One of the great challenges small business owners struggle with is diversification of income streams. It takes so much time and energy just to keep the core business going that many longtime small business owners face the serious risk of putting all of their financial eggs in one basket.
Large corporations, on the other hand, aggressively pursue income diversification strategies, both to increase their returns on capital and also to reduce their exposure to risk. In addition, income diversification often brings with it significant tax benefits, since (for better or worse) the federal tax code is largely biased in favor of investment income vs. earned income.
Some of the ways in which larger businesses and their owners or shareholders achieve these goals include investing in multiple businesses; building an investment portfolio of stocks and bonds; creating new and separate legal business entities to pursue new projects; and purchasing and owning real estate.
This raises a serious question: If you’re the kind of small business owner who finds herself or himself re-investing every dollar earned at the business back into the company, or living directly (and exclusively) on your salary and/or owner distributions from the business, what does this do to protect your financial future?
With that in mind, the question of whether you should own your company’s operating real estate is a critical one — one that every small business owner should seriously explore.
Advantages to Owning Your Operating Real Estate
There are many advantages to owning the real estate your business sits on — some related to your business, and some related to you personally, as the business owner.
The first advantage is that, if your business is a location-based entity such as a retailer or restaurant, owning your business location protects the company from rent increases and, increasingly, straight-out rent gouging, not to mention the risk of future demolition and redevelopment of the property you operate from. Local media in many communities are filled with stories of otherwise successful small businesses that have closed due to escalating rents or loss of their property to redevelopment.
In addition, owning the property protects the investment you make in that property. If you finance $500,000 for tenant fit-out and furnishing the space, then you’d benefit dramatically from being able to protect that investment for years to come by owning the space you just improved.
The second advantage is that it gives your business political clout, which is especially valuable if the community in which you operate is going through rapid changes. If you own a veterinary clinic, for example, it may be extremely difficult to even find suitable properties where zoning permits such a business to operate. And in the future, political winds may blow in favor of changing or narrowing approved land uses.
Even if your use is ‘grandfathered’ in new zoning codes, the future of your ability to stay in that location is put at risk – and rezoning can incentivize your landlord to push you out. If you own the property, your rights to remain are stronger — and more to the point, you have more power to influence local policy in your favor, since you own property in the community (and like it or not, local politics still largely favors landowners over renters, even in the commercial arena).
The third advantage is that you may be able to actually build a much stronger business on the real estate itself. The most famous example, perhaps, is that of the McDonald’s Corporation (originally called Franchise Realty Corporation), which was built on the concept that owning the land under which McDonald’s restaurants were built would be far more valuable than just operating (or franchising) restaurants themselves.
The fourth advantage is that you are building equity in an income-producing property, giving you greater borrowing power in the short term and the benefits of a cash-producing annuity in the long term. This is especially applicable if you own a multi-tenant building.
The fifth advantage is also worth serious consideration. Since the tax code is biased in favor of investment income, consider what happens when you own real estate and your business leases the property from you. Assuming that your business entity is a pass-through format (such as an LLC or S Corp), the tax benefits in total (between the company and the owner) include:
- The company deducts lease payments as operating expenses.
- The business owner deducts landlord management costs such as mortgage interest, depreciation and property maintenance.
- The business owner’s profits from the lease are taxed as investment income (at his personal income tax rate, and without the added burden of payroll tax).
- The business owner also gains the benefit of having the basis-adjusted profit from the future sale of the property taxed at the capital gains rate (usually lower than the personal income tax rate).
However, this can also present a disadvantage in that if you own the property and lease it to your business as the only tenant, the IRS may disallow the loss unless you have other passive income. This is because the IRS limits losses to individuals who own rental property, where the property is rented, in whole or in part, to entities that the property owner actually works in, or for rental properties that are rented to the owner’s other businesses.
