2009, Volume 12, Issue 2

Owner-Occupied Commercial Real Estate for the Entrepreneur

Practical Advice on Profiting from Commercial Real Estate in the United States

 

Alphonse Lordo, MBA, and Michael Kinsman, CPA, PhD

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Photo: Cezars

Case Study: M & G Consulting

Introduction

M & G Consulting is an engineering firm located in Southern California. They have rented space in a business park for many years and each year they have observed that their rent has increased by at least the rate of inflation. Although their business is successful, they have come to realize that their landlord has made just as much profit—in the form of rents and appreciation on the building—as they have in their business. They vowed to take control of their situation and began the search for their own building.

Identifying the Building

First, M & G identified the building size and amenities that suited their needs. They planned for the growth they expected over the next 10 years. In addition, they planned for future technology needs in terms of communications facilities, the image they wished to portray to clients, the proximity and ease of access to transportation hubs, and not least importantly, the geographic area. Their specifications were shared with trusted employees, and modifications were made based on ideas generated in group discussions. The owners then began their search and quickly settled on a building in a business park about 10 miles from their current site.

Negotiating the Terms

M & G negotiated with the owner of the identified building regarding his price, terms, willingness to carry back secondary financing, and willingness to complete necessary repairs and tenant improvements. The owner was flexible because he had held the building unsold for some time. The buyer and seller settled on a set of mutually acceptable terms and signed a contract.

Structuring the Entity to Hold the Building

M & G soon discovered that they could hold title to the building in a variety of ways, each of which had its own advantages and downfalls in terms of liability and tax treatment. M & G discussed the legal implications with their attorney and the tax implications with their CPA of the following methods:

Limited Liability Company (LLC)

M & G's attorney advised them that they could structure building ownership as an LLC, the major advantage being that it would be a legal entity separate from either M or G, and therefore limit personal liability from claims arising from the property. However, M & G's accountant pointed out four disadvantages of an LLC holding the property:

1. The cost of establishing an LLC, largely attorney fees, is significantly greater than for some other forms of ownership.
2. If an LLC has two or more owners, they must file partnership federal and state tax returns,[1] which require most taxpayers to seek professional (i.e., costly) tax preparation assistance.
3. In some states (e.g., California), an LLC, including a single-member LLC, is required to file a tax return and pay an annual fee based on gross revenue—the fee, which is $800 if the building makes no net income, can go as high as $11,790.[2]
4. Not only is the owner taxed on his or her portion of the net profits of the LLC, losses may have limited deductibility depending on the cash the owner has invested in the LLC.

Sole or Joint Ownership

M & G's attorney advised them that the property could also be held under sole ownership (one owner), or as a tenancy in common or as joint tenants with right of survivorship (multiple owners). Under any of these structures, the attorney opined, unlimited liability falls on the owner of the building for any potential claims against the property.[3]

M & G's accountant told them that the attractiveness of sole ownership or joint ownership versus an LLC is that it requires only one additional form on a personal tax return. Net rental income or loss on the property is taxed at ordinary income tax rates on the owner's tax return. He also pointed out that these entrepreneurs can mitigate personal liability risks through the establishment of a comprehensive insurance policy. That said, the decision of which way to structure the entity holding the property should be based on the LLC fees and costs versus the cost of any extra insurance required because the property is held in the owner's name.

Formal General Partnership

Essentially, a formal general partnership is a tenancy in common that is required to file a partnership tax return (usually form 1065), which is usually prepared by the partnership's accountant. Very often, establishing the partnership also requires an attorney to prepare the partnership agreement. M & G's accountant strongly urged them to have a formal partnership agreement if they chose to enter into any form of partnership; in his experience, many problems are avoided if they are anticipated, which is what the partnership agreement formalizes.

The partnership is not required to pay income taxes and each partner's share of net rental income or loss on the property is taxed at ordinary income tax rates on his or her tax return. The general partners have unlimited liability for the partnership's acts, and they will often opt to insure against loss from those activities.

