In this series of articles, we are exploring a concept we often get asked about. Business owners wonder if selling a business is like selling real property investments, as many owners have some experience with these transactions. While there are some similarities, the differences are substantial. It can be costly to a business owner to draw conclusions based on selling real property investment and selling their privately held business without professional help.
Let’s start with location. This is certainly an important characteristic of real property, as the location is fixed. Desirability of location is an important consideration when buying and selling real property. On the other hand, location is usually only important for privately held businesses that rely on customer traffic, such as retail establishments. Absent the need for customer traffic, location can be flexible, and businesses can operate in multiple locations. Revenue may also come from all over the world, both for brick and mortar businesses and those that offer online sales.
Tangible and intangible assets
Real property is by its very nature a tangible asset and can include office, industrial, retail, residential (both multi-family and single family), and speculative undeveloped raw land. The replacement cost of the land and improvements will usually set the “floor” for value in real property. By contrast, an operating business is made up of both tangible (property, plant and equipment) and intangible assets. Intangible assets include many things, such as customer lists, intellectual property (patents and trade secrets) and goodwill. Together, intangible assets and goodwill usually make up most of the value of a company. Value for intangible assets is primarily reliant on the income stream, which does not have a “floor”.
Revenue, net income and return
How are revenue, net income and return derived for real property vs. a privately held business? For real property, income and return are usually derived from net rental income and potential capital appreciation. Rental revenue typically flows from a written lease for defined amounts over a fixed period of time. By contrast, businesses operate under a revenue model derived from selling a product or service. Income is highly dependent on maximizing sales at a profitable level while also managing costs. Whether revenue is recurring, or project based is key to the valuation. Businesses with a recurring revenue model generally carry higher valuations. In addition, the strength of the employee team is very important to the operation of the privately held business.
Successfully operating a real property asset requires expertise in sales (leasing) and property management (upkeep), which can be the owner’s responsibility or outsourced to a property management company. To successfully operate a privately held business, you must build an effective management and employee team, as well as execute a well-defined and researched business plan. While many real estate owners outsource management to a property management company, outsourcing management of a business in a hands-off way is usually not an option, as compared to outsourcing responsibilities to a property management company.
Given the fixed nature of real property, growth opportunities are usually limited and require substantial capital investment. Growth can be accomplished by making improvements to a building or changing the use and/or purpose of the property. Businesses can be grown by increasing sales and profitability (cash flow). Owners can increase sales and marketing efforts to drive sales, open new locations, and offer new products and services. Rate of return and more is not limited to the footprint of the property and can be driven in many creative ways.
The asset characteristics of privately held businesses vs. real property investments are quite dissimilar in terms of revenue, operations, net income, growth, and more. Because of this, each require a very different sales process when the owner decides it is time to monetize the investment, and professional help should be sought to ensure maximum value is achieved when selling.
In upcoming articles, we will continue to compare selling investment real property and privately held businesses and the steps in the process. Next up, we’ll tackle valuation similarities and differences. Please reach out if you have a question or topic you’d like to see covered in future articles.