This blog appeared on Inside Indiana Business on Tuesday, April 13th 2021 as part of their daily email. We are appreciative of the opportunity with Inside INdiana Business.
I have spent 20 years in commercial real estate (“CRE”) and it is fascinating to me how many “experts” in CRE there are outside the industry. Should your business or practice own it’s own real estate? The answer to that is most likely a resounding NO. I understand it may give you a sense of pride but the risks are significant. I believe significantly underestimated vs any tax benefit.
First, how do CRE investors analyze real estate? By accepting various forms of risk (development, construction, leasing/vacancy, credit, financing risks), we attempt to create value. Value creation is either from 1) increasing income (rents) or 2) cap rate compression. Cap rate compression accounts for the vast majority of the potential return. I.e. build it for a 7% cap rate (14x) and sell it for a 6 cap rate (16.7x).
Furthermore, approximately 50% of the value is after year 10 and 43% is after year 15. Point being? The exit is the single greatest driver of the returns. Going in real estate will look great and possibly for several years…until you need to sell it.
When you buy or build you have two choices: a) occupy or b) rent at market rates. If you occupy the building, then you are forgoing the rent you could have received. Therefore, you are effectively paying that same rent by not receiving the income.
Why your business should not own it’s own real estate:
Lease Optionality: Consider that with a lease you can create optionality for your business. Kickout rights after a specified period of time, renewal options, who pays for significant capital repairs, and financing of build out of your space all provide financial options. In most cases landlords will accept a termination payments that can get you out of real estate a lot quicker than selling a building. This lease optionality has significant value.
Concentration / Covariance of Risk: Buying one single CRE asset concentrates the CRE risks that could otherwise be spread across a portfolio of investments as a limited partner investor. Furthermore, by investing that equity into the same CRE that your business occupies, you are creating a covariance of risk if your business fails effectively doubling down on the company with below market rate returns per above.
Prepaying Rent: If someone came to you and said: “Hey boss, I want to prepay the entire amount of our $1M annual supplies expense today, can I have $15M?” You would probably question their rationale. The same is true here. When you buy or build the building you are effectively prepaying the entire amount of the rent on day 1 and again 50% of the prepayment is for rent after 10 years from now.
Other Partners / Tenants: If you have a medical practice with partners you also create other problems. How do you value the entrance and exit rights of the real estate? If a partner does not want to participate do you simply create an entity and lease it to the practice/business? Will you lease out the space you don’t need to other tenants? If so, you have just created a side business to invest in CRE. What about in the event of a death? How will each partner get adequately liquidity and more importantly – value for your potentially minority interest (which in CRE carries a significant discount).
Residual value risk: Repeating for purpose – 50% of the value of the real estate is after year 10. Vacant real estate does not sell well as quickly nor for as much as occupied real estate with good credit leases. Vacant buildings typically go for 40% of an occupied building with rent paying tenants (see Realty Income REIT’s disclosures). You could wipe out the entirety of your returns in an instant (or prolonged slow death). To achieve maximum returns, you would be best to do a sale lease back thereby locking yourself into 5-10 more years in the building prolonging the period in the building. This residual value risk is significant and should not be underestimated.
Are there reasons to own real estate? Of course. Manufacturing, hospitals (not their satellite centers) and rural real estate are some. If someone has a compelling model – I will certainly listen.
However, leave ownership of CRE to the CRE professionals. Take the same equity and find limited partner investment opportunities with CRE professionals that will recycle your capital for great returns. A foundation I advise just had a multi-family investment sell for 5x equity investment after just 3 years. And if you still believe you can outperform CRE professionals then I certainly hope you don’t mind if some of my CRE friends and I scrub in to lead your next surgery procedure.
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