Formal Limited Partnership

A formal limited partnership is another type of tenancy in common required to file a form 1065 partnership tax return. However, while the limited partners' liability is generally restricted to the amount they contributed to the partnership, the general partner's liability is unlimited. There must be at least one general partner and most often it will be a corporate entity established for that sole purpose. If so, that corporate owner must file a form 1120 tax return to report its share of the income from the property.

Again, establishing the partnership often requires the services of an attorney to prepare the partnership agreement. The partnership is not required to pay income taxes. Each partner's share of net rental income or loss is taxed at ordinary income tax rates on his or her tax return.

C-Corporation (Regular Corporation)

It is rare that a property is owned by a corporation and leased out to others; doing so usually means losing tax advantages such as favorable capital gains treatment on the property at sale, the ability to deduct operating losses from the property, and the ability to take tax-sheltered cash from the property. In addition, any cash taken from the corporation would be double taxed (if taken as dividends) and subject to payroll taxes (if taken as management fees)—neither scenario is tax efficient.

The only advantage of corporate ownership is the limitation of liability; however, this can also be achieved by holding the property in an LLC or a limited partnership.

Method	Liability	Costs/Taxation
Limited Liability Company (LLC)	Limited	Legal fees for establishing LLC Partnership tax returns if two or more owners
Sole Ownership / Joint Ownership	Unlimited but potentially mitigated by purchasing insurance	Insurance policy (if purchased) Taxed at the personal level
Formal General Partnership	Unlimited but potentially mitigated by purchasing insurance	Partnership fees Insurance policy (if purchased) Taxed at the personal level
Formal Limited Partnership	Limited partner's liability is limited to initial equity capital General partner's liability is unlimited but potentially mitigated by purchasing insurance	Partnership fees Insurance policy to mitigate general partner's liability (if purchased) Taxed at the personal level
C-corporation (regular corporation) Ownership	Limited	Incorporation costs Double taxation at the corporate and personal level

Lease Agreements

Regardless of the form of ownership, M & G's attorney and accountant strongly urged them to have a written lease between the entity and M & G Consulting. A lease protects both the firm and the landlord by spelling out the rights and duties of each, and would provide uninterrupted tenancy for M & G Consulting in the event the landlords sell the building.

The Decision

M & G decided to hold their building as a tenancy in common. Each partner (and his wife) owns a one-half interest in the building. Because California (and eight other states[4]) is a community property state, each co-tenant holds a community property interest in the building.[5]

Loan or Cash?

This question is probably one that every entrepreneur looks at with disbelief—after all, paying cash is not something an entrepreneur does willingly. Perhaps the question is better rephrased: How much cash will M & G have to pay for the building, and how much of a loan they can get?

One of the most attractive attributes of commercial real estate is the ability to leverage (or encumber) the property. Historically, commercial banks have loaned (debt capital) up to 80 percent of the appraised value of the real property, depending on the quality of the tenant and in-place rental rates compared to current market rental rates.[6] So, if a commercial property is valued at $1 million, the acquirer would need a $200,000 down payment with the remainder of the purchase price provided by a bank loan.

The amount of leverage a commercial property can sustain is much greater than on a typical business balance sheet because real estate is tangible, stationary, and can be utilized in multiple contexts. High leverage is generally desired by commercial real estate owners because the greater the amount of leverage a real estate asset can sustain, the greater the return the entrepreneur will earn on his or her invested equity.[7]

Getting the Loan

M & G found that acquiring a loan on an owner-occupied commercial real property was fairly straightforward because they met the five main criteria that banks require:

1. Loan-to-value ratio that does not exceed 80 percent.
2. Debt-service-coverage ratio of at least 1.20x.
3. History of the business's profitable operating performance.
4. Business's stable and recurring cash flows.
5. Guaranty or recourse clause from the borrower.

A bank loan will be secured by a first deed of trust on the real property, and thus a bank must be certain that the value of the property is sufficient to repay the loan. In the event that the investor defaults, the bank assumes control of the property and sells it to repay its loan.

