Be Your Own Landlord

Mystery shrouds the work of real estate developers. There isn't an abundance of books written about how the process works or how money is really made and lost. The truth of the matter is that the process is pretty much the same for The Donald as it is the developer of a small office building.

The most sought-after commodity in commercial real estate is a tenant. If you ask an office building developer what his or her business is they'll likely say, "leasing." This is because developers can't build what they can't lease.

If the business you own has good credit and you rent, your lease has great economic value to the landlord, and that landlord might just as well be you. By simply signing a business lease, you are not only giving up rents on which there are profit, you're giving up substantial leverage. And it's leverage that makes the real estate world go round.

Leverage is a fancy term for simply using borrowed funds to make a transaction. It's also about the magic of ballooning small amounts of money into large amounts. Let's see how this happens with you as the developer.

Let's say you build a small office to rent, a 10-foot by 10-foot building (100 square feet) and rent it to your business for $10 per square foot per year. If your business pays all your expenses (taxes, maintenance, utilities, etc.), your property produces net operating income (called "NOI") of $1,000 (100sf x $10 = $1,000). So far, so good. Figuring your NOI is step one in the process.

Next, you trot your commercial lease to the bank in support of your real estate loan. Banks value (appraise) property in three ways: income production, reproduction cost and alternative use. Of these, we're only concerned with the first way, the income approach to value. This valuation concept says that a property is worth the mortgage it can repay from its income stream after first paying a dividend to you in the form of "cash flow." All this means that your returns from the property are greater than the cost to carry the debt.

An appraiser arrives at a market value for your deal by dividing a capitalization (cap) rate--a decimal--into your NOI stream. Whenever you divide a decimal into a whole number the resulting number balloons. Watch this: $1,000 (NOI) ( 10% (cap rate) = $10,000 market value. If the bank will lend 75 percent of market value, you can borrow $7,500 to build your commercial property.

What you have just done is to leverage a $1,000 lease expense to your business to a $10,000 personal asset on which you can borrow $7,500. You will repay the $7,500 mortgage with lease income and pocket about $150 per year in cash flow. In this little deal your personal balance sheet is enhanced by $2,500 ($10,000 - 7,500 = $2,500), not counting the value of your income stream, which is probably worth another $1,500 ($150 ( 10% = $1,500). If you think these numbers are small, multiply them by 10 (for a 10,000-square-foot building).

Are these numbers real? They're in the ballpark and illustrate the concepts.

Does my business lose anything? Not if you charge your business a market rent for the kind of facility you deliver.

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Actually, most businesses benefit in ways that you may not foresee. For example:

* A new building can streamline operations and save on costs. Remember, every dollar lost in operations means between $10 to $20 in extra billings to break even.

* A new building can reflect the dynamics of the enterprise and increase visibility.

* You rent from the world's friendliest landlord.

* Your balance sheet isn't saddled with real estate debt so that your business is worth more.

*If you decide to sell your business it can easily remain your tenant because of your lease agreement.

Is there a risk? Some, but something without risk probably has little reward. Your risk mainly runs to the quality and future of your business; the better your business the lower your risk.

Businesses and properties frequently have the same value structure--10 times earnings/net income, so it's not uncommon to see the real estate have values equal to or greater than the business. Think about what you leave on the table when your business leases from a third-party landlord.

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The Value of Property

* The market value of a rental property is based on its ability to produce income. To find the market value of a property divide NOI (defined as the income available for debt service and cash flow) by 9 percent or 10 percent.

* The mortgage value, the amount you can borrow, is a percentage of market value, usually 75 percent to 80 percent.

* Each dollar of NOI delivers a market value of between $10 and $11 and results in a mortgage of between $7.50 and $8.33, depending on whether a 10 percent or 9 percent cap rate is used.

Is the process really this simple? Yes and no. The concepts are not complicated and these rules-of-thumb show typical deals made today, but there are, as you might expect, many tricks of the trade. The object here is to give you an insight into how real estate is financed and a peek at what the rough numbers might look like. With all this in mind, let's move on.

Almost as important as the tenant-business is the actual lease it signs with the landlord. In a typical third-party lease the landlord tries to get the tenant to pay--and take responsibility for--as much as possible, while tenants try to accomplish just the reverse. As a result, the terms and conditions of a commercial lease frequently have more cost or value (depending upon your viewpoint) than minor swings in the lease rate. Are you responsible for the air-conditioning system? For taxes? For tax increases? For cleaning? The list goes on.

But when your company leases from you, its owner, things can get much more interesting and win-win deals happen with regularity. Remember as we go, we're talking about each dollar of NOI having a market value of between $10 and $11, so let's get creative.

Suppose the nature of your business calls for some special equipment that an ordinary tenant of the building wouldn't need. Instead of you paying for this special equipment, let your business pay for it as a leasehold improvement that can be written off for tax purposes. Because this special stuff is a leasehold improvement, it is to your benefit as the landlord since it is part of the building. The creativity in structuring a win-win lease is to allocate costs properly and completely between your business and you, something that's easier to say than to do.

If your business is substantial and signs a lease with you that is in step with the term of your financing--say, a 10-year lease, 10-year term--you might escape having your signature guarantee the mortgage note.

Into your business lease you can build in automatic rental rate adjustments that are tied to one of a number of recognized indexes. When this happens, your lease keeps pace with the time-val