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 bank lending 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 tax returns and financial statements and, usually, the opco's guarantee. Many lenders go further and run a global cash flow test across both companies and the owners, which is exactly what SBA lenders do.

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Most problems with a propco/opco structure trace back to a lease that was never written down, is out of date, or charges whatever suited the owners' tax position that year.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. SBA requires this in its eligible passive company structure.
• 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.

SBA eligibility: the eligible passive company

SBA lends to operating businesses, not to passive real estate investors. It makes one important exception for exactly this structure. An eligible passive company can own the real estate and borrow to buy or improve it, as long as it leases the property to an eligible operating company. The operating company must be a guarantor of the loan, or a co-borrower if it receives any of the proceeds. The lease must run at least as long as the loan, and every owner of 20% or more of either company personally guarantees it.

For SBA 504, occupancy is measured by the operating company: it must occupy at least 51% of an existing building, or 60% of new construction. For SBA 7(a), real estate carries maturities up to 25 years, compared with up to 10 years for working capital and goodwill. SBA also counts the two companies together as affiliates when it checks size standards, so a split does not make a business smaller in SBA's eyes. See SBA affiliation rules and SBA 7(a) vs 504 for which program fits the building.

The practical point: if you plan to use SBA financing for the building, set up the propco, its ownership and the lease so they fit SBA's structure before you apply. Retrofitting a lease or reshuffling ownership mid-application is slower and raises questions about why.

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 in SBA-financed sales. It lowers the purchase price the buyer must finance, and the seller's continuing role is as landlord; SBA does not allow the seller to stay on as an owner, officer or employee after a complete change of ownership. The lease is what the buyer's lender will scrutinize, so the terms in why the landlord lease matters apply in full, even though the landlord is the seller. 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. 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, we present the two companies to lenders as one credit with two borrowers, which is how they will underwrite it anyway. The 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.