Another important step in acquiring property is obtaining an appraised value sufficient to satisfy the bank's requirement that the property be appropriately priced. Appraisers base the value of a commercial property on its rental value (i.e., the cash flows that the building provides to cover its operating costs, including debt service). A commercial building is only worth the value of what it provides its owners in cash flow—no matter how pretty it is or how much it cost to build—and the bank will base the loan amount on that value. For example, if the appraised value of a commercial property is $5 million, the bank's lending standards might support a loan amount up to $4 million—as long as the income stream of the property can service the mortgage payment.

Banks typically require debt service coverage of at least 1.20x, which allows a cushion in case the property's net operating income (NOI) were to decline slightly. The debt-service-coverage ratio (DCR) is the ratio of the property's NOI to the monthly mortgage payment. In an owner-occupied scenario, a decline in the DCR is usually directly related to the deterioration in the business's performance; when the business's operating performance begins to falter, the owner decreases the amount of rental expense to the level of the mortgage payment. That is one reason that banks generally require the entrepreneur to sign a personal guaranty for the amount of the loan granted.

Another Advantage: Asset Diversification

The addition of real estate to a typical "stock-and-bond" portfolio often provides a reduction in portfolio risk without the sacrifice of return. This is because of the negative correlation of returns between real estate investment and financial securities. The U.S. National Council of Real Estate Investment Fiduciaries (NCREIF), which calculates quarterly rates of return for all commercial properties based on NOI and changes in market value, studied the correlation of real estate, stocks, and bond returns from 1978 to 2006. The following table details the result of that study and shows that real estate returns over the period are negatively correlated with the S&P 500 and 10-year bonds.

Return Correlation*	NCREIF Index
S&P 500	-0.0302
10-Year Bonds	-0.1600

*Years 1978 to 2006 [8]

The combination of negatively correlated assets in a portfolio provides enhanced diversification of systematic risk and makes a portfolio more efficient—it achieves a greater amount of return for the same level of risk. The graph below details the improvement in return of a stock-and-bond portfolio when real estate assets are added.

The red line represents a typical stock-and-bond portfolio's efficient frontier espoused by Harry Markowitz, the father of efficient portfolio theory. When real estate assets are combined, the portfolio's efficient frontier moves to the green curve representing lowered risk at each level of return. The improvement in the portfolio's risk-adjusted return is due to the negative correlation between real estate and equity and debt securities.

The Creation of Value and Net Worth

There are many innovative and legal ways of creating and capturing value in property. M & G will find that as its business and its building mature they will want to do serious planning to assure that their investments, including their newly acquired building, continue to meet their needs. Clearly, the building will be a major asset on the balance sheets of both owners.

Hopefully, M & G will continue a successful growth track that assures the company can pay the individual owners a fair and increasing rent from the building's strong cash flows. But M & G should also anticipate other needs, for example, they may want to monetize the equity value in their commercial property for personal uses (acquiring a second home, taking a three-month vacation in Europe, providing for a child's education, or investing in outside investments) while keeping ownership control of their property. In the future, they may even want to sell the building and purchase others, or they may simply want to assure a revenue stream with no management problems. M & G might consider the following options for achieving those goals:

Sale-Leaseback Transaction

This is the process of selling a commercial property to a finance company and then continuing to lease the building for an extended period of time (a minimum of 5 to 10 years). This transaction is popular when the mortgage on the property has been amortized for a number of years and market activity has increased the value of the property.

The advantage of a sale-leaseback transaction is that it provides a large infusion of cash to the owner of the building while allowing the user of the building to continue leasing on appropriate terms. Such transactions typically contain a repurchase clause that allows the partners to buy the property at the end of the lease.

Cash-Out Refinance

This is simply re-leveraging the commercial property to optimal debt-to-equity (80 percent) and debt-service-coverage (1.20x) ratios. This strategy would allow M & G to get non-taxable cash from their building without having to sell it. However, it is likely that the new loan on the building will generate non-deductible interest depending how M & G use the funds received.

