Non-Obvious Real Estate Value Creation When Selling Your Auto or Heavy-Duty Business

Auto / heavy-duty business owners who own real estate (RE) should understand this playbook before the sale of their business. You can significantly work your RE value upwards by doing the following.

If you own your RE, it’s important you are charging your business fair market rent. Undercharging rent causes problems by boosting and distorting EBITDA – a metric for profitability. Rent is a large expense and often quite variable on a percentage of sales basis. Undercharging for rent often masks low operational profitability.

For example, imagine you are ready to sell your business (and maybe your real estate). Your business does $15M in revenue with a below market rent of 4% rent-to-sales, or $600,000 annually. Assume 7-10% rent-to-sales is market rate for your business type, and you bump rent to 7% rent-to-sales, or $1,050,000 annually, because a potential acquirer needs to understand the true profitability. EBITDA would drop by $450,000.

This will impact the business valuation, leaving you with two options: a) make changes to make to your business more profitable; 2) accept the fact the EBITDA of the business is now correct.

Now that rent is fair market, let’s understand how fair market rent impacts real estate value. Real estate appraisers typically use the capitalization, comparable sales, or cost method to value RE. Many times, the income capitalization method holds the most weight. Rental income divided by cap rate gives you the RE value in this case. When the business rent was $600,000 on an 8% cap rate (established by the appraiser or an investor), that RE was worth $7,500,000. When rent is boosted to a market rate of $1,050,000 annually, and the business is turning a sustainable and reasonable profit at that rent level, the RE value becomes $13,125,000 at that same cap rate. Charging fair market rent for your real estate is important because many acquirers will want to buy your business but lease your real estate.

Now let’s get to the really cool part.

How about getting that cap rate down from 8% to 7%? Remember the formula: Rental income divided by cap rate = RE value. Cap rates are assigned by investors in real estate such as REITS, institutional investors and private capital buyers, or 1031 exchanges and are primarily driven downward as investment risk decreases.

A triple net (NNN) lease that’s 10-15 years long with annual escalators of 2-3%, particularly with a large credit worthy tenant, creates an income stream for a real estate buyer (not the business acquirer) that is durable and low risk. In this case, we could see cap rates drop to 7%. At $1,050,000 in annual rent, the RE value is now worth $15,000,000, not $13,125,000. In this scenario, you’ve seemingly created nearly $2,000,000 in RE value out of thin air! This isn’t pie in the sky math. For investors/buyers, business and real estate acquisitions are all about risk and probability of maintaining and growing cash flows.

The playbook above applies to service shops as well as manufacturing facilities and distribution real estate. Service businesses typically receive higher cap rates in the 7%+ range while industrial/manufacturing/distribution facilities receive lower cap rates of 5%-7%. The example I provided is based on a theoretical service shop.

We tell all our sell-side auto and heavy-duty clients to think about their business and real estate separately. The wealthiest owners I know typically own their real estate. Fair market rent, strong lease terms, and of course a solid profitable business are foundational to a winning exit, whether or not the transaction bundles the business with or without the RE.