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Real Estate On My Mind

Owned and Operated Newsletter
Owned and Operated Newsletter
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Meme of the Week
Real Estate
I have been heads down for a few months as we worked through some interesting issues on and in our business. I’m sure I’ll discuss more of them as we wrap up.
 
Today, the issue on my mind is real estate. One of the problems that nearly every business has to deal with eventually is whether to lease or buy the building they’re going to occupy. Many businesses opt to buy, including me at times. I’ll toss my opinion out now and then work through the nuance. It is very rarely the right decision to buy the real estate you occupy for your business. Time after time, I have seen it be the exact wrong decision. Many owners have been repeatedly told to buy real estate, so they think they’re making the right decision, but I want to debunk that and then offer some times that it is the correct decision.
 
We are going through this decision currently and, despite the overwhelming evidence against buying, will be buying our location. If I sound conflicted, it’s because I am. Enjoy.
 
     1. It’s a bad use of capital.
If you are in an asset-light business like mine, then a massive capex into a building is usually the exact wrong decision. That capital can be used to accelerate your business further and faster. My return on invested capital (ROIC) in real estate is lucky to be 8%, whereas I have consistently topped 40-50% in our operating businesses. We buy cash-cow businesses that create more cash than we need. We then use that cash to buy more cash cow businesses and so the flywheel goes. Adding real estate slows down the whole process.
As an illustration, if I bought a $1 million building for $250k down, I would create about $30k of cash flow a year after debt.
If I bought a 1M business for 250k down I would create about 200k of cashflow a year after debt.
 
     2. It’s not a “savings”
Some owners buy real estate because it’s cheaper than leasing. My only comment is “that’s dumb.” What you’re effectively saying is that you are going to pay yourself under market rent and gyp yourself instead of just paying someone else.
 
     3. It’s a distraction
I’m in the Home Service business. You’re in whatever business you’re in. Unless you’re in the real estate business, then it’s a distraction.
 
     4. It slows you down
I’ve met multi-location owners who own 10+ units of a franchise and the underlying real estate. Their regret was huge. The same cash that they used to buy all that real estate could have doubled their unit count and made a much more impactful exit.
 
     5. You can’t control values
This is the operator in me. If I buy a business, then I know I can increase revenue, cash flows, and values rapidly. often doubling the value of the business in a year or two. I can increase values in real estate through general value addition—raising rents and property enhancement—but that value increase may take a decade to be fulfilled, and even then, a double is hard to achieve.
 
There are a very few times when buying the underlying real estate makes sense:
 
     1.  If total cost of occupancy is much cheaper
I mean, much, much cheaper. Like free. This can happen occasionally because tenants pay the mortgage and all property costs. Another way is by negotiating move-in incentives with your local jurisdiction. Those incentives can often be no real estate tax, discounted utilities, huge discounts to payroll tax, or cheap lending on the building for improvements.
     2. If the real estate makes the business more lendable
I would LOVE to get a 20-year amortization with 5% debt on an acquisition. I know plenty of acquisition entrepreneurs that focus on businesses that the real estate can make up a meaningful amount of the total enterprise value, so the businesses are very easy to buy and the debt is friendly. Banks love lending on real estate, and the terms are great. I’ve seen this a lot in manufacturing.
 
     3. The location is strategically located and you can exist there for more than a decade.
This one is just nuanced. For me, this would mean the property is large enough for us to triple in size and is in high-income zip codes that can afford our services.
     4. You can refi on it
One of the advantages of real estate is that you can refi against it and cycle that capital back into the business.
 
Right now, we own one of our five locations. The owned location has been our headquarters for 50 years. We are now preparing to buy a very large property in a new city and move our headquarters. It is a strategic location that we believe we can stay in for at least 15 years, have very strong tax credits and incentives to move in, are in the right location where we can serve our customers, and will be borderline free to occupy because a tenant pays nearly all of the mortgage and underlying costs.
 
Even with it checking every single box, I still rethink this decision every hour because I know how bad a use of capital it is and wish that same capital could go to another acquisition. It’s a bad use of cash, it’ll slow us down, and I can’t control the value. All that said, we believe that the addition of value because of the location and stability of it will counteract the downsides. Only time will tell.
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