‘To Own or Not to Own’ – that is the question. We’ve all heard the business owners’ rationalization for owning the building where their business operates –

  • “My business is going to pay rent to someone, why shouldn’t it be me?” 
  • “We don’t want our business to be beholden to a landlord, we want to be in control of the rent [payment] and control our future”
  • “Our mortgage payment is less expensive than the rent we were paying.”
  • This list goes on and on…

While there have been many situations where the business and business owner have benefited from this arrangement, there is the other side of the coin.

Owner-occupied buildings have substantial fixed expenses and debt associated with a building can be significant relative to the overall size of the business. For those businesses that do not have adequate capital or unstable operations, the arrangement can result in an irreparable set of circumstances for the business and the borrower/business owner.

So far in 2020, of all the troubled debt situations we have seen, the significant majority of challenges arose from fixed obligations associated with owner-occupied buildings! Maybe it’s just a “point in time” and the law of averages will even out, however, at this point we can’t ignore the pattern!

A few common themes in these troubled situations:

  • The business contributed its liquidity to the down payment (and yes, many of them made a draw on their RLOC!)
  • Unstable revenues and/or projected revenues: Either the business needed to increase revenues to adequately support the fixed obligations or revenues were not stable enough to service monthly obligations when revenues declined.
  • The business owner(s) did not have substantial liquidity to contribute to the business to service obligations associated with the real estate.
  • A number of these represented new real estate ‘expansions’ where the operating companies were previously generating sufficient positive cash flow prior to the investment. The expansion neither improved production nor increased cash flow generation; however, in all cases, it reduced available cash, increased fixed obligations and overall leverage, and caused permanent damage to these once healthy businesses.

We understand the reality of the lending relationship – Yes, most banks need to grow and outstandings associated with owner-occupied real estate are stable and reliable; and if the bank is going to claim to be a relationship bank then it should provide the financing for the building that its borrowers operate in.

However, in today’s environment, there is a limited ability to reduce fixed obligations of owner-occupied real estate. We suggest analyzing three points when assessing similar situations in your portfolios:

  1. Utilization
    • Is building/real estate “essential” to business – does it add value via a special feature or make business more efficient?
    • Does business have maximum utilization of building square footage/land?
  2. Equity
    • Is there a material level of equity in the building given today’s market value?
    • Best use of equity to provide collateral support via cross-collateralization or could equity provide material impact on the operational strength of the business?
  3. Optionality
    • Current “utilization” of building space? Can space be utilized by sub-tenant (Either inside building, or outside parking/storage, etc.)? Would sub-tenant(s) provide a material source of cash flow?
    • Would the sale of real estate provide material equity and/or CF savings to the business? And if so, does it outweigh the “cost”/impact of selling building/moving operations to more appropriate relative size/expense structure?