Rooftop Lease

If an owner cannot create additional space inside a building to lease, how about leasing the outside of the building? Parts of the building can be leased to cell phone companies for antenna space and to utility companies for the installation of solar panels. Roof leasing for solar panels has been gaining popularity because of government green initiatives and the tax subsidies that go along with it. Currently, solar energy for real estate is economically feasible because of tax subsidies that are slated to expire in 2016.[9]

Exchanging the Building for Like-Kind Property

It may be that a firm like M & G outgrows its space or decides that it wants to have additional buildings. U.S. Internal Revenue Code section 1031 provides the opportunity to do a tax-free exchange of a property for a like-kind property. Tax law is generous in defining like-kind in the case of real estate. For example, an exchange of a commercial building for an apartment house, or even raw land, usually can be structured to qualify as a tax-free exchange.

Donating the Property to a Charity

Some highly appreciated property may generate large taxes when sold. However, if the property is donated to a qualified charity, those taxes can be avoided, and the former owner will generate a tax deduction for his or her charitable contribution. Often, the charity will also arrange for an annuity of payments to the former owner, which will give him or her an income for a specified period of time.[10]

Over time, M & G will likely use one or more of the above strategies to create more wealth for themselves. It is also possible that their creative accountants and attorneys could find additional ways to meet M & G's financial needs using the building.

Tax Preparation

The U.S. Internal Revenue Code defines rental real estate, regardless of the level of participation, as a passive business activity.[11] As such, real estate income and loss are treated differently on an individual's tax return: While profits must be fully reported, losses may be limited in dollar amount. Rental income and loss are reported on the first page of Schedule E of an individual income tax return.

In general, passive losses can only offset passive gains: If an individual invests in a partnership that generates $5,000 in passive losses, he will need passive income of at least $5,000 from some other activity to be able to take those losses. However, real estate passive losses are subject to more kindly tax rules than other passive losses. Current tax laws allow an investor to deduct net rental losses of up to $25,000 per year, if two criteria are met:

1. Minimum of 10 percent ownership in the real estate and
2. Active participation in the property, which typically consists of approval of capital expenditures and tenants.

The $25,000 loss phases out based on income: For modified adjusted gross incomes (MAGI)[12] of $100,000 or less, the allowable net loss is $25,000; for MAGI above $150,000, the allowable net loss is zero; and for MAGI between $100,000 and $150,000, the $25,000 allowable loss is reduced by $1 for every extra $2 of adjusted gross income (e.g., a $110,000 MAGI allows for a deduction of $20,000 of net rental loss).

Any "unused" loss is carried forward until one of three conditions is met:

1. The owner uses the carry-forward loss in a future year,
2. The owner sells the property, in which case the untaken losses reduce the gain or increase the loss from the property, or
3. The owner dies.

There are some exceptions to the passive-loss rules that bear notice. If an individual is designated as a real estate professional, he or she is allowed to have unlimited deductions. To be a real estate professional, the individual must spend a majority of his or her time in real property business,[13] thus meeting two critical requirements:

1. The individual must work a minimum of 750 hours in the real estate industry annually and
2. Number of hours in real estate has to be more than 50 percent of total hours worked in the year.[14]

It is possible to do very sophisticated tax planning with real property, taking expenses and income in the years when it is most advantageous for the owner. The ability to shift income between years is in itself a sufficient reason for the entrepreneur to purchase real property.

Conclusion

Owner-occupied commercial real estate provides an opportunity for large value creation in a variety of industries by providing an entrepreneur the ability to extract additional cash from his or her business in a way that is tax advantageous. A sophisticated entrepreneur can utilize real estate as a specialized vehicle to provide asset diversification, reduce tax liability, offset taxes from other investment sources, and provide the opportunity to leverage and acquire other assets. It is recommended that business owners work towards the goal of owning the real estate associated with their business and rent from themselves.

