Should an Operating Company own Real Estate?

Most hotels do not own the properties they manage. The Four Season Hotel Gresham Palace Budapest is currently owned by the State General Reserve Fund of Oman.

Should a Company own the Premises it Occupies?

As with most questions, there are pros and cons. Owning the premises can give some strength to your financial statements, and provide collateral to banks, should you need it. But, most importantly, owning the premises in which you operate may have important strategic benefits for your business, such as ensuring that you can stay there as long as you want, without the danger of a landlord terminating or not renewing your lease. There would also be less restrictive covenants than in a lease, thereby providing greater freedom of activity.

Some businesses simply do not have the financial resources to invest in their premises, or believe that they can obtain a much higher return on investment by investing into their core business, rather than into real estate, which typically produces a low but stable yield.
For example, many of the world’s largest hotel groups do not own the underlying hotels they operate, believing that they can achieve larger, steadier and more measurable returns without also owning the real estate.

Should a Company own Real Estate in a Separate Entity ?

Once you make a decision that your company should hold real estate, there are a number of reasons why a separate entity may be a superior solution:

•    Limited liability. Should anyone sue your operating entity, if the real estate is owned in a separate entity, the real estate will probably not be the subject of litigation.

•    Ease of accounting. Where the real estate and the operating company are in separate legal entities, the financial performance of your operating entity is not distorted by effects of owning and operating real estate.

•    Ease of exit. It becomes easier to sell the real estate or the operating business, should there be reasons for selling them separately. If an operating entity and real estate are in the same company, the situation may become complicated if a buyer wants one but not the other. In such instances, the real estate will probably need to be transferred to another entity, triggering capital gains and land transfer taxes. These tax effects may be substantial, particularly where the real estate has appreciated in value over decades. (While de-merging a corporate entity is a theoretical possibility, in most jurisdictions this takes six months or longer, thereby adding unacceptable delay to the timeline of a transaction.) This is an important element of exit planning.

In our opinion, there is really only one advantage of putting real estate and an operating business into the same corporate entity, namely a certain amount of cost savings, by not having to incorporate and maintain a second corporate entity. For smaller, simpler businesses, this may be an important factor. But where a business has scale or is likely to scale, it is worth considering the investment.

Of course, where your operating entity uses premises owned by a separate non-arm’s length real estate entity, care must be taken to ensure that the two entities enter into a lease based on market rents. This will help avoid possible issues with the tax authorities.

One final piece of advice: where you have an operating company and a real estate company, you may wish to create a holding company which owns both of them. While this creates an extra level of expense in creating and operating yet another legal entity, it also has a number of advantages:

•    Tax benefits: In many legal jurisdictions, should you sell a subsidiary (either the operating company, or the real estate entity, or both), this may be a tax-free transaction.

•    Accounting: You can produce a set of consolidated financial statements at the holding level that reflect the combined strength of multiple entities.

•    Maximum flexibility upon exit: You can sell the holding, (which owns the subsidiaries) , or one or more subsidiaries separately.

Les Nemethy is CEO of Euro-Phoenix (www.europhoenix.com), a Central European corporate finance firm, author of Business Exit Planning (www.businessexitplanningbook.com) and a former president of the American Chamber of Commerce in Hungary.