Rainier Group | Real Estate Within the Business- Good or Bad Idea?
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Real Estate Within the Business- Good or Bad Idea?

Real Estate Within the Business- Good or Bad Idea?

The following is a look at the advantages and disadvantages of owning real estate within your business. Depending on the impact to you and your business, it might make sense to reallocate where assets are held.

Corporate Ownership

Advantages

1.Cost control: For most businesses, lease expenses increase over time, whereas ownership costs can be relatively stable. In essence, ownership provides long-term expense control.

2.Control over usage: Ownership allows the corporation to expand, reconfigure or dispose of the property as necessary. Changing business needs may be more easily accommodated without a requisite renegotiation of lease terms.

Disadvantages

1.Non-performing asset: Property ownership alone will not increase the cash flow to the business. Especially in the earlier years of ownership, debt service payments offset the absence of rental payments.

2.Increase in firm leverage: The increased debt required for the company to finance the project will increase the company’s debt-to-equity ratio in the near-term. Until such time as the principal on the debt is reduced, the higher debt-to-equity ratio will increase the cost of financing other capital projects. This limits the company’s overall financial flexibility.

Impact on Company Value

Most company valuations are based on multiples of earnings or cash flow rather than on the appraised value of the company’s assets. In other valuation approaches the appraised value of the company’s assets is but one factor used to determine the company’s value. Even when the property turns out to be a good economic investment that often does not translate to the company’s valuation numbers. In these situations, a fraction of the real property’s increasing value makes its way to the stock price.

Impact on Company Marketability

Financial buyers and public companies are interested in return on investment. Because company-owned real estate is usually a drag on most measures of return on investment these buyers are usually not interested in buying the real estate. At best this complicates the transaction by requiring the shareholders to get the real estate out before the company can be sold, at worst the company fetches a lower price than it otherwise would.

Personal Ownership

Advantages

1.Diversifies the shareholders’ assets: Investment real estate constitutes an asset class that provides current cash flow as well as long-term appreciation. For closely-held business owners whose wealth is dominated by their business ownership, real estate ownership creates more options to achieve personal financial security.

2.Creates a dependable income source.

3.Holding real estate personally makes a company more likely to be transferred as a stock sale rather than an asset sale. Stock sales create capital gain tax rates for you, while asset sales generate a combination of capital gain and ordinary income (and in some instances double taxation).

4.Removing the asset from the company’s balance sheet makes the company more marketable to a future buyer because all their money will be purchasing performing assets.

5.Separating the real estate from the business allows the buyer to expense all amounts spent to access the real estate (lease payments) without the limitations of depreciation schedules.

6. Often purchasing the property would appear to be a reasonable investment. There can be a significant potential increase in the shareholders’ personal net worth.

7.Shareholders have significant personal control over the use of the property, allowing them to set rental rates in the future that provide for their personal cash flow needs.

Disadvantages

1.Not easy to finance: A company may have an easier time borrowing against the real estate because it can pledge business assets. Individual shareholders’ may not have the same access to capital that is available through their businesses.

2.Adds to estate: Each owner’s proportional share of equity in the property will be included in their respective estates. Planning may be required to handle the purchase in a manner that does not conflict with the current goals for their estates.

Real Estate Entity

Rather than holding commercial real estate personally, many business owners form a separate business entity, often a Limited Liability Company (LLC). Holding the property in an LLC will not only provide a pass-through of income, it will also limit your personal legal liabilities. Additionally, divisibility of ownership is easier. New interests can be created to expand ownership without reducing control. For purposes of estate planning, divisibility will also facilitate minority discounts, and it will allow for equitable distributions of the asset’s economic value without requiring a sale.

Equalization

Holding the real estate separate from the business allows many to achieve better equalization among their heirs in their estate plans. Those heirs active in the business may receive business interests, while those not active in the business may receive commercial real estate.

Recommendations

·    Identify corporately-held properties that might be separated from the company.

·    Determine the cost of separation and steps required.

·    Perform analytic scenarios to show the relative advantages and disadvantages to the company and its shareholders.

·    Make a decision and implement.