Buying Business Owned Real Estate: Why Office Condominium Or Retail Storefront Ownership Is Quite Often Not A Good Idea
BATTLECALL GUEST EXPERT: Robert J. Abalos, Esq., InvestingInLand.com
There is a growing trend for companies to own their own business related real estate, for example, office condominium ownership for lawyers, accountants, and other professionals or storefront retail space for sales firms selling specialty products like plumbing fixtures or computer equipment. Many businesses have traditionally owned their own real estate, such as manufacturers who have owned factories or real estate development companies that own land as inventory for future projects. But the notion that has been gaining a great deal of traction today in a variety of white collar endeavors is that it makes sense to own real estate used in a trade or business. Lease payments, so the logic goes, are making some other landlord rich so why not own the office a business is run out of or the storefront retail space acting as a showroom and make yourself rich instead?
I have quite a few problems with this trend, not because I think real estate ownership is bad, but because many business owners considering this idea are not realizing a number of negative effects such a program can have on their operating company. In some cases, these business owners are sacrificing profit margins and market share of their operating and cash flow generating lines to hopefully earn future potential real estate appreciation profits. They can also be messing up their income statements and balance sheets that can further damage a business and its competitive prospects in their industry.
Real Estate Ownership as Business
The logic of owning your own place of business is compelling. Why pay rent to a landlord? Buy your own workplace. Earn a profit not just on the operations of your company but also on the real estate it can own.
The problem with this line of thought is that most companies are not in the real estate business. If you sell kitchen fixtures out of a rented showroom, your focus is on selling fixtures, not managing real estate. One very common mistake budding real estate entrepreneurs make in this area is that they buy too much space for their business, in other words, they need an office now so they buy two in order to have space to grow into later. This means carrying debt and monthly obligations far in excess of what is currently needed or quite honestly in rental payments to a lessor for the very same space.
Most business owners are good at what they do and not so good at other things. I trust a tailor to hem my pants but I'm not so sure I would ask them to draft a triple net lease. Owing business real estate is not like owning a home, even if it is a rental property. It is much more complex and especially capital intensive. Landlords make repairs for tenants. Owners need to handle them on their own and often these matters are extremely complex in shared ownership situations. Ever replace the HVAC in an office condominium complex?
The bottom line for anyone considering buying real estate used in their trade or business is that they are no longer in their operating business alone. They are in the real estate business too, and many are not prepared for the increased financial and logistical burdens of being a landlord, even if it is to their own business. Most people think that real estate ownership and management are simple tasks requiring just a few hours a month. They are wrong. It is a complex undertaking that demands preparation and financially planning far in advance of any individual purchase. Client and employee liability is just one of many considerations that often do not receive adequate thought prior to investment. If you own the office and someone is hurt or injured there, your real estate investment makes a nice target for attachment by a lawyer and also increases your individual responsibility far beyond merely operating a business out of a rented location. Where your landlord previously shared some of the risk and blame towards injury, you are liable as both owner and operator if you own the space and run your business from it.
If you are busy running one business, your own, think of running two at the same time. That may not be very appealing for some.
Real Estate and the Impact on Business Operations
Most growing businesses need to focus more on increasing profit margins and boosting market share than buying investment real estate. In an increasingly competitive world, losing focus on the what makes your business a success while you chase real estate riches is a recipe for trouble.
Prosperous and rapidly growing businesses need to keep their available cash, working capital, and credit lines open for operations expansion. If something should be acquired it makes more sense for it to be a competing firm than some real estate. This is because real estate is not viewed as an asset by most bankers and venture capital types. Real estate owned is an obligation, mostly a series of debt expenses that must be serviced each month, everything from mortgage payments to condo fees to repair and maintenance costs, and therefore not an asset as the way the purchasing business owner thinks it might be.
More than one business owner has found themselves to be real estate rich and cash poor. The problem is that most business management is oriented towards short term goal planning, for example, increasing market share in the next quarter. Real estate appreciation is a benefit far removed into the future. The tradeoff therefore is sacrificing short term and necessary goals which build a business for long term gains which currently drain a business.
The best business model for young and rapidly growing businesses is to think lean and mean and focus on growing earnings by seizing market share from competitors and boosting profit margins to raise profitability. Real estate ownership has no place in that business model.
Real Estate Ownership on Financial Statements
Owning real estate dramatically obscures the true financial picture of a company when viewed from its balance sheet and income statement. This underscores the problems described above on how bankers and financiers view company owned properties.
