Traditionally, closely held businesses that also own and occupy their real estate properties are dealt with as one entity - the owner of the business, often a sole proprietorship, is usually the same individual as the owner of the real estate. The individual owns the operating business as well as the building the business occupies, personally, in the individual' name. This makes a significant impact on how the business and the real estate are valued.

For example, the marina that operates the boats slips, the repair shops and the boat supply store it occupies is dealt with as a boat maintenance business that happens to occupy its real estate. The manufacturer that is the sole occupant of the office/warehouse is valued based on its earnings, plus the value of its overhead cranes, manufacturing equipment and inventory, rather than as a tenant in a commercial property. The pizza restaurant that owns and occupies most of the small strip center it owns is valued as a business with the real estate as an asset of the business. The funeral home that also owns the building and land it occupies is valued as a business with the real estate as an asset of the business. In each instance, the real estate, which may have significant value in its own right, is often booked as a depreciating asset by the accountants, and shows up on the balance sheet, often to the negative.

Phantom Lease

Perhaps there is a better way to structure and value these types of businesses that are associated with the real estate they occupy. This structure changes the primary focus: from a business operation that occupies real estate, to owned real estate that is leased to the business. This different approach uses what has been described as a "phantom lease." This is a phantom insofar as the relationship between property owner and tenant is not arms length. This concept is not new - certainly not new to major U.S. corporations that seldom, if ever, own the real estate in the same name as the corporate parent. It may be a recent evolution impacting the small business and small real estate owner, one which needs to be further examined.

The Lessor

Under this proposed scenario, the land and improvements (buildings) are acquired and owned by a single asset, special purpose entity, whose sole function is to own and manage the real estate and the buildings. The entity can be an LLC, corporation, partnership, or any other special purpose entity that makes good legal and financial sense to the principal(s). Under this plan, this entity becomes the lessor.

The Lessee

The principal(s) of the company that owns the real estate can/should be the same principal(s) as those who own the business, which is then another, separate entity, or may continue to be an individual proprietorship. The business thereby becomes the tenant, called the lessee. The business can become or remain an LLC, corporation, partnership, sole proprietorship or other entity that it has always been. Or, it too can become a new corporate entity to better differentiate between the two.

The Lease

The lessor leases the real estate and improvements to the lessee, under a lengthy lease, at market rent, usually on a triple net basis. In form, this may not be different than what actually has transpired in the past. The manufacturing company, retailer, or other business owner continues to occupy, manage, maintain and operate the property. The major difference is that instead of the business being required to obtain a mortgage directly, and paying the debt service directly, (as well as the costs to maintain and operate the property), the lessee now pays rent to the lessor, as well as pays the costs to maintain the property.

Under this plan, the business does not own the real estate. It may still own the equipment, inventory, goodwill, customers, etc. of the company. It also is responsible for employing all of the employees. The business continues to pay for the utilities, insurance, repairs and maintenance, and even the real estate taxes, as in the past.

On the other hand, the lessor, who owns only the real estate asset, is able to borrow money pursuant to a mortgage, and is therefore responsible for the debt service payments. The funds derived for these mortgage payments are from the rent payments made by the lessee. To some, this appears to be taking money from one pocket and putting it into the other. It may appear to require additional overhead and cost with little or no benefit. However, that is not necessarily the case.

Advantages

Let' take a look at some of the benefits.

1. Real estate ownership - it has been demonstrated over recent years that an ownership structure that is a single asset, special purpose entity has an easier time in securing financing, and is simpler to track financially.

2. Protection against law suit liability - the real estate, to some extent, is protected against suit in the event of a liability claim against the tenant, which in this example is the business (and visa versa, too). A dispute that involves the business operation does not inevitably tie up the real estate, also. There is some additional security derived from this separation of "owners."

3. FF&E ownership - often, lenders that lend on real estate as collateral have little interest in FF&E as additional collateral. Accordingly, a lender may have no requirement to also file a lien and tie up the equipment, inventory, receivables, etc. of the business. This frees up this other collateral for the business to obtain additional operating capital and financing independently.

4. Real estate value - the real estate has its own value in the marketplace, unrelated to its value to the tenant-business. This asset is valued by examining the market independently of the tenant, using market rents and comparable sales. Such rents and sales have no specific relationship to the tenant, the tenant' creditworthiness, or its operating profit. If a lease is established between the tenant and the property owner, based on market rent for similar properties with similar occupancies in the area, the value of the building can be established accordingly, outside of the scope of the tenant' business enterprise. The two valued separately may result in greater total value, than if valued as one enterprise combined.

. Off-balance sheet financing - the debt on the building is not necessarily a debt on the operating business. The company may have a more healthy balance sheet as a result. It may find greater flexibility in seeking other operating financing, like factoring, equipment financing and leases, etc.

6. Freedom to relocate - in the event that that business grows (or dies), it can relocate without disposing of the real estate. Alternatively, if the business alone does not survive, it does not automatically mean the loss of the real estate, too. The real estate can be leased to another tenant, or tenants, and survive independently.

7. Financial independence - in the event of financial distress, the real estate can be sold off with a sale-leaseback agreement, permitting a large infusion of new unleveraged cash into the business, without the need to simply shut down. This happens through an immediate sale of the real estate, with a recoup of equity as new capital.

8. Income tax shelter - the ownership of real estate can be used as a tax shelter in certain circumstances, with real estate losses used to shelter other passive income by deferring personal income taxes. This special purpose entity owning the real estate may be the correct vehicle to take advantage of such a special situation.

Disadvantages

Disadvantages are few. They involve the need to pay the fees necessary to establish the new separate entity that will own the real estate. There is the requirement to maintain two sets of books and records - one each for the business and a separate set for the real estate, the requirement to file tax returns separately, and possibly to bear two income tax burdens. Also, to convert an existing business situation into the two entity structure, the real estate must be "quitclaimed" to the new entity, without incurring a taxable event. (If the principals remains unchanged, this should not present a problem.)

Conclusion

Small business owners may maximize the financial benefits of also owning the commercial real estate that the business occupies, by establishing a phantom lease between the real estate owner, separate from the business operation. It is good business planning for the short term, and offers a wide range of capital and financing options for the long term.

Brian A. Opert, is a partner with Sterling Partners Capital LLC, a private lender focusing on hard-to-finance commercial real estate transactions nationwide.

©2001 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.