For many manufacturers, buying their facility was one of the best investments they ever made.

A building purchased for $1 million, $2 million or $3 million decades ago may now be worth several times that amount. The mortgage may be paid off, the company may have occupied the property for years without paying rent, and the owners may understandably view the real estate and manufacturing company as parts of the same enterprise.

Then they decide to sell the business.

Suddenly, a structure that worked perfectly well for decades can create a significant problem.

We are increasingly encountering manufacturing companies where the real estate is held inside the same corporation as the operating business. Because the company effectively owns its own building, there is no rent expense on the income statement.

Meanwhile, industrial real estate values have appreciated substantially.

The result can be an unusual disconnect:

• The real estate may be worth far more than the manufacturing company’s cash flow can economically support.
• A buyer who wants both the company and the building must finance both. A buyer who only wants the business must determine what the business’s earnings will look like after it begins paying market rent.
• Neither calculation may resemble the historical financial statements.

This is one reason manufacturers should consider the ownership of their real estate long before they contemplate an exit.

The Traditional OpCo/PropCo Structure

A common alternative is to separate the two assets.

The Operating Company, or “OpCo,” owns the manufacturing operation: employees, equipment, inventory, customer relationships, intellectual property and other operating assets.

A separate Property Company, or “PropCo,” owns the land and building.

The OpCo then leases the facility from the PropCo under a formal lease.

The two companies may ultimately have the same individual owners, but they are separate legal entities with separate accounting records, bank accounts, insurance policies, contracts and obligations.

The concept is simple, but its consequences can be significant.

1. Separating the Real Estate Can Create an Important Layer of Liability Protection

Manufacturing carries risks that many other businesses simply do not.

A manufacturer can potentially face claims involving:

• Product liability
• Defective components
• Workplace accidents
• Equipment-related injuries
• Contract disputes
• Intellectual property claims
• Environmental issues
• Vehicle accidents
• Customer losses allegedly caused by a failed product

Consider an extreme example.

A manufacturer produces a component that is later alleged to have caused a catastrophic product failure. A lawsuit is filed against the manufacturing company seeking damages far beyond available insurance coverage.

If the manufacturing facility is owned directly by the operating company, that property is generally among the assets of the defendant company.

A substantial piece of real estate that may have accumulated millions of dollars of equity over several decades can therefore be sitting inside the same entity that is conducting the higher-risk manufacturing activity.

Separating the property into a properly structured and maintained real estate entity can help isolate the real estate from liabilities generated by the operating company.

It is important, however, not to overstate this protection.

Creating a second LLC or corporation does not make the building untouchable under every circumstance. Courts can disregard separate entities in certain situations. Among the factors considered in “piercing the corporate veil” cases are commingling of assets, misuse of the entity and inadequate respect for corporate separateness. State laws differ significantly.

For the structure to have meaning, the entities need to operate like separate entities.

That generally means maintaining separate bank accounts and books, properly documenting transactions between them, observing applicable corporate or LLC formalities, carrying appropriate insurance and establishing a legitimate lease between the property owner and operating company.

The lease should not simply exist on paper.

Market Rent Matters

If the same individuals own both entities, it may be tempting to charge the manufacturing company an artificially low rent.

That can defeat one of the most important financial benefits of the structure: understanding the true economics of the operating business.

The IRS also specifically cautions that related-party rent should be reasonable. Rent generally becomes problematic when it exceeds market value, and related-party rent should approximate what the business would pay an unrelated landlord for comparable property. (IRS)

For an owner preparing eventually to sell, market rent serves another purpose.

It gives you a far more realistic picture of what the company actually earns.

2. No Rent Can Make Manufacturing EBITDA Look Better Than It Really Is

Suppose a manufacturer reports:

• $15 million in revenue
• $2.5 million in adjusted EBITDA
• No facility rent

That EBITDA figure may initially appear attractive.

