What Is Owner-Occupied Commercial Real Estate?

A dental practice that buys its office, a manufacturer that buys its plant and a professional firm that buys a small office building are all owner-occupants. Each owns the place where it does business. Each is called an owner-user, because it is both the owner and the user of the property.

There is no single definition that applies everywhere. The word is used by bankers, regulators and loan programs, and each may draw the line differently. The federal bank examiners’ handbook from the Office of the Comptroller of the Currency (OCC) treats nonresidential real estate occupied by its owner or a related party as a category of income-producing commercial real estate. CDC Small Business Finance, a lender, describes it as a property where the business owner uses a required portion of the building for its own operations.

The phrase "a required portion" is the part to watch. A building can be partly leased to others and still count as owner-occupied, but only within limits set by whoever is applying the label.

The same building can suit either buyer, and they will judge it differently.

• Purpose. An owner-user buys a place to operate. An investor buys a stream of rent and an eventual sale.
• Source of the money. An owner-user’s loan is mostly paid from the profits of its operating business. An investor’s is mostly paid from tenants’ rent.
• What makes a building good. An owner-user cares about layout, loading, parking, location for staff and customers, and whether it can adapt the space. An investor cares about the rent roll, tenant credit and lease length.
• Biggest risk. For an owner-user, trouble in the business and trouble with the building can arrive together, because they are tied to the same company. An investor’s risk is spread across its tenants and its other holdings.
• Exit. An investor expects to sell. An owner-user may stay for decades, then sell, lease to someone else, or sell and lease back.

Because of these differences, investor tools such as cap rates matter less to an owner-user, though they do not disappear. An appraiser, a lender and a future buyer may all use them.

The OCC handbook is written for examiners of national banks and federal savings associations, so it does not bind every lender. It is still a useful window into how a regulated bank is expected to think. On owner-occupied loans it makes these points:

• The primary source of repayment is usually the cash flow generated by the occupying business.
• Sound analysis typically considers the ability of the occupying business, the borrower and any guarantors to repay.
• Collateral still counts. Loan-to-value limits and appraisals or evaluations remain relevant.
• Specialized improvements can cost more than the value they support, so the analysis should consider what the property is worth to another user.
• Where a property is partly leased to an unaffiliated tenant, classification depends on the primary source of repayment. If half or more comes from third-party income, the property should be considered non-owner-occupied.

In practice this means your company’s financial statements matter at least as much as the building. A strong building will not rescue weak company cash flow, and a sound company may still run into trouble with a building that would be hard to reuse.

Before you fall in love with a highly customized building, ask what it would be worth to the next user. Your lender is likely to ask the same thing.

The clearest bright-line rules come from the SBA. Its 504 loan page says the program is for operating businesses and cannot be used for speculation or investment in rental real estate. The federal regulation at 13 CFR 120.131, which covers both 7(a) and 504 financing, sets occupancy limits:

• Existing building: the borrower may permanently lease up to 49 percent of the rentable property if it permanently occupies and uses no less than 51 percent.
• New construction: the borrower may permanently lease up to 20 percent if it permanently occupies and uses no less than 60 percent, with plans to occupy some of the remaining space within three years and all of the space not permanently leased within ten years.

These figures are as stated in the regulation at the time of writing, and they can change. Confirm the current rule, and how rentable space is measured, with a lender or Certified Development Company. Conventional lenders set their own standards.

"Owner-occupied" does not always mean the operating company’s name is on the deed. The OCC handbook notes that in many cases the owner of the occupying business owns the building through a separate entity and leases it to the business. The SBA regulation similarly addresses an Eligible Passive Company that leases all of the building to one or more operating companies, which must then meet the same occupancy rules.

Lenders may still treat that arrangement as owner-occupied, but expect them to look through it. The OCC handbook cautions that rents set between related parties may be inflated, so the rent used for valuation should be consistent with the market. The IRS raises a related point on deductions: rent paid to a related person is reasonable if it is what you would pay a stranger for the same property. Your attorney and CPA should decide the structure.

• ✓What share of the rentable space will we occupy on day one, and in three years?
• ✓Are there existing tenants, and can we end those leases or must we buy subject to them?
• ✓Will more than half of the money for debt service come from our own business or from tenants?
• ✓Who will hold title: the operating company, or a separate company owned by the same people?
• ✓Is any part of the building so specialized that another user would pay little for it?
• ✓How does each lender we are considering define owner-occupied, in writing?

Tenant Advisory Group represents occupiers rather than investors, so we evaluate a building for how your company will use it and then help you raise these occupancy questions with your lender before you are under contract.