Some sellers may want you to buy the entity that owns their property and not the property itself. Can you do that? In this Self-Storage University podcast we’re going to drill down on the concept of buying an entity, what can go wrong with that concept, and how to mitigate that risk.
Welcome to the Self-Storage University Podcast, where you will learn the correct way to identify, evaluate, negotiate, perform due diligence on, renegotiate, finance, turn-around and operate self-storage facilities. And your host is a partner in one of the largest real estate portfolios in the U.S. with nearly $1 billion of holdings, Frank Rolfe.
Typically when you say you're buying a self-storage facility, what you mean is you are buying that asset, that piece of real estate, that building in the land. But sometimes the seller will want you to, instead of buying the asset by itself, buy the entity that owns that asset. This is Frank Rolfe, The Self Storage University Podcast. We're gonna talk about the difference between buying an asset and buying an entity. Let me first say I am not a lawyer, I have no legal training whatsoever, I'm just giving you observations that I have noted from real life, but you would always wanna talk to an attorney on this very thorny issue. Now, let's talk first about what the big differences are between buying an entity and buying the asset. Let's start off with when you buy the asset. When you buy the asset, you are getting something: A piece of property, a piece of real estate, but it does not tie back to anything that happened prior. That's the way it works here in America. The typical property law is you buy the asset, but you're not buying anything that happened prior to the date of closing 'cause it wasn't yours.
So now no matter idiocy Mom and Pop did earlier, that's washed away as far as you're concerned. Yeah, for example, the seller has done some horrible employment law violation prior to the day of closing while that person can sue them for that, but can't sue you, you weren't the owner back in that period, you're the new kid in town. As a result, you're not bound by what Mom and Pop did. However, when you buy the entity, things are very, very different, because now you're not buying the asset free and clear of all prior grievances, you're buying something that comes with often a plethora of virtual buffet of potential problems, none of which you know about, and that's the first problem when you buy the entity, is simply liability. You don't know what Mom and Pop did. Let's say, for example, Mom and Pop had a manager at the storage facility and they underpaid them and they overwork them, and they owe them a whole bunch of over time or some other kind of employment violation, and you buy the entity and then three or four days later, the entity gets sued by that employee. Says, "Wait, you owe me a ton in over time, you violated my rights," and all this different stuff. Well, you're sucked into that now, because that grievance is again the entity that owns the self-storage facility, and so that means you.
So the first initial problem when you buy an entity, whether it be an LLC or an LP or whatever it may be, is you inherit all of the liabilities, and see you don't know what those are. There have been many, many cases over the years where people bought things thinking everything seemed fine, well, gosh, Mom and Pop seem friendly enough, not realizing they had been doing bad stuff. And the problem is all those bad things they did are all coming back against that entity which you now own. The next problem falls under the terms of depreciation and tax implications. Self-storage facilities, like all forms of real estate other than land, are typically depreciated. So all those buildings and roll-up doors and roads and all those different features, those all have depreciation schedules, but the problem is when you buy the entity and not the asset, many of the schedules have already been depleted pretty significantly. So you may have significant taxation and depreciation issues in buying the entity.
This is one case where you definitely have to get the feedback from a competent license CPA or another accounting professional to tell you exactly how that is going to play out, because that may be a real eye opener for you when you find that by buying that entity, you are gonna lose a lot of the advantages you could have had in depreciation and taxation issues, and those are all gone. The third one, which is a huge one, is lenders aren't going to wanna do it. Now, why would a lender not want to finance you buying an entity? Well, for the reasons we've just stated. The lender is now also getting sucked into whatever prior strange this Mom and Pop did, and that makes that loan much more dangerous. All of your banks simply wanna make a loan, a first lien loan on an asset purchase, that's what they've classically been trained to do, that's the safest position for a bank to be in. When you come to them and say, instead, you wanna go and have them finance you buying this entity, you're trying to put something in a box that they don't have a label for at the bank. Remember that banks are very risk-averse.
Banks only make money on the interest on the principal they loan you, but they get no upside no matter how well you do with that storage facility. So as a result, they don't wanna do anything risky, they don't care about doing anything risky. They just wanna get their money. There's an old saying in the banking industry, before you can have return on principal, you have to have return of principal, which means you really don't wanna be taking any risk as a banker. So since they don't know or appreciate or understand the entity and the purchase of the entity, they really don't want anything to do with it. So a big issue you will have is simply the fact that the lender isn't going to want to do it. Now, how do you mitigate any of those issues? Can you mitigate liability? Not really, you can't buy insurance for things that we don't know what happened in the past with Mom and Pop, so that we really can't. And you can really mitigate depreciation tax implications, they're just set in stone, whatever they may be. Now you can mitigate would a lender do it or not simply if you could get Mom and Pop to carry the paper. So it would be possible if you bought the entity that they would, in turn, carry the financing if you couldn't get a bank, but that's about the only thing you can do from a risk perspective to mitigate those issues.
So then the big question is would you ever do it? In what cases would you find it acceptable or attractive to buy an entity rather than the asset? Well, the first one would be if you're doing kind of a zero down non-recourse deal. So there's an old saying that that kind of construction really cures all evils. So when you're gonna do a zero down non-recourse deal, you really don't have any risk in it. I always buy an entity and I did it for that sole reason, it was zero down non-recourse debt. So even though I was concerned about what came with the entity, what misdeeds had been done in the past, I thought, "Well, the worst case is I'll just walk it, I don't have a penny in it." In the end, years later, I was able to sell the thing and it all worked out okay.
But I have to admit, it always concerned me 'cause I didn't know what was gonna pop up in that entity that I was unaware of. Another reason you might do it, and again, underline the word might, is if in buying the entity, you escape some kind of permit issue. Some self-storage facilities are built in what is called a legal nonconforming manner which means they were built based on a time in the past where you could build that storage facility but it no longer meets current law, and when you do that, you're passed into an arena called legal non-conforming, also know as grandfathering. Sometimes you might wanna buy the entity rather than the facility because it may have an attractive issue regarding that zoning. So that would be one time in which you might wanna go ahead and buy the entity, but there's a flip side to that. If you're buying the entity to avoid whatever the zoning issue is, let's say it's a special use permit that is somehow invalidated if the property is ever sold, then how are you gonna sell it?
Think about that for a minute. Now what happens is years from now after you've got the thing in a really great position, and now you wanna go out there and sell it, the only way someone can buy it from you is to buy the entity. So once again, it's gonna be just as hard to find someone to step into your shoes as a buyer now in the position of a seller. The bottom line to it is you're really better off always just buying the asset. I don't know anyone who would tell you, "No, buy the entity that's the way to go." I'm pretty confident, even though I'm not a lawyer, not a CPA, that very few people would ever tell you, "Yeah, no, buy the entity, that's a smart thing to do." But there may be certain finite reasons why you find that to be a superior construction. And there are a few ways you can mitigate that risk, but by and large, when Mom and Pop tells you, "Hey, I don't want you to buy the asset, I want you to buy the entity," the reason they wanna do that is there's a benefit to them, and that's the big issue. It's rarely beneficial to the buyer. Typically all of the benefits flow to the seller, and since you're the buyer that's typically not a wise thing for you to do.
This is Frank Rolfe, The Self-Storage University Podcast. I hope you enjoyed this. Talk to you again soon.