But assume comparable industrial property would rent for $750,000 annually.

If a buyer purchases only the operating company and leases the facility from the seller or another landlord, the buyer will inherit that $750,000 expense.

Economically, the business may therefore be generating something closer to:

$2.5 million EBITDA before occupancy normalization

Less: $750,000 market rent

Equals: $1.75 million of normalized EBITDA after rent.

That difference can dramatically change valuation and financing.

An owner who has operated rent-free for decades may understandably focus on the $2.5 million historical EBITDA number. A buyer and its lender are likely to focus on the $1.75 million that remains after providing for the cost of occupying the facility.

This issue becomes even more pronounced when industrial real estate has appreciated dramatically.

3. Real Estate Appreciation Can Outrun the Business

Imagine a manufacturing company worth $6 million operating from a facility now appraised at $12 million.

The seller would understandably like to receive approximately $18 million for the combined assets.

But a buyer purchasing the property with conventional commercial real estate financing might need to contribute several million dollars of additional equity and then service substantial real estate debt.

At the same time, the buyer is financing the acquisition of the manufacturing business.

The relevant question is no longer: “What are the business and building worth?”

It becomes: “Does the operating cash flow support the cost of owning both?”

Those are very different questions.

A manufacturing facility can unquestionably be worth $12 million based upon comparable industrial property values while simultaneously being too expensive for the occupying business to support.

Neither valuation is necessarily wrong.

The assets have simply become financially mismatched.

Separating the real estate from the operating business earlier in the company’s life makes this issue much easier to identify and manage.

4. Separate Ownership Creates More Options When the Company Is Sold

One of the greatest benefits of separating OpCo and PropCo is flexibility.

When the owner eventually exits, there are several potential transaction structures rather than one.

Option One: Sell the Business and Real Estate Together

A buyer acquires the operating company and real estate, usually in separate acquisition entities.

This can work extremely well when the business generates enough cash flow to comfortably support both acquisitions.

Option Two: Sell the Business and Keep the Real Estate

The seller retains the property company and signs a long-term lease with the buyer of the operating company.

This can produce substantial post-closing rental income for the seller.

For some retiring owners, the arrangement effectively converts an illiquid industrial property into a long-term income-producing retirement asset.

It also allows the seller to defer the decision about when the real estate itself should ultimately be sold.

Option Three: Sell the Real Estate and the Business to Different Buyers

There is no inherent reason the best buyer of a manufacturing company must also be the best buyer of industrial real estate.

A strategic manufacturer or private equity-backed company may place the highest value on the operating company.

A REIT, family office, industrial real estate investor or private investor may place the highest value on the property.

Separating the assets allows each to potentially be sold to the buyer willing to pay the most for that particular asset.

Jones Lang LaSalle has specifically noted that separating property and operating-company transactions can allow owners to seek the best owner for each asset and potentially improve the combined sum-of-the-parts valuation.

Option Four: Use a Sale-Leaseback

For manufacturers with highly appreciated real estate, this can be one of the most useful alternatives.

5. How a Sale-Leaseback Can Help Get a Manufacturing Transaction Done

A sale-leaseback separates ownership of the property from use of the property.

The property is sold to a real estate investor.

At the same time, the operating company signs a lease allowing it to continue manufacturing in the facility.

Nothing necessarily changes operationally.

Employees still report to the same plant. Machines remain where they are. Customers can continue being served from the same location.

What changes is the capital structure.

Consider this hypothetical scenario:

Manufacturing business value: $8 million
Industrial real estate value: $12 million
Combined value: $20 million

A strategic buyer may be very comfortable paying $8 million for the manufacturing business.

What the buyer may not want is another $12 million tied up in real estate.

Rather than requiring that buyer to fund a $20 million transaction, the parties could potentially structure simultaneous transactions:

Business Buyer
Purchases the operating company for $8 million.

Real Estate Investor
Purchases the property for $12 million.