Disadvantages to Owning Your Operating Real Estate
With these compelling benefits to consider, it might seem clear that owning your operating real estate is really a foregone conclusion — i.e. if you can do it, do it. And for some small business owners, that may be true. But for others, owning real estate can come with just as many disadvantages. Let’s look at a few:
The first disadvantage is that you’re locking your business into a fixed location. If you operate a location-based business (retail, restaurant, etc.) then this may not be an issue. It also may not be an issue if your business is not in a growth mode (for example, if you run a small law firm and don’t envision growing your headcount significantly in the future).
But keep in mind that market trends change. Today’s ‘hot’ restaurant location may be tomorrow’s forgotten corner of town. More than a few small businesses have seen their location value plummet when a highway exit ramp was relocated, or a redevelopment project in a different part of town created too much competition and shifted customers to a new preferred neighborhood.
The second disadvantage is that as a small business owner, every new venture you pursue pulls capital and focus away from the last one. Large companies can put entire departments on the task of pursuing diversification strategies. You can’t. If you’re your own landlord, that means that when the roof leaks you have to take care of it. When the boiler breaks, you have to take care of it. The risk and cost of maintaining the property falls on you, and your time, energy and capital may go in that direction more than toward the core business.
The third disadvantage is that it locks you into an inflexible real estate strategy. If you run a small professional services firm, you might be tempted to either purchase an office condo that’s sized for your current needs alone (in which case, what do you do when you need to grow?), or one that’s much larger so you can accommodate growth (in which case, what do you do if the growth doesn’t happen and the company itself is paying too much rent to you, the owner of too much space?).
The fourth disadvantage is that the strategy is often predicated on the assumption of a low-to-no exit value for the business entity itself. Innumerable small business owners have been so tied up with one location and the operations associated with both the business in that location and the building they own to house it, that the future sale value of the business at exit has been essentially zero. Instead, they could have stayed out of the real estate business and focused on building out multiple locations for the operating entity, thus creating far greater value in the core business.
The fifth disadvantage is that as a property owner, you still have to ensure that the property is filled, even if your business can’t or shouldn’t be the one still filling it. If your business shrinks, you need to deal with the complexities of a sublease or relocating the company while you find a new tenant for the space.
And when it’s time for your business to move, close or merge with another business, you (the owner) still need to lease out the property to cover your mortgage and/or maintain it (or you need to sell). This may work out, if the location of the property is in high demand for similar uses (or if the uses that would be in high demand are permitted by zoning). If one or both of these is not the case, you’re suddenly finding yourself facing all of the risks that a ‘pure-play’ real estate investor faces, without any of the expertise or capital to overcome them.
Questions to Ask About the Lease vs. Buy Decision
Let’s step back and make an important overall point: It is important for everyone to lower risk, maximize their tax benefits and diversify their income streams wherever possible, in order to protect and maximize your retirement benefits. As people live longer, it’s even more critical that you plan today for the future. But in order to determine whether your personal diversification strategy should involve owning your company’s operating real estate, consider these questions:
- Is my business generally location-dependent or location-independent? If it is location-dependent, can I reasonably anticipate that a good location today will be a good location 15-20 years from now?
- Is my (current or envisioned) operating location a new or newer building with a reasonable to low expected maintenance burden, or an older or more complex operating location with a higher expected maintenance burden?
- Does my operating business involve any risks that could significantly increase my liability as the property owner (for example, a gas station property with underground storage tanks or an industrial company that may be subject to groundwater runoff regulations).
- Can owning my company’s real estate give me greater financial flexibility to grow my core business and maximize its own value, or will the two priorities pull against one another (both financially and operationally)?
- Do I have sufficient capital and bandwidth to maintain both my core business and the commercial structure housing it?
- What beneficial financing instruments might I be able to use (such as SBA 504 loans, USDA loans or other economic development financing) to lower my cost of capital and make the purchase more financially advantageous?
- What other methods can I use to increase my overall tax benefits (both to the company and to the owner), and diversify my income streams (especially with the objective of creating at least one annuity investment for the long term)?
In order to answer these questions, make sure to sit down with your CPA and perform a what-if analysis to effectively evaluate your options and determine the best path forward — both for you and for your small business.