We have on many occasions stressed the importance of looking at your space as an integral part of your business rather than just a place to put your business.
Facilities cost is one of the biggest of your fixed expenses, so it only make sense to make sure each of those dollars is spent in a way that optimizes overall efficiency. But, balancing the short term changes to your operation with a years’ long lease or owned facility is problematic. Most leases run 5 years or more, and owner/users tend to hold their properties for even longer.
One of the first questions we ask clients when we sit down with them is: how has your business changed since you moved into your space? We rarely get an answer of “not at all”. In fact, most business owners we speak with have a sizeable list of changes that have impacted the efficacy of their current facilities. Some are growing rapidly, others are suffering from lower revenues and need less space, while others have a need for a different building configuration related to power, loading, beam clearance, office layout, location, etc.
Recently we wrote a post on Getting Unstuck that was all about working around long-term lease obligations to optimize space efficiency. And, given the rapidly changing economy, we are seeing more business owners taking a more proactive look at relocation as a way to adjust to the more challenging business environment. In this post we look more at the owner/user sector, as their challenges are different than those business who lease their facilities.
Currently, sales prices remain near the peak level of 2022, mainly due to low availability of buildings offered for sale, which has softened the impact of a sharp drop in demand from potential owner/users. However, this may not be the case looking ahead. The cost of servicing mortgage debt has doubled in a year, inflation is still running hot and the economy is losing momentum. That uncertainty is sending potential owner/users to the sidelines, as the cost of a new mortgage is substantially higher than a monthly lease payment for the same building. So, they are keeping their powder dry and opting for the less costly alternative of leasing.
However, existing owner/users are in a good position to put themselves in the optimum facility due to the massive equity they have accumulated during the longest bull real estate run-up in history. By using the 1031 exchange mechanism, they are in position to trade into an alternate facility, fully tax deferred. Since they have a mountain of cash to acquire their up-leg properties, they are less dependent on more expensive mortgages to get themselves into the right building. Consider the following example that mirrors an assignment that one of our colleagues is working on now:
In this case there are three properties of 9,000-square-feet, 18,000-square-feet and 32,000-square-feet. Our colleague is the listing agent on the 18,000-square-foot property. The owner/user of the 32,000 square-footer needs less space and is selling his building to exchange into the 18,000-square-foot building with all cash. At the same time, the owner of the 18,000 square foot building will exchange into the 9,000 square-footer, the owner of which will exchange into an income-producing investment and lease a smaller space for his business.
The final result: all three businesses get to right-size their facilities, sell their investments at full market value, defer all capital gains taxes and, in case of the owner of the smallest building, create an income stream to support his upcoming retirement. Each party will have optimized the use of their equity instead of leaving it tied up in concrete structures they no longer need. If that’s not a winning scenario, then we don’t know what one looks like.
We think we are going to see a lot more of this in the next couple of years. New entrants to the owner/user community will become fewer and farther between. They just can’t afford to pay a premium price and then service expensive debt at the same time. Trades between existing owner/users either eliminate the need for debt or reduce it substantially, as most of them are sitting on piles of equity. And, they can pay each other higher prices because that is all rolled up inside the 1031 exchange.
So, if you are an owner/user who would like to right-size your operation, give us a call to discuss this interesting alternative for those like you who were smart enough and brave enough to buy your own building. You deserve a big win of your own.