 

Alphonse Lordo, MBA, graduated from the Pepperdine University Graziadio School of Business and Management in August 2008 with a concentration in finance. He has held positions in investment real estate and corporate banking, and currently works in the leverage finance and syndications division of a financial institution. Alphonse is also a partner at Blue Point Capital & Consulting, a firm that provides consulting services and capital expertise to entrepreneurs, start-up businesses, and small firms. He is a CFA Level I Candidate and is working towards a CPA designation.

Dr. Michael Kinsman is the Luckman Distinguished Professor of Finance and Accounting at Pepperdine's Graziadio School of Business and Management. A former systems analyst for General Electric Corporation, financial analyst for Pacific Telephone, and consultant for a variety of large and small firms, he currently operates a CPA and consulting firm in Laguna Beach. He has written and lectured on a variety of subjects and has been published in the Journal of Finance, the Journal of Accountancy, and other periodicals. See his faculty page here.

Comments (11)

Dr. Kinsman & Alphonse- Your publication was exceptional and greatly appreciated! As an investent advisor broker and IAR, I found your article very succinct in capturing a plethora of details every business owner and real estate investor must consider. Too many times clients go blindly into these very large investments without sensitizing the details. I think the last 25-years of prosperity driven by exhuberent appreciation in real estate and high margins of business have masked many operational inefficiencies. Because the current economic and financial psunami we are living will change the landscape going forward, investing in real estate - and any other security for that matter - is going to be very critical as the appreciation and profit margins will be much thinnner. Your article is an excellent case study for every investor and business owner to digest as they look at their operational plans. I appreciate your time and effort in putting a great read together. Regards, Jonathan E. Bunce EMBA Grad '97 Class Advisor for EMBA in NorCal Pertria real estate investment firm  ...Jonathan E. Bunce 4/16/2009 7:43:33 AM

A very good article that touched upon every aspect of commercial real estate investment and more. As I read the article I could relate to not just every topic within real estate course but also some aspects of business law, which I studied during my MBA courses @ Pepperdine University. The article not only comprehends the subject matter but also simplifies the language that can be followed by someone who hasn't formally studied business and real estate. Yogi ...Yogi 4/17/2009 12:05:54 AM

Jonathan, Thank you for your kind comments about our article. Alphonse and I read them and were thrilled that you found the article useful for you and for your clients.  ...Michael Kinsman 4/17/2009 7:35:04 AM

I've underwritten $25B+ in commercial real estate loans over the past 18 years. Part of the market collapse is a result of PHDs and CPAs giving real estate advise. Don't use terms like 'income stream in perpetuity' as it misleads investors. BOA, KeyBank, RBC, Prudential, Wells Fargo and most local banks will not make an 80% LTV without a guarantee from a AAA tenant plus a 1.20x underwritten coverage. ...Roger Matlin 4/17/2009 8:29:09 AM

Mr. Matlin,
I appreciate both your background and your experience. I am surprised that you take exception to the article "Owner-Occupied Commercial Real Estate for the Entrepreneur" on the grounds that you do.
*Real estate does in fact generate "an income stream in perpetuity." The size of that stream, and whether it increases over time and its present value was not discussed in either the comment or your criticism of it. That comment is made in the introduction to the article, and is mentioned nowhere else in the article. It is surprising, then, that you should think that it misleads investors--it is a simple statement of fact. The harsher realities of real estate are contained later in the article.
*In addition, since most of the small business clients we are discussing, such as M & G consulting, are not buying large shopping centers or real estate that they intend to rent to others in at least the intermediate term, our (CPA) practice has found few occasions that "local banks" have a guarantee requirement from a AAA tenant. I will grant that of late (in fact, significantly after the start date of the writing of this article), credit requirements have become significantly more stringent. I suspect that you missed our footnote six, which is shown above in the article.
*Finally, I am surprised that you take exception to "PhDs and CPAs giving out real estate advise (sic)". We, as practicing CPAs, are one source that clients can turn to for unbiased information and analysis of real estate. That's one reason that I am sitting a building in Laguna Beach owned by my firm--we ran the numbers and it made sense. The market collapse you cite is much more likely a result of faulty underwriting standards (in large measure promulgated by optimistic bankers and Congress) than from the advice provided by practicing CPAs.
Thank you for your comment. I hope you get the chance to re-read the article in light of my comments above, and that you keep reading the Graziadio Business Report--whether or not you believe all our articles are perfect, they do try to stimulate thinking in both our authors and our readers. Clearly they have done so for both of us.
Michael Kinsman, Ph.D., CPA
Luckman Distinguished Professor of Finance and Accounting
Pepperdine University
and
Certified Public Accountant
Kinsman & Kinsman, CPAs ...Michael Kinsman, Ph.D., CPA 4/28/2009 10:44:38 AM

