Real Estate in M&A: Expectations & Complexities

In this episode, we dive into the complexities of real estate in business transactions. We'll discuss the challenges of transferring lease agreements, negotiating new terms, and how lease structures can impact both buyers and sellers. You'll hear insights on how to protect your interests, navigate tough negotiations, and decide whether to keep or sell real estate when selling your business. Tune in for valuable tips that could help you maximize the value of your transaction.

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TRANSCRIPT

Welcome to Integrated Insights with ICCG. For more than 30 years, our team has partnered with small business owners to prepare for and navigate the business transaction process.

Pull up a chair as we share stories and insights from our experience on all sides of the M &A table. All right, well, welcome back to another episode of Integrated Insights.

Today I've got Dave and Grant back with us talking part two of real estate and transactions and just other considerations to have. So started off with what are the potential challenges when transferring lease agreements during a business transaction?

Oh for they are many. They can be. I mean they don't have to be but oftentimes there's not and oftentimes it's dictated by the lease that's already in place. So there's there's an assignment.

leased by the owners of the business. They were all the same owners of the businesses. They leased two of the properties, and they owned one of the properties, so that made it really interesting too.

And on that particular, on the property that they owned, that lease needed to be redone because there wasn't much time left on it, so they wanted to extend it. And so that end up being something that was a really interesting part of the negotiation because there was this tension between doing a lease that was advantageous for our client,

but they were really wanting to make sure that the lease was written well so that they could then sell the property in the future. The value of a property in a really high real estate market our high value real estate market has a lot to do,

has everything to do with how the lease is written because the banks are going to loan on how that lease is written in the future. And so, you know, we try to be cooperative with that while at the same time we don't want to make our client have to pay more than they're supposed to pay or make sure the options and everything.

So, you know, we on the other, the other one that was really interesting on that and really affected the property was We were held hostage a little bit by the landlord. Not that they were, I mean,

they were very, we had great conversations, but they really held the power because that lease was like one month from being done and there were no more options.

We basically had to go in and negotiate a new lease and the market rate that they had come up with was really too high for our client to,

it just didn't make sense. It didn't pencil with the kind of business this is. And so it was a really interesting discussion. Fortunately, we were able to prove to them that their comps really weren't applicable to this particular business.

And so we were able to go in and actually do a pretty decent rent increase over time. And then also we were able to lengthen the lease and then add a couple of options on it as well.

So that ended up being a pretty good deal for the client. So a lot of time that I've seen you do this, Dave, when you are negotiating because you end up being neck deep in that part of the woods and you come across this where also the guarantor of the lease is changing.

In other words, you know, in that particular business, a medical business, and so there was doctors that were guaranteeing the lease, and now all of a sudden we have a corporate owner that is going in there and he doesn't want to personally guarantee anything.

And so, you know, how do you negotiate that? And so the guarantor piece as well as the term of the lease sometimes lands us in a position where a whole new lease is negotiated rather than the old one is assumed.

And whenever that happens, you have to be careful because the rental rate is then renegotiated and it might cost the valuation on the business as well. - Yeah,

that's a good point. Yeah, it's a great point. - So how can lease agreements be structured to protect the interests of the property owner? I mean a trip in that lease is probably the most common we see and based on what that means there's a base rent and then there's there's another piece of that rent that pays all the taxes insurance upkeep maintenance maintenance and it's a it's a you know the landlord never has to

really touch the property unless there's something catastrophic that happens or something that they're responsible for But in most cases, the tenant is responsible for everything. So that protects the property owner a lot.

And so if we were representing a seller who was wanting to keep the property, you know, we would want to make sure that we would hope that we would want to make sure that they have a triple at least.

And oftentimes the real estate broker that maybe has been doing this brought back in to negotiate that part. Sometimes we don't have to really negotiate that. We kind of get them to do that.

If we're representing the buy side, we tend to get involved in the negotiations a little bit more. Yeah, because it affects the valuation of the business for sure.

We get involved with it. And I think the other side to it is that the times when Dave and I have owned our own businesses and they've owned the real estate in a different entity,

you'll find those leases are not arm's length. They're just there just to satisfy the bank when you finance the purchase because it's not like you're going to sue yourself for rent,

right? And so The lease is not tight at all, it's very loose and when you are now going to lease,

you're going to keep the property as a seller and now you're going to lease it to a new buyer, you want to make that lease very tight and so you're not going to let that buyer assume that loose lease,

you're going to want your lawyer to draw app a lease that protects you and make sure that it holds them accountable to do their part of the lease.

That's good. You guys have kind of touched on this but how do existing lease agreements affect the sale or the acquisition of the business? Well I mean it's it's part of you it's part of your expenses so it's gonna be part of your cash flow analysis And ultimately,

you know, you're looking forward. So let's say you're getting ready to have to take a next option, you know, you're not only looking at, and just say you're paying four times multiple on EBITDA.

Well, you're going to need to kind of take that into consideration, look forward and go, well, in two years, the rent's going to be X and maybe they've got a pretty good, or maybe it's not determined. Maybe it's one of these, you know,

at market rate, which I always find that extremely scary in leases, that really holds, it's a great thing for the landlord to put in, but it's really not all that great for the tenants.

