From a small northwestern observatory…

I devote a whole chapter in Real Estate Valuation and Strategy to this topic, with some additional insights in other chapters as well. Time and time again I’ve seen family businesses (car dealerships, restaurants, manufacturing, etc.) with a substantial portion of their net worth tied up in the real estate needed to support the business. There is no question that this real estate investment is necessary, but three issues seem to regularly arise:

1. The value of the real estate changes over time in a different arc from the business itself. In fact, I’ve seen situations where the business value dissipates to near nothing but the value of the underlying real estate increases, to the point where the real estate, if vacant, would be worth more than it is presently worth incumbered with a business. This phenomenon is often masked because the family business fails to account for the imputed rent on the real estate (the rent it would pay every year if it didn’t own the dirt) and all of the so-called profits in the business are really just foregone imputed rents.
2. The real estate isn’t managed well over time. This includes, but is not limited to, failures to maintain proper insurance, failures to manage environmental issues, and mismanagement of property taxes.
3. When the business passed thru generations, some family members may want to actively participate in the business, while others may want to enjoy passive income on the assets. Proper allocation of “rents” (business returns versus real estate returns) and proper compensation of the family members who do managed the business can be complicated without realistic value allocations.

Naturally, a lot of these problems get settled at probate, but waiting until then often leads to costly and time-consuming problems For example, waiting for the inevitable limits the options for estate planners to develop orderly and tax minimizing solutions. Further, it often entails wealth dissipation over time, as the underlying real estate is mis-managed.

For example, we knew one extraordinarily wealthy investor who had a bad habit of putting the vast real estate holdings that supported his extensive business interests in his personal name. This became even more complicated when it was found that some net ground leases and other contracts supporting real estate investments were also personal contracts. After he passed away, it took a team of not-inexpensive attorneys a decade to straighten out the problems.

Another family, with substantial real estate holdings underpinning their business, finally asked to have all of the property valued when the principals (several elderly family members with complex joint ventures and family holdings) neared retirement. The real estate had been accumulated opportunistically over many years, and often adjacent to existing holdings (and thus gaining some hidden aggregation values). Most of the holdings were in areas which enjoyed above-average value growth over time. The final valuation came in with some substantial sticker shock, with liquidity implications for any sort of estate settlement.

Over time, the real estate needs of the business may change. For example, the site size may not be optimal, either too much or too little land. Recent word from southern California indicates that Disneyland, thanks to ride-share and such, no longer need as much parking as they did just a few years ago. With that, they plan to convert some parking into new attractions for the park. In a somewhat different example, a manufacturing / distribution firm saw a very significant shift in the highway on which it fronted, necessitating trucks approach the facility from a different direction. This, in turn, had very real implications for truck turning space, parking, and even the location of loading docks and doors.

Family business owners with underlying real estate should, at a minimum, consider the following for internal and estate planning purposes:

1. Have the real estate and the business valued separately, as if they had separate owners, preferably by different valuers. Then compare this to the value of the integrated whole. Repeat this process periodically, as valuations shift over time.
2. At least for internal discussions, compute the imputed rent on the real estate (the rent you would pay if you didn’t own the dirt) and then deduct this from the business ledger as if it was an actual expense. Even if you don’t have passive family member-owners, this exercise lets you know how much you earn from the effort of running the business, and how much you’d alternatively earn as a passive real estate investor.
3. Periodically, review the real estate holdings with a qualified consultant, with an eye to long-term holdings and optimizing both the real estate owned and the business served by that real estate. Such an “audit” should include a review of property taxes and an allocation of the real estate rents.

Obviously, I put a lot more into the book chapter, and if this is a problem you or a client faces, I would encourage more research into the topic. If I can be of any assistance, or answer any other questions, please let me know.

John A. Kilpatrick, Ph.D., MAI — john@greenfieldadvisors.com