Get 'em Kinsman. Roger appears to be a Broker and in this market, he is probably not brokering much. As a Real Estate Investment Banker, I found your article interesting and intuitive. Nice Job to you and Lordo! ...Jon 4/28/2009 5:15:45 PM

Thank you for taking the time to write such a wonderful and thorough article. I found your analysis to be very complete and easy to understand. The average investor or business owner could benefit from reading your article. I am a strong believer in owning real estate long-term. Especially multi-tenant industrial buildings, if you can afford them. It does a good job of diversifying the investors risk, and it provides a pretty consistent cash flow over time. Too often business owners do not see the advantages of purchasing their own building, or at least another building in the immediate area. If you own a business and are thinking of purchasing, I would suggest you read this article and look into financing a building, seeing how the interest rates are still very competitive, so long as you meet the financing requirements. Good work gentleman!  ...Matthew V. Johnson 5/2/2009 2:25:52 AM

Alphonse and Professor Kinsman, I enjoyed reading your article as it is very timely for me. Great information on a very large topic. I am currently considering different types of legal structures for a few real estate deals. For example, I am part owner in an apartment building and it too is held in tennacy in common. I was going to move it to an LLC (with great pain) but I concur with your analysis as I think it is the best legal structure given the information. You have saved me some expense and time. Excellent article! Thanks, Ted ...Ted Hooten 6/5/2009 1:36:21 PM

A statement of fact is that the commercial real estate markets, including owner-occupied, continue to decrease in value and occupancies. I'm not a broker nor an 'investment banker'. I consult to buyers, owners and banks on how not to lose money purchasing real estate. In my 18 years of underwriting loans, I never approved a loan that defaulted. Your article is well written. I simply disagree with the points of your opening. Perpetuity can also mean 10 years of $0.00. Roger Matlin MCG Real Estate Strategy www.matlinconsultinggroup.com ...Roger Matlin 6/19/2009 12:54:30 AM

Being an entreprenuer owning my own building personally and used by my closely held businesses myself I appreciate your insight about this article - one question if I may - with structuring a lease between me and my business for the commercial building-how my personal income/debt ratio can benefit from this lease ? thanks for your clarification ...robert chan 10/5/2009 5:57:23 PM

As an entrepreneur, Mr. Chan, you know that there are many taxes involved in your business--not the least of which (if you are not a corporation) is self-employment tax (an employee would call those FICA and Medicare or the generic "Social Security Tax"). Your self employment tax is calculated on your (share of the) net income from your business, after all expenses. One of the expenses, were you to own a building, would be the amount you pay yourself in rent. Obviously, that rental income goes onto your personal tax return rental schedule in exactly the same amount that it came off of your business. However, that rental income is not subject to self employment tax on your personal income tax return. On the other hand, you have lowered your self employment tax from your business income on your personal tax return by the amount of the rent paid. Depending on your income, that saving could be as much as 15.3 percent of your rental expense. In addition, if you have a building that makes a profit, you may be able to use passive losses from other rental properties and passive activities that would otherwise be suspended on your personal return. So, the answer to your question is that the building ownership benefits you in two ways: It reduces the taxable income from your business, and therefore lowers your self employment tax (but not your income tax because the net income from the rental goes on your personal return in exactly the same amount as your business income was reduced); and it has the potential to lower your income taxes because you may be able to accelerate otherwise suspended passive losses because of the income from your commercial property rents.  ...Michael Kinsman 10/6/2009 10:23:20 AM

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