A central question for most small businesses is how to handle occupancy issues.  Even in this age of internet interconnectivity and mobile offices, most businesses still need a physical presence and location no matter what goods or services they provide, and at some point the question arises, do we want to own or lease real property?  The purpose of this article is to provide some thoughts and considerations that might guide small business owners in making this important decision.  One thing is certain.  The decision to buy or lease commercial real estate should not be a snap decision since its implications will be long lasting and vital to the business’ and ownership’s financial success.  It is also certain that decision to buy or lease commercial property will force the prudent business person to think carefully about his or her business and personal goals and plans for the future.
   The “pros” of owning a business’ commercial real estate are obvious.  There is a measure of certainty and control that comes with owning property that can not be obtained in a leasing situation.  As an owner of commercial real estate, a business person doesn’t need to worry about increased rents, the possibility of non-renewal of the lease, the sale of the property, or the even worse, the landlord’s bankruptcy or foreclosure.  Moreover, once the financing is in place the business owner will have a fairly certain idea of occupancy costs, at least until the commercial mortgage becomes due and refinancing is required.
  Another “pro” is that as the business owner can modify or develop the property as he or she sees fit.  A commercial landlord might limit changes in fear that they would reduce the attractiveness or utility of the property to future potential tenants.  However, the business owner may rightfully see a well-designed or prominent property as a way to increase the business’ identity and establish its brand.
  The investment potential of real estate is also an attraction.  Occupancy costs that formerly were expenses now become a form of investment that creates value for the owners through the payment of mortgage principal.  The basic thought is why should we pay someone else’s mortgage when we can be paying our own? 
  Additionally, although the real estate is invariably held in another legal entity, the combination of a business and its real property may contribute to the overall value of the company and provides a supplemental asset that can increase the borrowing power of the business.
  Now, let’s turn to the “cons”, which are often the flip side of the positive factors.  The stability of owning the real estate can easily turn into a negative, locking a company into a site that has become inefficient or overly expensive in a changing real estate market. Indeed, a business may become too successful and outgrow a property that once was thought to have plenty of room for expansion.  A business’ customer base may change and it may need to move to become closer to its core customers, or to respond to changing transportation needs.  A property may become inefficient over time and newer facilities offer substantially lower rents and better utility management.
  Business planning and succession issues can become complicated by real estate ownership.  Buy outs of departing owners may become financially unwieldy and even impossible to finance internally and could require the liquidation or sale of the company.  New business partners and investors may not be interested in investing in real estate, or conversely, may want a piece of the real estate to cement their relationship and gain a bigger say in the management of the company.
  The ownership of real estate also makes the business more susceptible to attacks from outsiders, including the spouses of the owners.  Statistics tell us that there is an even chance that each partner will experience matrimonial discord.  That partner’s in business real estate may be subject to equitable distribution claims which could require a business partner to sell his or her interest in the business’ real estate holdings. It could be worse.  Business real estate is often held by the business owners and their spouses, which means that the other partners (and their spouses) may be forced to be unwilling participants in the divorce proceedings. 
  There is another major consideration.  The ownership of the business property imposes a new role on the business owners:  commercial landlord.   All of the tasks that a commercial landlord normally performs now fall in the laps of the owners.  Burned out light bulbs, stopped toilets and snow removal now become major concerns (or irritants) and may detract from ownership’s core business activities.  Additionally, the ownership of property can increase the potential for liability claims for poor premise’s maintenance.
  Finally, if the ownership group of the real estate does not match that of the business, there is the possibility that conflicts over the property can arise as the business develops.  Failure to have a fair and equitable lease agreement can lead to oppressed shareholder or partner litigation and may cause tax problems.
  These decisions are not easy and should not be made quickly or alone.  Trusted advisors in real estate, accounting and business planning should be consulted and the business owners should carefully consider what they expect of each other and the business.  Exit and entrance strategies should be carefully considered and weighed.  The long term needs of the business partners and their families should also be considered.  Only after these important considerations have been made should a business make the decision to purchase real property.
  Once the decision to purchase commercial real estate is made, the path is clearer.  It is universally recommended that real property be held in a business entity separate and apart from the primary business entity.  The most basic reason for this separation is asset protection in case of claims against the either the business for its operations or arising from the occupancy of the property.  Simply put, a creditor or judgment holder against the business will not generally be able to levy against the real estate, and likewise, a person with a claim arising from a defective condition of the property will not have a direct claim against the business and its assets.  Although business insurance provides protection for many claims, the prudent practice is still to separate the ownership of the business and its real estate.
  Also, this separation of ownership makes it easier for the business to detach itself from the real estate in case a move is necessary or if there is a change in the ownership of the business.
  There is also universal agreement that the preferred business form is the limited liability company or LLC. The LLC business form provides the members with a similar liability protection given to shareholders of a corporation but the LLC form is much easier to administer.  Rather than having to assign and transfer shares, ownership rights in a LLC are set forth in an operating agreement that can be easily amended as circumstances change. There is also the availability of making a Subchapter S election for income tax treatment, if suggested by a qualified tax professional.
  The advantages of separate legal entities can be lost if care is not taken to keep the entities separate.  The case law speaks of the need to maintain the formality of the business forms. This means that annual filings and registrations must be maintained.  The corporate books and accounts must be separate. There should be a fair and balanced lease between the business and its landlord, which should be updated as needed.  The lease terms should reflect market conditions.  A lease that is overly favorable to the landlord may create claims from the non-real estate owners that the company is favoring the real estate ownership group, and it may create unforeseen tax problems since excess earnings could be treated as passive income for the real estate owners.  In fact, Rich Nocella, a tax attorney in Marlton, suggests that the best plan is for the real estate entity to “net out” each year to avoid tax liability for its members for such passive income. 
  In sum, the decision of business owners to purchase and occupy commercial real estate is a critical one.  A full understanding of the “pros” and “cons” of real estate ownership is necessary.  This understanding must then be coupled with a honest and considered evaluation of the goals for the business and its owners.  Finally, even the best plan must include provisions for flexibility since the reality of the future is often far different than our present visions and aspirations.
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Article Provided by: Tom Barron, Barron & Posternocl, LLP
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