It is indeed a wise decision to own the building in which your business operates, and many entrepreneurs consider this a nice arrangement.

Typically, the process involves forming a corporation, such as a limited liability company, that takes title to the property. The business then “leases” the address from the LLC, often as a separate entity.

This solution offers some clear advantages: tax benefits, depreciation, interest deductions and the opportunity to build equity. However, many owner-occupiers make serious mistakes that can undermine these benefits.

Let’s take a closer look at two of the most serious errors:

Do not pay market rent

When purchasing a building, businesses typically finance the purchase, often through the Small Business Administration, which provides financing of up to 90% of the purchase price.

Because only 10% equity is required to purchase, the resulting debt service typically determines the rent the business pays to the LLC. This means that rent is usually based on debt service requirements rather than market rates.

While this may seem convenient, it can lead to significant financial discrepancies over time.

Remember, while debt decreases, rent remains the same and may fall below market value. This discrepancy can cause significant financial problems.

For example, if the rent is significantly below market, the company’s profits will appear artificially inflated. This can complicate matters if the owner decides to sell the company. Potential buyers may see an inflated profit margin that is not realistic when market rent is taken into account.

I experienced this myself with a company that owned its building since 2001. It benefited from below-market rent for over 20 years. When it came time to sell the company, the profit appeared much higher than it actually was, creating a difficult situation for both valuation and sale.

To avoid these pitfalls and ensure the financial health of both the business and the real estate company, it is important to adjust the rent to current market prices.

In order to always maintain an accurate financial picture, it is important to regularly review the rent and adjust it to current market conditions.

No agreement between owner and tenant

Another common mistake is overlooking the need for a formal lease agreement between the real estate company and the operating business.

Many owner-occupiers assume that a formal contract is unnecessary because they control both. “I own the business and the building, so why do I need a contract?” is a common phrase. This mindset can lead to serious complications, especially when unexpected events occur such as death, divorce or sale.

I remember a particularly extreme case involving a manufacturing company.

The owner, who also owned the building, died suddenly. Without the company’s knowledge, the owner had changed the ownership of the building and divided it among several heirs.

None of these heirs wanted to continue the business, and since there was no lease, the store was vacated so the building could be sold, resulting in a costly and disruptive move for the company.

To avoid such scenarios, a written agreement between the owner and tenant is crucial. It ensures that both parties are clear about their obligations and protects the business from unforeseen events.

This agreement should outline the terms of the lease, the amount of rent, the duration, and any other relevant details. This is a simple step that can save a lot of hassle later.

Owning the building in which your business operates can be incredibly beneficial, providing tax advantages and the opportunity to build equity.

However, you should definitely avoid these two common mistakes: not paying market rent and not entering into a formal agreement between owner and tenant.

By regularly reviewing rental prices and adhering to clear agreements, you can ensure that both the company and the real estate unit are financially sound.

Allen C. Buchanan, SIOR, is principal of Lee & Associates Commercial Real Estate Services in Orange. He can be reached at [email protected] or 714.564.7104.