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Running Your Business:
How Real Estate Affects the Bottom Line for Restaurants
By Christopher Perez

Perhaps the most striking feature about the money made by homeowners from their house was how little of it was intentional. For many, a mortgage payment was simply a substitute for the monthly rent payment. But over time, loan balances went down, values went up, and suddenly there's a half a million in equity sitting on the table.

Although a similar opportunity exists for restaurants, few owners take the leap. Running a restaurant is challenging enough, why add the headache of owning additional property? This may be true, but buying real estate to house your restaurant - as opposed to renting -- can have a material impact on your return from the business and your overall wealth.

To see this concept in action, consider the performance our hypothetical retailer, The Cafe Bistro, which, before and after the purchase of real estate.

For years, The Cafe Bistro provided a nice living for its owner. Located in the suburb of a major metropolitan area, the business, a subchapter S corporation, consistently generated $750,000 in sales and distributed net profits of 5% or about $37,500 after the payment of a $60,000 salary to the owner. Since the business was stable, the owner typically took the net profits out of the business in the form of a cash payment.

Suddenly, the owner receives a call one day. The building owner has died. The executor of the estate would like to know if he would be interested in buying the building for $750,000? Because the owner had invested his bonuses wisely over the past 10 years, there was no question he had the cash to make a 40% down payment of $300,000.

But the question became would the purchase of the building have a positive or negative effect on the Cafe Bistro's owner? Let's assume the owner buys the building personally, and rents it to the restaurant to see how far out ahead he might come after 10 years, versus continuing to rent.

If the $450,000 balance was financed with a 6.25% adjustable rate mortgage, the monthly principal and interest payment would be $2,770, if amortized on a 30 years basis. Including the annual taxes of $7,200 increases the monthly payment to $3,370. This is less than the current monthly rent of $6,500 that the company pays, so the transaction is off to a good start.

But let's be conservative and assume that the Cafe Bistro's owner spends $37,500 annually on maintenance and operating expenses for the building. This $37,500 is annual difference between the old rental payments and the new mortgage and tax payments.

Now we need to make two adjustments to account for depreciation and principal contributions.

Let's take principal first. The mortgage payments of $2,770 per month which total $33,240 annually contain about $5,300 in principal payments in the first year. These principal payments cannot be expensed.

On the other side, there's depreciation to consider. Net of land, which cannot be depreciated, the value of the building is $675,000 which is $750,000 less an assignment to the value of the land at about $75,000 or 10% of the total value of the property. The useful life prescribed by the IRS for non residential commercial real estate is 39 years. Therefore the annual depreciation expense for the property is $17,308 which is the $675,000 basis divided by the 39 year useful life.

The income statement for the first year will look like this:

Income $78,000

Expenses
Mortgage Payments
Net of Principal $27,940
Taxes $ 7,200
Operating Expenses $37,500
Depreciation $17,308
Total Expenses $89,948

Net Loss $11,948

The landlord feels none of this net loss because it's delivered in large measure by the non cash depreciation expense. On the down side however, he also doesn't really feel the increase in equity of $5,300, because, despite the lower mortgage balance, the mortgage payment does not change.

Regardless, what's important is the ability of the landlord to take this loss and net it against the profits he receives from his retail business that will ultimately have a material impact on his wealth.

Remember the 5%, or $37,500 in profits? Thanks to the loss on the building the owner will pay taxes on just $25,553 ($37,500 profits - $11,948 loss from real estate). In a 35% bracket, this means avoided taxes of $4,181

Said differently, the Cafe Bistro's net margin would have to increase to 5.86%, to leave its owner with the same amount of cash after taxes. This represents an astounding 17.2% (0.86% / 5.00%) increase in net realized profits to the owner.

It's important to keep in mind however that the feds, as a general rule do not like to see passive income (i.e., such as income from a real estate investment) offsetting active income, (i.e., such as income from running a retail operation). There are rules that govern limits to the offsets over certain amounts. And if you get into a discussion with the Internal Revenue Service that your ownership and management of the building is active, you might very well be unable to get them to see your point of view.

Now project 10 years into the future, and assume that rather than selling the restaurant, the owner simply shuts it down and sells the building. Also assume that after the first year he replaced the 6.25% adjustable rate mortgage with 9.87% permanent financing. How did he do? At the end of 10 years, he owed the bank $410,000. However because real state values went up by an average of 7% per year, he sold the building for $1.47 million. After paying off the mortgage, the Cafe Bistro's owner has $1.06 million.

True, he doesn't get to pocket this. He must pay long-term capital gains taxes. And all that depreciation he took for so many years comes home to roost, in lowering the cost of the building, and in turn increasing the capital gains tax owed. In this case the $17,308 in annual depreciation reduced the owner's cost basis by $173,080 over 10 years. Said differently, the owner must now pay taxes on this so called "unrecaptured" depreciation at a rate of 25%. The balance of the gain will be taxed at the recently enacted long-term capital gains rates of 15%.

However this must be weighed against the avoided taxes of $4,181 in the first year and $9,800 in years two through 10 (as a result of a mortgage with a higher interest rate). But more importantly it must also be weighed against the $634,692 ($1.06 million proceeds - $125,308 capital gains taxes - $300,000 initial investment) earned on the real estate investment after payment of all long-term capital gains taxes.

The average after tax gain of $63,469 ($634,692/10 years) per year is the equivalent of $97,644 pre tax income in a 35% bracket. Adding this to the owner's salary and profit distribution of $97,500, means that diverting the cashflow that normally went into rent toward ownership of real estate doubled his income. It's as if he made the business twice as big but never added a single square foot to the operation. Yes, it's safe to say that adding real estate into the business equation can have a very material effect on the wealth of principals in a restaurant.


Christopher Perez is the Director Commercial Lending for Nassau Mortgage Company in Newtown, PA. As a former bar and restaurant owner, he understands and appreciates the problems facing the restaurant industry when it comes to financing. You may contact Chris directly at cperez@restaurantreport.com or by phone @ 1-800-481-5101




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