Phantom Leases: The Best Occupancy Structure for An Owner-OccupantBrian A. OpertPhantom Lease, Owner-Occupant, Protection Against Law Suit Liability, real estate
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
owner of the real estate as well. This individual owns the
operating business and the building that the business occupies in
their name, which makes a significant impact on how both the
business and real estate are valued.
For example, a marina that operates the boats slips, repair
shops and a boat supply store is dealt with as a boat maintenance
business that also occupies its real estate. The manufacturer, who
is the sole occupant of the office/warehouse, is valued-based on
the business earnings, plus the value of its overhead cranes,
manufacturing equipment and inventory, rather than as a tenant in a
commercial property. A pizza parlor that owns and occupies most of
the small strip center is valued as a business, with the real
estate as an asset of the business. A funeral home that owns the
building and land it occupies, is valued as a business with the
real estate as an asset of the business. In each situation, the
real estate, which may have significant value in its own right, is
often booked as a depreciating asset by the accountants and often
appears on the balance sheet as negative.
Phantom Lease
Perhaps there is a better way to structure and value these types
of businesses that are associated with the real estate that 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 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, especially for 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, 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 and special
purpose entity, whose function is to own and manage the real estate
and buildings. The entity can be an limited liability company
(LLC), corporation, partnership or any other special purpose entity
that makes legal and financial sense to the principal(s). Under
this plan, this entity becomes the lessor.
The Lessee
The principal(s) of the company who owns the real estate can and
should be the same principal(s) as those who own the business,
which then becomes another separate entity or continues to be an
individual proprietorship. Thereby, the business becomes the
tenant--also called the lessee. The business can become or remain
as an LLC, corporation, partnership, sole proprietorship or other
entity that it has always been. It can also 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 and the costs to maintain and operate the
property, the lessee now pays rent to both the lessor and to
maintain the property.
Under this plan, the business does not own the real estate. It
may still own the equipment, inventory, goodwill and customers of
the company, and is responsible for hiring all employees. The
business continues to pay for the utilities, insurance, repairs and
maintenance and even the real estate taxes--similar to 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,
therefore, is responsible for the debt service payments. The funds
derived for these mortgage payments are obtained from the rent
payments made by the lessee. To some individuals, this appears as
taking money from one pocket and putting it into the other and
appears to require additional overhead and cost with little or no
benefit. However, this is not necessarily the situation.
Advantages
Let us 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 and 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, as well as visa versa. A dispute that involves the
business operation does not inevitably tie-up the real estate.
There is some additional security derived from this separation of
owners.
3. Furniture, Fixtures and Equipment (FF & E)
Ownership
Oftentimes, lenders who lend on real estate as collateral have
minimal 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 and receivables 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 in 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's 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's
business enterprise. When the two are valued separately, this may
result in greater total value than if valued as one enterprise
combined.
5. 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, such
as factoring, equipment financing and leases.
6. Freedom to Relocate. In the event that the
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 imply the loss of the real estate as
well. 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 with a
sale-leaseback agreement, permitting a large infusion of new
non-leveraged cash into the business, without the need to simply
shut down. This is completed 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 of
owning the real estate may be the correct vehicle to take advantage
of such a special situation.
Disadvantages
The following are the few disadvantages: paying the necessary
fees to establish the new separate entity to own the real estate;
the requirement to maintain two sets of books and records--one for
the business and one for the real estate; the requirement to file
tax returns separately; and the possibility to have two income tax
burdens. Furthermore, to convert an existing business situation
into the two entity structure, the real estate must be
"quit-claimed" 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
separately 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. He may be reached at (203) 256-9068, fax (203) 256-9564 or
e-mail
[email protected].
