Business Buyers Will Always Check For This… It Could Be Costly
Blog Series 2 of 6
Author: Mark Mroczkowski
Buyers consider many things when looking to acquire a business, and real estate is an essential factor. Buyers first consider whether the company owns or leases the property and seeks to understand each’s pros, cons, and valuation impacts.
Lease vs. Own
Owning property as a business owner is not the same value proposition as owning a home. There are pros and cons to owning that need to be thoroughly weighed before deciding how to structure a business transaction. The positives are simple: you have more collateral to support the borrowing capacity of the business, and as you pay down the mortgage, you build equity value in what you hope is an appreciating asset. Owning the property also gives you flexibility in customizing the space and potentially expanding it without landlord approvals.
The downside to owning is that it requires additional equity capital to acquire an asset that produces a lower IRR than the business, thereby lowering the overall rate of return on the total investment. When selling the company in the future, the next buyer may not want to purchase the real estate. The business could have out-grown the current space, or the location may be inconvenient or unattractive to the labor pool required by the company. All these factors need to be evaluated when considering owning real estate.
Leasing a facility comes with its own set of positives and negatives. As a lessee, the business is not necessarily tied to its facility long-term and has the option to renew its lease or move to a newer location better suited for its needs. Additionally, the business has limited liability for capital expenditures associated with the normal aging and wear and tear associated with an older property. Leasing’s negative aspects are that the landlord may not renew the lease or escalate the rent, thereby making renewal cost-prohibitive and forcing the business into an unwanted relocation. Moving a business is challenging, disruptive, and costly.
Types of Leases
There are three main types of leases: Non-Triple Net (or Gross), Triple Net, and Absolute Triple Net.
The Non-Triple Net (or Gross) Lease is a lease agreement between the lessee and lessor where all costs and expenses of the lease are included in the monthly base rent.
A Triple Net Lease requires the lessee to pay the base rent and its proportionate share of the real estate taxes, building insurance, and basic repairs and maintenance to the building.
The Absolute Triple Net Lease has the same stipulations as the Triple Net, except the lessee is responsible for virtually all structural repairs to the building and surrounding property. The lessee has the responsibility of an owner but without the benefits of ownership.
Terms of Leases
Whether a buyer is assuming a lease as part of a transaction or renegotiating the lease terms at the expiration, there are six essential items to consider.
Annual Increases. Understand the magnitude and timing of any increases to rent. Look for comparable market terms in the area.
Taxes. Understand the assessment of the property and verify the business is not paying an overburdened tax bill.
Common Area Maintenance (“CAM”). These charges typically include costs to maintain the building like landscaping, snow removal, janitorial services, common area utility costs, and general repairs to the building shared by all the tenants. However, a lessor may include additional items into this category, such as cost-sharing on roof repair and replacement, HVAC systems, capital improvements, lighting, plumbing, or electrical wiring.
Expiration and Renewal. Understand when the lease ends and how it will affect the business. If the business needs flexibility, it should look for a short-term lease. If the business needs a guarantee of longevity in the building, then look for renewals with longer-term provisions.
Tenant Improvement Funds. These are funds given to the lessee to improve or potentially fully build out space in the desired fashion. Typically, this will increase the value of the lessor’s space, so they should be amenable to most changes. These funds are usually given at the renewal or start of a lease and include new carpet, paint, and office buildouts.
Indemnification. This provision is required before acquiring a company that leases the building from a related party. The seller of the business (or related party) needs to indemnify the buyer from any material problems with the building or property.
There are many factors to consider in the lease versus ownership debate. Many buyers prefer to rent instead of owning real estate because it creates a less complicated transaction.