Real Estate and the Family Business in Divorce

Travis Harms recently wrote a piece for our Family Business Director Blog about the family business’ investment in real estate. Below, we have adapted his piece for business owner clients going through a divorce.

As the pandemic recedes further into the rearview mirror, long-term business consequences continue to reverberate through the economy.  In addition to recalibrating expectations among domestic manufacturers, foreclosures on distressed commercial real estate are accelerating.

For many business owners and their spouses, the marital net worth may be concentrated in the value of the business. Furthermore, the company’s real estate can be a significant portion of this value or may represent additional value. The lingering pandemic-induced weakness in commercial real estate values may encourage families to re-evaluate their real estate strategies, though this varies by asset class, use, and geography among many other considerations. Re-evaluating real estate strategies is particularly necessary for couples seeking to equitably divide assets in a marital estate pursuant to a divorce.

Below we highlight three real estate strategies we often see for those who own and operate a business.

Real estate strategy #1 – Operating business owns real estate needed for operations

This strategy is often the default strategy for enterprising families.

• This approach has the virtue of simplicity. When additional productive assets are needed to take advantage of growth opportunities, the company acquires them, whether those assets consist of machinery & equipment or real estate.
• Owned real estate provides the operating business with leverage capacity. Lenders take comfort in real estate as collateral, so businesses that accumulate operating real estate on their balance sheets will likely have greater borrowing capacity when attractive investment opportunities arise.
• All else equal, an operating business that owns real estate is probably less risky than one that does not. Real estate holdings are likely to have alternative future uses outside the business and carry less risk than intangible assets, goodwill, and other assets that are specific to an operating business.
• Real estate offers the prospect of capital appreciation. Rolling stock, production equipment, and other operating assets depreciate and lose value over the long term.  In contrast, investments in operating real estate can provide opportunities for capital appreciation in addition to the value created through operating the business.

Real estate strategy #2 – Operating business leases real estate needed for operations from a third party

Instead of purchasing real estate for operations, some family businesses elect to lease facilities needed for operations from unrelated third parties.

• This strategy preserves the greatest flexibility for the operating business. Beyond the remaining term of the lease agreement, the operating business is not committed to the real estate from which it operates.  As strategies and market opportunities evolve, the operating business’s real estate needs are likely to evolve as well.
• Leasing real estate from a third party allows management of the operating business to focus on running the business. Call it “core competency” or what have you: developing & managing real estate well requires a different skill set than running an operating business.  Leasing the real estate needed for operations rather than owning allows the management team to focus on what they do best.
• Leasing can boost return on invested capital and shareholder returns. By reducing the amount of capital committed to the business, lessees can realize higher returns on invested capital.  Of course, return follows risk, so the higher expected returns come from bearing greater risk.
• This strategy avoids the risk of falling property values weighing on business returns. While real estate values do often go up, appreciation is not guaranteed.  As noted in the second article linked in the introduction, commercial real estate values are currently under pressure in many sectors and markets.  For lessees, that is someone else’s problem.

Real estate strategy #3 – Operating business leases real estate needed for operations from a related party

This strategy represents a “hybrid” of the other two strategies.  Under this approach, the operating real estate is owned by a related family entity and leased to the operating business.

• This approach can add governing complexity. The real estate entity will need its own governance mechanism, specifically a lease agreement defining the arrangement.
• Separating ownership of operating real estate from the business can allow families to offer a more tailored risk and return profile to family members. Not all family members have identical return objectives and risk tolerances, and housing operating real estate in a separate entity can accommodate a wider range of shareholder preferences.
• While most divorcing couples prefer not to be economically tied to their spouse post-divorce, this is not always attainable. Splitting the operating business and the real estate can potentially represent an amicable solution for both parties. In this case, significant post-marital efforts increasing the value of the core operating business accrue to the “in-spouse”, while the current rental income and passive capital appreciation of the real estate accrue to the “out-spouse” who is not able to meaningfully improve the value of the operating business post-divorce.

Intentional or not, all small business owners have a real estate strategy.  An outside perspective can be helpful if your real estate strategy is due for a simple refresh or a wholesale reconsideration, in the context of a divorce or not.  Give one of our senior professionals a call today to discuss your situation in confidence.

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