Operating Company
Signs a long-term lease with the real estate investor.

The seller has monetized both assets.

The business buyer has avoided investing substantial acquisition capital in real estate.

The real estate investor has acquired an industrial property with a manufacturing tenant already in place.

And the manufacturing operation remains in its existing location.

Sale-leasebacks are widely used precisely because they can unlock capital trapped in owner-occupied real estate while allowing the occupant to remain in the facility. CBRE Group, Inc. describes the strategy as a means of releasing capital for reinvestment, debt reduction and other corporate priorities.

Recent manufacturing transactions demonstrate that this is not merely a theoretical strategy. Jones Lang LaSalle has completed numerous industrial and manufacturing sale-leasebacks, including transactions involving individual manufacturing facilities and portfolios of manufacturing and assembly properties.

The Lease Becomes Critically Important

A sale-leaseback does not make an affordability problem disappear.

The manufacturing company still needs enough cash flow to pay the rent.

That means owners considering this structure should pay close attention to:

• Initial annual rent
• Lease term
• Annual rent escalations
• Renewal options
• Triple-net obligations
• Property taxes
• Insurance
• Building maintenance
• Roof and structural obligations
• Capital expenditures
• Expansion rights
• Assignment provisions
• Change-of-control provisions

A seller may naturally want the highest possible price for the property.

But real estate value and rent are mathematically connected.

A higher property valuation generally requires sufficient rental income to provide the investor with an acceptable return.

If maximizing the sale price of the building creates a rental obligation that the manufacturing business cannot support, the structure may hurt rather than help the business sale.

The goal should therefore be to maximize combined transaction value while preserving sustainable operating-company cash flow, not simply to achieve the highest possible appraisal or real estate sale price.

6. Separate Real Estate Ownership Can Improve Financial Discipline

There is another benefit that is frequently overlooked.

Rent forces management to measure the manufacturing company’s performance as though the facility were owned by an unrelated investor.

That creates a more realistic income statement.

Manufacturers regularly measure labor, material, machine utilization and overhead.

Occupancy is also a cost of doing business.

When the building is buried inside the operating company and fully depreciated or debt-free, management can lose sight of the economic cost of the real estate being consumed by the business.

A formal market-rate lease forces that cost into the operating company’s financial model.

That can improve:

• Product costing
• Quoting
• Margin analysis
• Facility utilization decisions
• Make-versus-buy decisions
• Expansion planning
• EBITDA analysis
• Acquisition readiness

It can also highlight a different problem: underutilized manufacturing space.

A company occupying only 40% or 50% of a valuable industrial property may be generating an inadequate return on the remaining real estate.

That discovery may lead management to lease excess space, subdivide the property, consolidate operations, relocate or eventually monetize the real estate.

7. Separate Real Estate Can Also Help With Succession Planning

Not every family member involved in a manufacturing company has the same long-term objective.

One child may want to operate the manufacturing company.

Another may want passive investments.

A third may have no interest in the business at all.

Separating the operating company and property can provide additional flexibility when designing ownership succession, estate planning or family buyouts.

It can also allow ownership of the real estate and operating company to evolve differently over time.

These strategies can have substantial tax and estate-planning implications, however, and should be designed with qualified tax and legal advisers rather than implemented solely for convenience.

What Are the Disadvantages of Separate Ownership?

Holding the real estate separately is not automatically the correct answer for every manufacturer.

There are additional costs and complexities.

