Owning the building where your business operates is indeed a smart move, and many entrepreneurs find it to be a beautiful arrangement.
Typically, the process involves creating an entity like a limited liability company to take title to the real estate. Then, the business operation “rents” the address from the LLC, often as a separate corporation.
This setup offers some distinct advantages: tax benefits, depreciation, interest deductions and the ability to build equity. However, many owner-occupants make critical errors that can undermine these benefits.
Let’s delve into two of the most significant mistakes:
Not paying market rent
When acquiring a building, businesses typically finance the purchase, often through the Small Business Administration, which allows financing up to 90% of the purchase price.
With only 10% equity needed for the buy, the resulting debt service typically dictates the rent the business pays to the LLC. This means the rent is usually based on debt service requirements rather than market rates.
While this might seem convenient, it can lead to significant financial discrepancies over time.
Consider this: As the debt decreases, the rent remains static, potentially falling below market value. This discrepancy can create substantial financial issues.
For instance, if the rent is significantly below market rate, the business’s profits appear artificially inflated. This can complicate matters if the owner decides to sell the company. Potential buyers might see an inflated profit margin that isn’t realistic once market rent is factored in.
I’ve seen this firsthand with a company that owned its building since 2001. They enjoyed under-market rent for over 20 years. When it came time to sell the business, the profit appeared much higher than it actually was, creating a challenging situation for both valuation and sale.
Keeping rent aligned with current market rates is essential to avoid these pitfalls and ensure the financial health of both the business and the real estate entity.
Regularly reviewing and adjusting the rent to reflect current market conditions is crucial for maintaining an accurate financial picture.
No agreement between owner, tenant
Another common mistake is overlooking the necessity of a formal rental agreement between the real estate entity and the operating business.
Many owner-occupants assume that since they control both entities, a formal agreement is unnecessary. T”I own the company and the building, so why do I need a contract?” is a common refrain. This mindset can lead to severe complications, especially during unexpected events like death, divorce or a sale.
I recall a particularly extreme case involving a manufacturing company.
The owner, who also owned the building, passed away suddenly. Unbeknownst to the company, the owner had altered the building’s ownership, distributing it among several heirs.
None of these heirs wanted to continue the business, and without a lease agreement in place, the business was evicted, so the building could be sold. This resulted in a costly and disruptive relocation for the company.
Having a written agreement between the owner and tenant entities is crucial to avoid such scenarios. It ensures that both parties are clear on their obligations and protects the business from unforeseen events.
This agreement should outline the terms of the lease, rent amount, duration, and any other pertinent details. It’s a simple step that can prevent significant headaches down the line.
Owning the building where your business operates can be incredibly advantageous, offering tax benefits and the ability to build equity.
However, it’s essential to avoid these two common mistakes: not paying market rent and not having a formal agreement between the owner and tenant.
Regularly reviewing rental rates and maintaining clear agreements will help keep both the business and real estate entity on solid financial footing.
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at [email protected] or 714.564.7104.
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