Owning business real estate is a common and often effective strategy for small business owners. Owners buy for many reasons, like control of a strategic location, a hedge against rising rents or a diversification of income and assets. Some look ahead to post-transition and plan to lease the business real estate to a buyer and secure an income- generating asset.
The success stories of business owners buying their property are plentiful, but there are risks of being long on business real estate. Business real estate plans unravel when neighborhoods change, real estate prices decline or ownership costs (repairs and maintenance) explode. Real estate diversification puts you in the real estate business and that may be one that you don’t know as well as your own. Remember that real estate investments may not be as attractive as they seem. Real estate that doubles over 15 years is earning less than a 5 percent annual return. You may be better off putting more money into your core business rather than putting it into real estate.
If you do go forward with exploring a business real estate purchase, keep the following in mind:
Know where to start the process
Before you start, consider the following questions about your current leasing situation:
- Are you in a long-term lease that would expose you to penalties if you were to break it?
- Can you sublease your space, so you can avoid lease break fees?
- Do you have a short, remaining lease term, so that you could transition to another property if you were to buy one?
- If your new property acquisition will occur after your current lease ends, check for a provision in your lease called "holdover.” Holdover outlines your ability to remain in the space after the lease expires and specifies the rental rate if you do so. It will usually be priced at a premium to your current rent.
- Do you have the opportunity to purchase the space you are currently leasing?
- Will making a move from your current location hurt your revenue stream and/or cost structure?
- Will a new location be convenient for your employees? If not, how would employee loss and replacement affect your business?
If buying is right for you, communicating early with your landlord usually provides more options and retains a positive landlord relationship through termination.
Evaluating property considerations
Every business is different, but most should consider:
- Do you operate a business that relies on high-traffic? Is your business a destination point in itself? Do customers coming to your business plan ahead to make that visit, possibly even scheduling appointments.
- Do customers visit your place of operation? Or, is most of your business done through ecommerce?
Locations with higher traffic also have higher prices. If you operate a business that doesn’t rely on traffic, paying a premium for location may be a waste of funds.
Qualities to look for in a space
Here are a few traits that business owners watch in evaluating a property:
- Industrial/warehouse property—Ceiling heights, truck/tractor-trailer access, number of bays, floor bearing capacity, proximity to major roadways, railways, airports, etc.
- Retail property—Visibility, signage, ease of access, higher-traffic counts, complementary businesses in the area, stability of businesses in the area, parking sufficiency, etc.
- Office property—Similar considerations as retail, but with less emphasis on being in a high-traffic area, depending on the nature of the business. Visits to accountants, attorneys, doctors, etc., are not impulse visits. They needn't be in high-traffic locations.
Assembling your team
As you move forward, seek the guidance of knowledgeable advisers:
- Real estate counsel—Early in the process, well before you execute a purchase contract, you should engage real estate counsel. Real estate legal considerations are highly specialized, so it’s crucial that you have an expert real estate attorney in your corner. The real estate attorney will assist you with everything from how the property should be held, to ensuring you’re not exposed to various liabilities.
- Buyer's representative—Navigating the world of commercial real estate and finding the right property can be daunting. A commercial real estate agent holding a property listing has a fiduciary responsibility to the seller, not you. You need to have someone on your team who is knowledgeable about the market and can advise you on the merits of a property.
- Accountant—Your accountant should be able to evaluate the financial benefits and risks of owning versus leasing and guide you in evaluating the financially feasibility of a purchase.
- Banker—Your banker should be familiar with all elements of a purchase. Your banker can assess your capacity for debt to finance the transaction.
Conducting due diligence
Your real estate purchase contract should have a “due diligence” period that enables you to perform inspections and examinations of the property including generating:
- An appraisal report to help determine whether the purchase price is fair.
- An environmental report to assess the likelihood that the property has environmental issues. You need to uncover any issues in advance so you can consider them in your purchase price and negotiation over responsibility for remediation or cleanup.
- A property conditions report finds any deferred maintenance or systems deficiencies in need of repair. Consider those items in the price for the property, deduct repair costs from the sales price or have the seller fix them before the sale is completed.
Don’t skip due diligence. Lenders will require it as part of securing financing. If you don’t finance the transaction, you will still want to protect your hard-earned cash and equity from risk for problems that may crop up later!
Financing guidelines vary according to the type of real estate purchased but generally require:
- A loan to value and a loan to cost that are at or below 80 percent.
- A debt-service-coverage ratio of at least 1.25 times.
- A successful history of business operations.
- Personal loan guarantees supported by good personal credit for the owner(s).
Don’t go it alone. Put your best advisors to work in deciding whether to own or lease your business real estate.