Structure	Potential Advantages	Potential Disadvantages
Real estate inside operating company	Simpler administration, one entity, fewer tax returns and agreements, no intercompany lease	Real estate exposed to operating-company liabilities, less M&A flexibility, no visible occupancy expense, business earnings may require normalization at sale, valuable property tied directly to manufacturing risks
Separate PropCo and OpCo	Better risk segregation, clear market rent, cleaner operating-company economics, greater transaction flexibility, ability to retain property after business sale, separate financing and succession options	Additional accounting, legal and tax filings, formal lease required, separate insurance and banking, potential state tax implications, greater administrative complexity
Sale-leaseback	Converts real estate equity to cash, can reduce buyer’s acquisition capital requirement, allows continued occupancy, separates business buyer from real estate investor	Creates continuing rent obligation, property appreciation transfers to new owner, tenant loses some control, lease restrictions matter, sale can create tax consequences

The appropriate structure depends upon the owner’s objectives, tax basis, debt, jurisdiction, ownership structure, insurance program and long-term exit strategy.

A Critical Warning: Do Not Wait for a Lawsuit to Move the Building

There is an important distinction between legitimate long-term business planning and attempting to move assets beyond the reach of creditors after a liability has arisen.

Transferring valuable real estate out of an operating company after a significant claim or lawsuit has emerged can create serious legal issues.

Fraudulent-transfer and voidable-transaction laws generally allow creditors to challenge transactions made with the intent to hinder, delay or defraud creditors, and certain transfers for less than reasonably equivalent value can also be challenged.

Asset protection should therefore be proactive.

The best time to examine the company’s real estate structure is before there is a problem and well before a contemplated sale.

Moving Existing Real Estate Out of an Operating Company Requires Planning

Owners who currently hold their building inside the manufacturing entity should not interpret this article to mean that they should simply deed the property to a new LLC next week.

Unwinding an existing structure may create consequences involving:

• Federal income taxes
• State and local taxes
• Real estate transfer taxes
• Property tax reassessment
• Existing mortgages
• Lender consent
• Depreciation and tax basis
• Environmental representations
• Title insurance
• Ownership percentages
• Estate planning
• Related-party transactions
• Existing or contingent creditors

The tax consequences can be particularly significant when a property has been owned and depreciated for decades.

The IRS treats the disposition of business property separately according to the nature of the assets involved, and sales of real estate and depreciable business property can produce different tax consequences from the sale of inventory, goodwill and other assets. (IRS)

For that reason, restructuring existing real estate ownership should be coordinated among the company’s M&A adviser, CPA, tax attorney, corporate attorney, insurance adviser and, when appropriate, commercial real estate counsel.

One of the Most Important Questions Manufacturers Should Ask Today

For owners who expect to sell their manufacturing company within the next five or ten years, there is a relatively simple exercise worth performing now:

What would our company earn if we had to pay market rent for our facility?

Then ask a second question:

If a buyer had to purchase this building at today’s market value, could our company’s cash flow comfortably support the real estate debt?

If the answer to either question is no, the company may have an issue that deserves attention long before an M&A process begins.

The problem is not that the building became too valuable.

Real estate appreciation is a tremendous wealth-building accomplishment.

The challenge is making sure that the ownership structure allows that wealth to be realized without simultaneously making the operating company difficult to sell.

The Best Structure Preserves Options

There is no universal rule that every manufacturer should own its real estate separately.

But there is a strong argument for treating the operating company and the property as two economically distinct assets.

Manufacturing companies generate value through employees, customers, equipment, technology, intellectual property, processes and cash flow.

Industrial real estate generates value based upon location, land, improvements, market rents, tenant quality and investor demand.

Those values do not always grow at the same rate.

When the two assets are permanently locked together inside a single corporation, the owner may eventually discover that the real estate has appreciated beyond the financial capacity of the company occupying it.

Separating them can provide greater liability protection, clearer financial reporting, more disciplined operating analysis, additional succession alternatives and, perhaps most importantly, substantially more flexibility when the time comes to sell.

For manufacturers that already have decades of appreciation trapped inside their operating company, restructuring may still be possible—but the legal and tax consequences need to be evaluated carefully.

The objective is not simply to move a building from one entity to another.

The objective is to make sure that the value created in both the manufacturing company and the real estate can ultimately be preserved, financed, and monetized independently.