Difficulties Transferring the Pharmacy’s Lease

This may be the most problematic obstacle of all the impediments faced by sellers.

Whereas a great majority of the obstacles are somewhat within sellers’ control, that is not necessarily the case with transferring a facility lease.  Landlords can be unpredictable and typically have a lot of leverage in lease negotiations with prospective buyers.

Become thoroughly familiar with the terms of your lease

Before ever putting your business on the market, you need to be familiar with the legal language in your lease.  Your intermediary might help you preliminarily interpret the lease but should also strongly suggest you ask your attorney to review and interpret the lease provisions.

Most facility leases will address the issue of assignability of the lease.  Many will allow the lease to be assigned, but usually “only with written permission from the landlord.”  You also hope to see the phrase that the landlord’s permission “shall not be unreasonably withheld.”

In addition, there may be provisions explaining what the landlord needs to approve a new tenant.  There also may be notification time frames stated, as well as the landlord’s required response time.  It’s also possible there will be transfer fees associated with obtaining the landlord’s approval.

About lease assignments

Typically, if a lease is assigned to a new tenant, the original tenant remains liable in the event of a default by the assignee.  The implications are if the buyer struggles after acquiring your business and stops making payments on the lease, the landlord can look to collect lease payments from you for the remainder of the lease commitment.  In the final definitive documents of the business sale, you will likely have indemnity clauses in your favor from the buyer.  But, although you have the legal right to do so, there is no assurance funds will exist to reimburse you if the buyer defaults on an assigned lease.

SBA financing requires the lease term (with options) to match the loan term.

There’s another complicating factor.  If the buyers’ financing is based on an SBA loan, the SBA will require the lease term, including tenant options, to match the loan term – usually either 7 or 10 years. That can be favorable for landlords because they can use that fact to achieve longer term lease commitments, but the option has to be the tenant’s, so that creates an offsetting factor.  The real difficulty arises if the landlord has other plans for the leased space and is not willing to negotiate a lease term to match the loan term.  Or, some landlords will use that prerequisite as leverage to try to negotiate unreasonable lease terms. 

Novation agreements are desirable

As the tenant on a lease, your ideal solution is to negotiate a novation agreement, which means the landlord and prospective buyer enter into a new lease agreement at the same time you are released from obligations under the original lease agreement.  In theory, it’s great.  In reality, it’s extremely difficult to negotiate because in most circumstances the landlord has all the leverage in lease negotiations.  Unless, of course, the business can be relocated, but even that leaves you on the hook for the remaining lease term.

When to talk to the landlord

The other difficult decision is when to approach the landlord.  On one hand, if you discuss a lease assignment early in the sale process, you have to be very concerned about the landlord honoring your request for confidentiality of your intentions to sell.  That is a very legitimate concern that requires significant consideration.  On the other hand, if you approach the landlord two weeks before closing, that’s not enough time to avoid an angry response.

One approach is to informally ask about transferring the lease far in advance of the sale.  For instance, “I’m thinking I might sell my business in the next few years.  What’s the process of transferring my lease?”  Then, once you have a serious buyer with whom you’ve reached a preliminary agreement subject to due diligence, consider contacting the landlord at that time.  The longer the notice you can provide, the happier the landlord will be.  Then again, you still need to be concerned with confidentiality.

Preparation is the key to a successful lease transfer

Because a lot is not within your control, lease transfers can be an extremely difficult obstacle to overcome.  But you need to do what you can to prepare.  Having a good working relationship with your landlord, as opposed to an antagonistic relationship, is a good first start.  Know the terms of your lease and ask your attorney to interpret the language.  It’s important to prepare yourself mentally for a lease assignment that requires you to remain liable for the lease if the buyer defaults.  The possibility of negotiating away that provision is slim.

And, finally, select an intermediary who has significant business sales’ skills, AND also has experience in dealing with lease transfer issues.

Real Estate Transfer Issues

The biggest obstacle created by ownership of commercial real estate in a business sale transaction is establishing the fair market value (FMV) of the property.  Commercial real estate values are much more difficult to determine than residential real estate values.  As opposed to the housing market, where there are comparable and recent sales of homes to help establish value, that is not the case with commercial property.

Eliminate the obstacle created by unknown values of commercial real estate.  Have your property appraised, not by real estate agents, but by professional licensed commercial real estate appraisers.

About commercial property valuation

Commercial properties are usually fairly unique, with differing extents of construction types, build-outs of office space vs. warehouse space, size of land, types of usage, zoning ordinances to be dealt with, and the consideration of location, location, location.  Since there are far fewer commercial transactions than home sales, actual sale comparables are hard to find.  Asking prices are usually astronomical when compared to actual sale prices.  So the few asking prices in the current marketplace are not reliable comparables.

The business value is dependent on the real estate value

There is another complicating factor when a business owner also owns the facility the business occupies: the business value is dependent on the real estate value.  Since business valuations are a function of the business’ cash flow, the cost of occupancy at FMV has to be determined.  In other words, if the owner owns the facility’s real estate and the business is not paying the owner rent, the business shows no occupancy cost in its financial statements.  In this example, in determining the cash flow of the business, the cost of occupancy would have to be considered and imputed (negative adjustment to cash flow).  Before a business is valued, the cost of occupancy should always be adjusted to FMV.  But when it comes to commercial real estate, it is not all that easy to do so.

Benefits of obtaining a real estate appraisal

There is a way to address this particular obstacle.  It is imperative to obtain an appraisal from a professional and licensed commercial real estate appraiser.  There are many benefits to doing so:

  • By obtaining the FMV of the property’s sale value and the FMV of leasing the facility, you can adjust the business occupancy cost appropriately and set a reasonable asking price for the business.
  • Buyers always have fear of overpaying.  A real estate appraisal eliminates that issue, so you only have to reach agreement on the price of the business.
  • Based on the information received, you can determine if you prefer to sell or lease the real estate to the buyer of the business.
  • If the real estate is to be sold, a lender will require an appraisal.  When a recent appraisal already exists, and the lender’s appraiser is made aware of the value, the second appraiser’s value is likely to be similar to the first appraisal.  Consider this: which appraiser is likely to provide a higher value, the one you hired or the lender’s appraiser?  Isn’t it a good idea to have your appraisal ready for the lender’s appraisal?

Obtaining a real estate appraisal is an important step in preparing for a business sale

Benefits #1 and #2 above are key.  Given the nature of commercial real estate’s fluidity in perceived valuations, it’s almost impossible to successfully negotiate a business acquisition because the buyer cannot get comfortable with the cost of occupancy he will face.  With that much uncertainty, buyers have a very difficult time moving forward.  The real estate appraisal is one of the most important preparation steps to selling a business because it addresses an obstacle that is sure to arise.

Should you sell or lease your real estate to the buyer?

It’s usually best to allow the buyer to decide.  If you require a sale, you may lose a legitimate buyer and vice versa.  If the buyer leases, you have additional monthly income, or you can turn around and sell the property to a real estate investor.  If you prefer a lease for the monthly income, but the buyer prefers to buy the facility, you can invest the proceeds in another piece of commercial real estate.  Or, you can finance the buyer’s acquisition of the real estate and have a recurring monthly income with a lien on the real estate.

If the business is realistically priced, your intermediary can help the buyer understand it and defend the asking price of the business.  However, even if the intermediary is a licensed real estate agent, as he should be, an appraisal is necessary to establish the real estate price.

Eliminate the obstacle created by unknown values of commercial real estate.  Have your property appraised, not by real estate agents, but by professional licensed commercial real estate appraisers.

If you want to know how to deal with real estate you own in a pharmacy sale, give ColonyRX a call today.