapidly consolidating, such as the collision industry, capital is scarce. In an industry where rapid growth is key to success, many large consolidators are not interested in investing in property. They are collision repair specialists, and the best use of the firm’s resources is in acquiring, building, and operating collision repair facilities. In other words, they have a core competency in collision repair and not property investment and management. Investing in property would distract the management team from doing their core job – building a successful collision repair business. Every dollar invested in real estate is a dollar the management team is unable to reinvest back into their existing business.

Additionally, many of the large consolidators are backed by some of the largest and most prolific private equity groups in the world. While the large private equity groups that have invested in the industry have access to what at times seems like infinite capital, the reality is they also face constraints on the allocation of capital. Even the largest most prolific firms like Blackstone and Carlyle have limited resources. Within those limited resources, they raise billions of dollars into individual funds with very specific investment and growth strategies. These investment strategies are often carefully designed to diversify specific risk to build an optimized portfolio of financial assets. In other words, the investment fund that invests in collision repair is separate and unique from the fund that invests in commercial property. The nuances and risk factors involved in collision repair are unique to collision repair and share little if any similarity with the risk factors associated in investing in real estate. Much for the same reasons that operationally a large consolidator does not invest in property, financially private equity groups also do not wish to mix investments in real assets with operating assets.

Property remains key part of any business. It has been an incredible wealth creating vehicle over many decades. For smaller business owners that are not constrained by managing an efficient portfolio of investments, real estate still provides many attractive investment features. Owning real estate makes a lot of sense for a lot of reasons. Large consolidators would actually prefer to negotiate a sale where the owner controls both the business and the real estate. But understanding the role real estate plays to other investors is critical to maximizing the value of that asset over time.

Perhaps the biggest area for improvement I encounter when speaking with owner about real estate is when a single legal entity owns both the property and the business. You’ll want to check with your tax and/or estate attorney, but in most situations it is strongly recommended that the legal structure between the business and the building is separate. From a risk mitigation standpoint, separate legal entities helps shield a business owner from a catastrophic loss that could potentially put both the business and real asset at risk. From a financial planning standpoint, separating out the assets and associated liabilities of such a large asset provides clarity into the actual operations of the business and allows for better forecasting and planning. If you are looking to grow, using finance to forecast and drive systematic growth is very important.

If you are contemplating a sale, however, separating out real from operating assets becomes even more important. A key reason that real estate should be held separately from operating assets in a business transaction is the simple fact that real estate and businesses are valued in very distinct ways. Aside from structural differences in valuation methods (cap rates vs discounted cash flows vs EBITDA multiples), real estate has a very different risk profile compared to an operating business. Thus, while a discounted cash flow model can be used to evaluate multiple assets, the inputs that go into driving the results (i.e. discount rates) are very different for real estate compared to a business.

Further complicating the transaction are unique tax issues depending on your specific situation.  Again, you will want to consult with a CPA specialized in business transactions, but if you are a C-Corp and the C-Corp also owns the building, real estate will be taxed differently than the business.  Due diligence is different for real estate as well, often requiring environmental exams and specialized third party appraisals. In short, attempting to value real estate in conjunction with a business only results less clarity around the value of the overall business.

These are just a few areas where including real estate in an overall transaction can quickly get complicated. We have not even begun to discuss how above or below market rent can impact the value of your business, sometimes by the millions of dollars. Or how to evaluate the option to lease your property back to the acquiring firm compared to selling the property to a third unrelated party. Real estate gets complicated quickly, and perhaps the most important thing to keep in mind is to plan ahead early and integrate your business strategy with your real estate strategy.

There is no one right answer to how to best manage real estate. But I am eager to hear from you what you think. If you would like to discuss this, or any topic in more depth please feel free to reach out to me via my contact page. I find strategy and finance truly fascinating and very much enjoy discussing.

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Until next week.