If you operate a small business, owning your location can make a great deal of sense. Generally, it looks like this—you form a Limited Liability Company to acquire the property and your business signs a lease with the LLC. In short, you pay rent to yourself. Brilliant!
Owning your real estate has a number of benefits. Real estate costs are fixed and the ‘tenant’ is under your control. The purchase is financed with fixed rate debt. The most common vehicles are SBA 504 & 7A loans, which allow the buyer to put as little as 10% down and pay a dirt-cheap interest rate of 2.69% as of January 2021. In addition to controlling your business’s real estate, you personally benefit from the asset appreciation, principal reduction and tax benefits.
Now, let’s add a very real possibility into the equation, one that many business owners are facing these days. Someone offers to buy your business or your business no longer needs the same real estate it once did due to trends such as remote work and technological advancements. When you find yourself in either situation (even if the purchaser of the business plans to sign a new lease with your LLC) the question you need to ask yourself is: would I want to own this location if it were vacant? Business changes, motivation varies, locations fall out of vogue. Whatever the reason may be, you run the risk of having a costly vacancy.
When you are the owner/occupant, the dynamic is different than being just the owner. You are now an investor who must compete with other landlords for quality tenants. The cost of originating a new lease is staggering. In some cases, up to 20-25% of the lease income is lost to securing a new tenant, not to mention the fact that the process doesn’t happen overnight. Are you prepared for that potential risk? If the answer is no, there are steps you can take to minimize the risk of owning a vacant building.
First, analyze your location’s monthly carrying costs—debt service, taxes, insurance, common area maintenance, etc. You should maintain a 9-12 month cash reserve of this total amount.
Next, determine how marketable the vacant building is. A commercial real estate professional familiar with the market can help you with this. You want to know how many similar buildings are available in the area, the current market conditions, what concessions your competition may be offering and if there are any improvements needed, interior or exterior.
Lastly, is your Plan B. If you decide Steps 1 & 2 aren’t for you or you just want to be a prudent real estate investor, you need to determine what the lease income is worth to an arm’s length investor. This amount less any debt owed, closing costs and taxes owed determines the proceeds that can be deployed into an alternate non-real estate investment. If you choose to invest in another income property, the gain may be tax-deferred if the new purchase meets certain criteria. But Chris, why would I sell one piece of real estate only to buyer another? The simple answer is to lessen the risk. By selling a special purpose property and investing in a general purpose multi-tenant property, the management is greater but the downside is more manageable. It’s the same thought process as selling stock in a single company and buying a mutual fund or ETF that tracks multiple companies.