Deal Breakers: Real Estate

Real estate is the key to wealth creation.

Andrew Carnegie believed so. After selling his steel business to J.P. Morgan in 1901 for $480 million (equivalent to approximately $13 billion today), he commented: “Ninety percent of all millionaires become so through owning real estate. More money has been made in real estate than in all industrial investments combined. The wise young man or wage earner of today invests his money in real estate.”

Years later, Franklin D. Roosevelt echoed Carnegie’s sentiment when he said: “Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid in full, and managed with reasonable care, it is about the safest investment in the world”.

But does their sage advice still apply to companies and value in the context of selling a business?

Real Estate in the Context of an M&A Transaction
While real estate is not typically a deal breaker, per se, related considerations do impact value to both sellers and buyers over the course of an M&A transaction. In the context of selling a business, owners should take a comprehensive view of “deal proceeds”, which includes monetizing every facet of their operations (i.e., company cash flows), real estate, and other fixed and intellectual property. Assets that aren’t required for, or directly related to, core operations can often be “carved out” and sold separately.

This blog post, the fourth of the Deal Breakers series, examines common real estate issues that arise during deals. Many of these can be addressed proactively before the business is marketed for sale. However, doing so requires forethought months – and in some cases years – in advance.

Common Real Estate Issues that Arise During Deals
Real estate issues rarely cause a deal to fall apart completely, but often result in a loss of value, a delayed transaction closing, or additional concessions from the seller. The following list details the most common issues, along with possible steps to avoid them.

Owned Real Estate
Facility size (too small or too large). Facilities deemed “too small” won’t be able to adequately support headcount or production growth. In these situations, the buyer must plan to move to another facility, add additional space, or reorganize workflows, which increases deal risk. Conversely, having too much floor space implies overhead costs (e.g., janitorial services, utilities, non-productive personnel movement, etc.) are and will continue to be, higher than necessary.

Ideally, the space available can meet the 5-7 year growth projections of the business without further investment. In many situations, forming a plan to use alternative workforce management strategies (e.g., additional shifts or increased flexibility to work from home) is an effective way to mitigate buyers’ concerns that a facility is spatially inadequate.

Pending capital investments. Buildings require regular maintenance. Owning the building makes it the business owner’s problem; certain leases also require the occupant to bear maintenance responsibility. Buyers will perform detailed reviews of building systems during the due diligence period to ensure there are no hidden surprises, which usually imply expensive repair, replacement, and/or construction costs will soon be required. Depending on facility type, common “surprises” include degraded roofing, failing HVAC systems, damaged concrete, and/or old carpet. Buyers may reduce their purchase price dollar-for-dollar to account for the expected cost of bringing antiquated building components up to code. Proper ongoing maintenance or a sale-leaseback of the property can mitigate this potential issue.

Facility located in an undesirable area. Facilities that are difficult to travel to (e.g., no airports nearby), unusually exposed to natural disasters (e.g., located in a flood zone), experience workforce availability constraints (e.g., low number of skilled workers or unusually low unemployment rates in the area), and/or in unsafe neighborhoods can all pose issues for a buyer. Once the decision to operate in one of these areas is made, it’s difficult to mitigate the associated risks.

The best way to avoid this issue is to select a location with none of these undesirable traits. For a facility already burdened with one or more of these characteristics, several options exist to mitigate associated risk. First, if possible, consider selling the property and either moving to another location or leasing the current location back; either option provides more flexibility if structured properly. Second, reduce risk by purchasing applicable insurance (e.g., property & casualty, including “acts of God”, and business interruption coverage). Finally, establish emergency action plans, detailed hiring strategies, and data backup protocols to help buyers feel comfortable that proactive steps have been taken to ensure business continuity.

Leased Real Estate
Challenging landlord. Landlord inflexibility manifests in several ways. The first signs of a problem are usually encountered during initial lease negotiations. A landlord who is unwilling to compromise is a clear warning sign of potential future problems. Once a contract is signed, the company is subject to the lease agreement and, by extension, the landlord. Outside of defaulting on the agreement and facing costly litigation, there’s very little a company can do about a challenging landlord once the lease is in place.

Livingstone recently worked with a client whose landlord refused to allow any changes to the property without signing a new lease with a 10-year extension without any “outs”. This became an issue for certain buyers, some of whom already had facilities nearby, and wanted to consolidate their footprint after closing the deal.

Long-term, “no-out” agreement. The largest benefit of a long-term lease is its stability, as terms are set up front, and the tenant has a high level of visibility into occupancy costs. Unfortunately, most leases are not easy to break, which reduces flexibility and limits buyers’ available real estate options. This circumstance can erode value in the context of selling a business.

For business owners, the best solution is to negotiate favorable lease terms in advance of a contemplated sale. If there’s even a chance the company could be for sale during the proposed lease period, a shorter lease term, sublease and assignment provisions, and/or an option to terminate (even at an incremental cost), can all mitigate issues related to “no out” agreements.

Out-of-market rates (both high and low). Above-market lease rates depress cash flows and reduce the company’s ability to invest in promising projects and pay down debt. Lease rates deemed to be below market may cause concern that rate increases are looming after closing the deal. Prior to entering into any lease, market test your lease rate with knowledgeable real estate experts to ensure your rates are in the “Goldilocks” zone.

Assignability and Sublease Provisions. Without proper language in the lease agreement, a sale of your business may trigger a landlord’s ability to renegotiate terms, which can often be unfavorable to the new owner. Incorporating language that protects the seller and future owner of the business, and provides optionality in the event of a change of control helps avoid this issue.

Hire an Advisor to Create a Real Estate Plan
An independent, third-party real estate advisor is in the best position to audit your company’s real estate situation. A good advisor can provide a comprehensive recommendation, including local market rental terms and facility sale comps. Often times, monetizing owned real estate before selling the business unlocks value that would otherwise be ceded to the buyer, usually without even knowing it.

For real estate owners, the advisor can draft a sale-leaseback analysis to compare the value of selling a property to the expected impact to the business’ cash flow (primarily due to the introduction of lease expenses). With additional feedback from an investment banker to determine how the change in cash flow will impact business valuation, a business owner can get a view of the best approach to maximize total proceeds.

For businesses that are already leasing, a real estate advisor can help negotiate lease terms conducive to a sell-side process. Important terms include duration (short-term or month-to-month); monthly lease rate (compared to market); ability to terminate, assign, and/or sublet the lease; right of first refusal on the property; and building maintenance obligations.

Get Real with Your Estate
So, were Carnegie and Roosevelt right? It depends. As with many things in life, the “right answer” between buying and leasing changes with time and circumstances. One such circumstance is the decision to sell a business. Upon making the decision to sell, and hopefully well before, business owners should consider each real estate decision carefully to ensure total proceeds are maximized.

In this way, sellers can avoid their own “day that will live in infamy” by ensuring no value is left “on the table” on the day of closing.

Special thanks to Matt Wrobleski, an Associate Director and real estate professional in Stan Johnson Company’s Corporate Finance Group, who reviewed and commented on this blog prior to its posting.

In Case You Missed It…
The first three Deal Breakers posts introduce the series, discuss hiring and employment issues related to undocumented workers, and address common tax-related issues encountered during diligence. Check them out if the topics seem interesting.