When real estate is owned by a business, a number of factors impact the balance sheet. First, more debt is visible making it appear the business is more highly leveraged than is true. It is hard for the balance sheet to distinguish operational debt from real estate debt. Second, real estate owned is reflected at original cost due to accounting conventions on this subject and that fact alone will understate the actual equity of the business. In other words, a liability will be fully stated but the corresponding equity will not. Third, if depreciation deductions are taken on the owned real estate, the difference between actual equity and remaining debt become even more pronounced.
Similar effects occur on the company's income statement. All the operating expenses of real estate ownership are subtracted from the operating gains of the business. Again, depreciation is a major issue since a dollar of depreciation "loss" is not the same as a dollar of net income received on sales. It is a common sense rule of thumb that it is cheaper to lease office or factory space than buy it and maintain it. Therefore ownership of this space will distort the income statement and make it appear a company is less profitable than it really is since more expenses will be reported and each will be higher at that.
These accounting statement impacts are crucial when applying for lines of credit or other business loans. Often business owners believe that owning the real estate used in their operations strengthens their financial status when in most cases quite the opposite is true. In a business real estate purchase necessary capital has been deployed away from the operations side of a business, where it can usually earn the highest rates of return, towards a slower growing, less profitable, and ultimately voracious consumer of capital that will eat after tax profits in good times and bad.
Business Real Estate Decisions
Owning an office condo or a factory or a storefront may seem like a good investment but is it?
First, it means locking yourself into one location. Are you sure it is a good one for your clients, customers, and employees? Are you sure it will remain such for a long time to come? This is crucial since if the location no longer works for your firm it may not work for anyone else when it comes time to sell your office condo or storefront.
Is the space too large or too small for your current needs? Few people would lease a space too large for their company in the hope of growing into it. The same logic should apply when buying business real estate although one of the persistent sales pitches in this area is that you can buy space you'll need tomorrow at today's prices. It is very easy to move from one rented space to another, larger or smaller, whatever the needs of a business require but it is difficult to sell real estate or sometimes lease fractions of what is owned.
Is the space being purchased new or old? Has the building been wired for modern technology and energy efficiency or is it in need of modernization? The prime consideration here other than cost is inconvenience. It is hard to run a business from a construction zone. Many older buildings are being converted to office condominium use and the buyers of these units need to know that current landlords are shifting future but ultimately necessary rehab costs to them.
Are all the expenses of ownership being factored into the investment decision? Many business owners simply concentrate on their current lease payment versus their projected mortgage payment without considering a host of new added monthly obligations that were previously paid by their landlord. Such items include janitorial and cleaning services for the building inside and out, utility bills on common areas, property taxes and other business assessments, snow removal, landscaping, elevator and escalator maintenance, trash pickup, and many others. As I said earlier, owning business real estate means running a real estate business, even if the tenant of your real estate is really your own business.
Will a new location work for your business? Many businesses work fine out of one rented location and their owners consider moving to another purchased one. Think intangibles for employees, clients, and customers and such things as parking, public transportation, restaurants, and quality of life issues. I recently saw an office condominium building advertised that was near a fire station. Fire trucks have sirens, very loud ones. I'm not so sure that most law offices would do well in that location.
The Bottom Line
The best candidates for business real estate ownership are stable, mature firms with lots of excess free cash flow. These firms do not do much growing but instead just plod along generating cash like a cow does milk. These types of companies know how much office or retail space they need so buying the precise amount is easy. Management of these firms tends to be complacent and thinks all the growing that needs to be done has been done. Firms like this make ideal takeover targets, by the way, and the first thing that is usually sold is the company owned real estate.
New and rapidly growing firms need to keep their financial houses in order and their powder dry. Instead of buying real estate they should lease cheaper work space, avoid debt, and work on building their finances not by investing in real estate equity but by capturing market share and boosting profit margins.
Buying business real estate will have many negative effects on a growing business, since taking on a high proportion of debt to total business equity will make a business more heavily leveraged than it really might appear. The balance sheet and income statement will inevitably suffer, making borrowing for operational capital and expansion more difficult.
It should always be noted that owning real estate for most people and businesses is NOT an asset but a liability. Rental real estate that produces an income is an asset, everything else, including individual home ownership, is viewed as a liability by bankers and others who loan money. To quote the old Wall Street expression, assets feed you and liabilities bleed you. Owning your own office condo means your business now has a liability due each month whether you work or not, whether you have clients or customers, regardless of the season. It means being married to a specific building and location rather than just dating one through a lease.
Buying business real estate is one of the most tricky and difficult decisions any business owner will ever make. It will have a profound effect on any operating firm and supreme caution is advised. For most businesses it makes little sense and so many others go into this decision chasing real estate profits while ignoring the bottom line of the company that will pay the mortgage every month.
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