As we have noted in prior perspectives, there are many things to consider when buying a business. One item that does not always get the attention it deserves is the real estate of the business. First, you must know if the business owns or leases the property and understand the pros, cons, and valuation impacts to each scenario. Second, assuming the business leases its property, you need to understand the type of lease it is contractually tied to and its terms.
Lease vs. Own
Owning property as a business owner is not the same value proposition as owning a home personally. There are pros and cons to owning that need to be fully weighed before deciding how to structure a transaction for a business. 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 hopefully an appreciating asset. Owning the property also gives you flexibility in customizing the space, and potentially expanding it without having to get approval from the landlord.
The downside to owning is it requires additional equity capital associated with an asset which has a lower IRR than the business, and thereby, lowers the overall IRR of the investment. When selling the business 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 for the business. 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 building/area 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. The negatives of leasing are the landlord my not want to renew the lease or can escalate the rent, thereby making renewal cost prohibitive and forcing the business to relocate when it does not want to. Moving a business is challenging, costly, and comes with many headaches.
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. The lessee pays the agreed upon rent and nothing more. Everything is included within the monthly rent, outside of the lessee’s customary obligations to maintain the leased premises. Base monthly rent under a Gross lease is typically higher than base rent under a Triple Net Lease, as all landlord costs and expenses are included.
A Triple Net Lease requires the lessee to not only pay the base rent, but also its proportionate share of the real estate taxes, building insurance, and basic repairs and maintenance to the building. Because the lessee is paying separately for the costs and expenses incurred by the lessor, the lessee generally pays less in monthly base rent than in a Gross lease.
The last and most onerous type of lease is the Absolute Triple Net Lease. This type of 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. For example, if the building foundations, driveways, sewer lines, or roof deteriorate and needs to be replaced, these costs become the responsibility of the lessee. The lessee has the responsibility of an owner, but without the benefits of ownership. This type of lease is very common with property that has related party ownership with the business or has gone through a sale-leaseback transaction, both situations where the terms of the lease are generally more favorable to the lessor.
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 key 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 that have longer-term provisions.
Tenant Improvement Funds. These are funds given to the lessee to improve or potentially fully build out the space in a desired fashion. Typically, this will increase the value of the space for the lessor so they should be amenable to most changes. These funds are usually given at the renewal or start of a lease and will include new carpet, paint, and office buildouts.
Indemnification. This 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 own debate. In general, many buyers prefer to rent versus own, and it creates a cleaner transaction.