We always try to define that whether it's a 2 % or 3 % escalation annually, which we see all the time. That's not unreasonable, but so those things just have to be really dug into,

you dig into those things during due diligence and figure out, And you may have to adjust the price if all of a sudden you realize, you know, next year our lease is going to be, you know, $20 ,000 more for the year than you would adjust.

You know, in most cases, we would adjust that multiple a little bit or adjust the EBITDA number. You know, Mason, there's a business that you and I have just dealt with that, you know,

the fair market value rental, the fair rental rate of that real estate is way too much for the business to endure. You see these plays where years ago Dave and I looked at a business that was an RV storage and repair place.

It was massive real estate right off of the highway in Plano, Texas, and the real estate was worth, I don't know, $20 million, but the business wasn't making very much.

And so they were trying to sell the business and the real estate, but the business was just not able to support what would be fair rental on a very prized piece of property like that.

And so it's almost impossible And so, you know, you see that on a very much smaller scale in the business that we just dealt with where the seller has asked a real estate agent,

"Okay, how much is the fair rental rate?" And they came up with a $20 ,000 a month rent. Well, the business is not used to paying that. The business is used to paying $5 ,000 a month in rent and the seller doesn't want to change the sales price.

And so, you have to be very careful in considering the lease and what you're asking for as a seller, for sure, because it will affect whether the business needs to stay.

And I would just tell you, it's our experience that some businesses need to stay on that particular real estate. It is key. That exposure maybe, maybe it's in the middle of the highway system,

so it's easy to get everywhere. Maybe it's strategic in the way that it's that it's equipped, you know, a lot of you know,

certain way. Yeah. And so it just, you know, sometimes real estate is super important. And so a buyer may want to secure that either with a longer term lease or a purchase of that property,

but it's super difficult to kind of get your arms around how important that real estate may be to the buyer.

So when we're representing a seller, we're looking at it holistically. What happens if we were the buyer? What would we want from a real estate standpoint,

from a lease standpoint, from a term standpoint, all that kind of thing, because it can change the business. Some businesses are, you can move it any way you want,

and it's no big deal. We interviewed another business owner the other day, and he said, "Hey, I'm taking $12 ,000 a month in rent,

but anybody can just move this business to some place that charges $2 ,500." Okay, you know, if it doesn't matter where the business is, then you can do that.

Yeah. Yeah, that's really good. Did he not care whether the business went with the sale? No. No. Because, because the fair rental value was way north of what he,

you know, what he knew that was fair to the, for the business to pay. And so he said, well, let them go and I'll leave the rented to somebody else, or I'm going to sell their real estate. So this,

this is, um, maybe this brings up a soapbox just real quick. A lot of these guys will go to an investment guy who is, who is unfortunately incentivized based on the amount of money they invest.

And I would just tell you that Dave and I, obviously we, Obviously, we like to invest through investment advisors, but we also like to have real estate. But our investment advisor is not paid to invest money in real estate.

And so the advice that they're getting is, sell all your assets, give us your money, we'll invest it, and you can retire. Well, sometimes it's not the greatest advice.

You need to keep real estate and invest some of the proceeds in the market. And so getting a more rounded perspective on that is super helpful.

Yeah, because you got to remember that not every not every advisor is getting paid, you know, as a fiduciary that's, well, let's just say some are not fee, some are fee -based,

right? Which most of them are fiduciaries and some are commission -based. And when you're And when you're selling a property, you're not just selling it for the rent.

You're selling it for the increase in the property price. Dave and I represented a family that had a rental property that was right next to a yacht club in an exclusive area of California.

And Let's just say it was a good purchase that this guy did what, 20 years before that? Yeah. They rented this place to a body shop. If you...

Nobody... I mean, the body shop's not going to be able to afford more than $20 ,000 a month in rent, but the property was worth multi -millions,

and eventually, somebody did buy that piece of property and they built it a high -rise on it because it overlooks with the condos overlooking the yacht club in a beautiful area but you have to sometimes just keep $20 ,000 a month in rent even though you could maybe make a whole lot more while the fair market value of that property is climbing and then you sell it at the right time and you get the best of both

worlds. In that case, at least it doesn't matter what it says. It's all about the value of the land. That's right. Yeah. No, that's really good. We'll end on this one,

but what advice would you give a business owner that's contemplating a sale that also owns the real estate? Yeah. I think Dave and I would always say, "Hey, consider keeping it." If you're going to sell to a PE group,

which is who we normally sell businesses to, we sell to individuals as well, but PE groups don't necessarily want the real estate, cut a deal on the lease,

and it's great passive income in retirement or in just to keep for like Dave and I said we have done on a couple of properties and so you know the price of real estate generally will will will go up protect yourself inside of an entity so you don't get hit with EPA stuff but it's a great investment.

Yeah that's great. All right well thank you everyone for tuning in and we'll see y 'all next time. And that wraps up another episode of Integrated Insights with ICCG.

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