Property owners in selling mood face expenses vs. profits – Orange County Register

You’re reading this on Super Bowl Sunday. A celebration of a very long National Football League season that climaxes with the clash of the remaining titans — in this case, our hometown Rams and rival Bengals. Enjoy the guac!

Two weeks ago, I discussed the circumstances under which a piece of commercial real estate housing a business becomes significantly more valuable than its resident.

Why does this matter, right? It’s all paper until you’re a seller. Today, it’s time to continue the conversation.

Becoming a seller creates two tough challenges for owner-occupied commercial real estate — increased expense to the operation and “what do we do with the money?”

Increased expense

Occupants of commercial real estate generally purchase their business homes for very different reasons than investors who strictly look at cash production. By this I mean, the business is the focus and all efforts are made to enhance the enterprise’s value.

Appreciation that occurs from that address is strictly a circumstantial benefit. The emphasis is placed on machinery, equipment and employees which all drive revenue, and in many cases, provide a greater return on the company owner’s investment.

Ask most proprietors and they’ll tell you, “we purchased our building for our operation.” Sure, 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 the operation clips along and produces its product or service — machine-tooled parts, injection-molded widgets or storage and logistics for customers. Hopefully, sales increase and the enterprise’s worth is enhanced. Recall, this worth is a math problem that deducts expenses from revenue to form a net figure. A multiple applied and voila! Enterprise value.

Meanwhile, our real estate becomes more valuable simultaneously. Market conditions change, rent increases, capital becomes cheaper, investor appetites are voracious, supply contracts, demand for space increases and boom.

So, if we look at the way commercial real estate appreciates (increase in comparable market value, replacement cost, or through a bump in rent and compressed cap rates) — it allows the occupant to pay less than market rent actually devalues the premises.

Let’s take a look at a quick example.

Assume rent paid by the enterprise 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 lease rate reflected the market. On a 100,000 square foot box, that’s $9 million!

But to reap the $9 million and sell the building with our company inside suggests our resident must bear the added rent expense of $3.60 per year or $360,000. Reduced is the bottom line of our company.

What do we do with the money? If — and it’s a big if — an owner’s operation can swallow a big jump in rent, the next issue arises.

So, I saddle my group with the $12 lease and take that 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 stay put, we avoid a costly move and I pocket $30 million. Easy!

Hmmm, don’t forget. You’ll pay a bit of dowry for that gain. In some cases, up to 45%! Certainly, we can employ some tax deferral through a 1031 exchange, a Delaware Statutory Trust or a partial exchange. But in the end – you’re trading the devil you know – your company is housed, they pay you each month, and you control the operation for the devil you don’t – another leased parcel of commercial real estate.

Many business owners opt to say “thanks for the free appraisal but we’re not sellers.”

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104.

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