Should the real estate be held separately from the operating business?

How the split works

The owners form two companies, usually with the same or overlapping ownership. The propco holds title to the land and building and does nothing else. The opco employs the staff, sells to customers, owns the equipment and inventory, and pays the propco rent under a lease between them. Because the same people sit on both sides, that lease is a related-party lease, and it is the document everyone who lends to or buys either company will read first.

Owners set things up this way for several reasons: to keep the building out of reach of claims against the operating business, to let family members own the real estate in different shares from the business, to sell the business later and keep the rent, or simply because the building was bought separately years after the company started. Any of those can be sound. The financing consequences are the same whichever reason applies.

The split has costs. Two companies mean two sets of books, two tax returns and two insurance programs. Moving a building the opco already owns into a new propco can trigger transfer taxes or a property reassessment, and if a mortgage is in place, the lender's consent. Weigh those before restructuring an existing building; the case is easiest when you set it up at purchase.

How lenders underwrite each side

On paper you have two borrowers. In practice each lender looks through to the business, because the business is where all the cash comes from.

A lender to the propco on a single-tenant building leased to its own owners is not really making a real estate loan to an investor. It is lending against one tenant's ability to pay, so it will want the opco's financial statements and tax returns and, usually, the opco's guarantee. Many lenders go further and run a global cash flow test across both companies, so the rent is tested once as the propco's income and again as the opco's cost.

Lenders underwrite the rent twice: as the propco's income and as the opco's expense. It has to make sense from both sides.

The related-party lease is the hinge

Most problems with a propco/opco structure trace back to a lease that was never written down, is out of date, or charges whatever suited the owners' tax position that year. Lenders test it on four points.

• Is the rent at market? Rent set above market moves cash from the business to the owners through the building. While it is being paid it is a real fixed charge, and an opco lender will add the excess back only if the lease is reset to market; the propco's lender will then ask whether the mortgage still works on the lower rent. Rent set below market flatters the opco's earnings, and a lender or buyer will cut earnings back to what market rent would cost.
• Is it actually paid? Rent that accrues unpaid, or is paid in lumps when cash allows, tells a lender the propco can't service its mortgage without help. Monthly payments that match the lease are what they want to see in the bank statements.
• Does it run long enough? Both lenders want the lease, including renewal options, to run at least as long as their loans. A lease that expires before the mortgage leaves the propco's lender with an empty building and no tenant.
• Who comes first? The propco's lender takes an assignment of the lease and rents. The opco's lender wants the propco, as landlord, to waive or subordinate any landlord's lien on the opco's equipment and inventory and allow access to collect them. The two lenders' documents need to agree.

A worked example shows why market rent matters in a sale. Say the opco earns EBITDA of 1,000 while paying its owners' propco rent of 100, and market rent for the building is 200. A buyer of the business alone will sign a lease at 200, so it will value the business on earnings of 900. At a price of 5 times earnings, the business is worth 4,500, not 5,000. The owners have not lost anything, because the propco now collects the higher rent, but the price of the operating company falls, and so does the amount a lender will lend to buy it.

Where the building fits in a cash-flow loan

Cash-flow lenders size the opco's loan on EBITDA, and EBITDA is earnings after rent. A company that owns its building inside the operating company pays no rent, so its EBITDA is higher than it would be if it leased, and its earnings are not comparable with competitors that rent. Lenders and buyers notice. When the building sits in a propco and the opco pays market rent, the opco's EBITDA already carries the true cost of its premises, and the leverage test runs on a figure a buyer would recognize.

The building also earns less in a cash-flow loan than owners expect. A lender sizing on a multiple of EBITDA takes the property as extra collateral but usually does not lend much more because of it, while a mortgage lender would lend against the same building on a longer schedule and at a lower rate. Financing the building separately can therefore raise the total the owners can borrow at a lower blended cost. The catch is that the opco then pays rent, which lowers its EBITDA and counts in fixed charge coverage, so the opco's own loan may shrink. Run both sides before assuming the split raises total proceeds.

Some lenders go a step further and test leverage with rent treated as a debt-like obligation, precisely so that moving from owning to leasing does not flatter the ratios. Where a lender does, the split changes the documents more than it changes the answer.

Separating the building is a financing decision as much as a legal one. Model the opco after market rent before you decide.

What it changes in an acquisition

When a business being sold sits in a building owned by a propco, the buyer has a choice: buy the opco only and lease the building from the seller's propco, or buy both. The trade-offs are covered in buying the building with the business vs leasing it from the seller.

Keeping the building and leasing it to the buyer is a common arrangement, and many private equity buyers prefer it, because it keeps their equity in the business rather than in real estate. It lowers the purchase price the buyer must finance, and the seller keeps an income property with a tenant it knows. The lease is what the buyer's lender will scrutinize, so the usual lease terms apply in full, even though the landlord is the seller: market rent, a term at least as long as the loan, the right to assign, and a landlord waiver. Where the buyer takes the building too, financing an acquisition that includes the real estate explains how the pieces fit.

What it changes when you sell or refinance

A clean split gives you options at exit. You can sell the business and keep the building as an income property leased to the buyer. You can sell the building to an investor and stay as a tenant, the sale-leaseback route. Or you can sell both to one buyer. Each option only works if the lease is one a stranger would accept.

Refinancing works the same way. The propco's mortgage and the opco's loans can be refinanced separately, on different schedules, with different lenders, and a propco with equity in its building can raise cash for the owners without touching the operating company's debt; sale-leaseback vs cash-out refinance compares the two routes. That flexibility has a price: cross-default clauses and cross-guarantees often tie the two companies' loans together anyway, so a problem on one side can reach the other. Read those clauses before assuming the companies are as separate as the org chart says. Where a holding company sits above both, borrowing at the holdco vs the opco covers the next layer.

Setting it up so lenders don't have to ask

• A written lease between the propco and the opco, signed, current and with rent at a level you can support as market.
• Rent paid monthly from the opco's account to the propco's account, matching the lease.
• Separate books, bank accounts and tax returns for each company.
• A lease term, with renewals, at least as long as the longest loan on either side.
• An organization chart showing who owns what share of each company.
• A debt schedule that lists every loan in both companies and every cross-guarantee.

With those in place, Midas Partners presents the two companies to lenders as one credit with two borrowers, which is how they will underwrite it anyway. The financing model shows the opco after market rent and the propco's coverage on that rent, and the lender package explains the structure before a lender has to ask. Once the documents are in, the package is built in a day, and a senior banker checks every page before the client approves it. With 1,800+ lenders in the book, the opco's loan and the propco's mortgage can be taken to the lenders suited to each, rather than forced into one lender's appetite.