In light of the slow recovery of the economy, you may not be ready to commit your business to an expansion. But many analysts remain optimistic that the economy will continue to improve.
However, a plan to expand and move into new space may be in your organization’s not-too-distant future. That makes now a prime time for evaluating how to proceed when you’re ready to pull the pin, says Gregory T. Warsek, senior vice president/regional manager, Commercial Real Estate Division, Associated Bank.
“A primary decision is going to be whether to buy or lease office, retail and/or manufacturing space,” says Warsek. “Financial considerations may be of prime importance, but don’t overlook other consequences of your decision. There are pros and cons to buying and leasing, so be sure that you review your options carefully and discuss them with your financial team.”
Smart Business spoke with Warsek about how to determine whether leasing or buying is the better choice for your business.
What are the benefits of buying?
First are the tax benefits. The interest on a mortgage and property taxes may be tax-deductible, the property may be depreciable and costs associated with owning a commercial space may be deductible. Talk with your tax attorney or adviser to see what tax breaks you may be eligible for.
Buying also gives you greater freedom to convert the space to your needs, allowing you to build on, tear down or reconfigure to meet your needs. In addition, there will be no rent increases. Locking in a commercial mortgage can give your business a clear idea of future costs. And should you decide to sell, you may make a profit if the value of the property has increased. Ownership also creates the potential for additional income. If you buy or build a multi-tenant building, you can enjoy an income stream from rent paid by other tenants.
What are the drawbacks of buying?
Buying creates more upfront costs. Initial capital outlay includes down payment, possible property improvement costs, and appraisal and maintenance costs. Evaluate the opportunity cost of those dollars being spent in other ways. It also puts the property on your balance sheet, which may create future borrowing restrictions resulting from real estate debt. And it creates a lack of flexibility, making it difficult to adapt quickly to changes in your market. It takes time to plan and construct or purchase a property or to sell a property. For businesses whose success depends on location, owning may make it more difficult to adapt to market shifts.
Owning also creates operational costs, and the time and energy devoted to maintaining a property can be a distraction. If you buy a multi-tenant building and lease space, consider how being a landlord fits with your primary business. If you don’t want that responsibility, leasing may be the better option.
What are the benefits of leasing?
Leasing is easier on a business’s cash flow. When you buy, you tie up a significant amount of equity. Leasing doesn’t require as large an outlay of capital at the outset. Not having money tied up in real estate frees up working capital, allowing your business to respond to other opportunities in the market. Leasing also makes it easier to move into prime locations and eliminates the headaches of selling if the area cools. Also, the rent a business pays on a lease may be tax deductible.
What are the drawbacks of leasing?
Leasing subjects you to uncertain costs, as you may be subject to rent increases when your lease expires. Some leases also allow for annual increases tied to changes in the Consumer Price Index. There may also be restrictions on adapting the space to your needs. If you find that the space no longer meets your needs, your only option may be to move. Leasing also makes you dependent on a landlord, who may decide to terminate your lease if it has other plans for the property.
The answer to lease or purchase commercial space is not clear-cut; it melds market, tax and financial analyses with other business considerations. Discuss your situation with your company’s finance team, commercial banker and tax adviser to make the most informed decisions about buying versus leasing.
How can environmental cleanup responsibilities impact your decision on whether to buy or lease?
Almost every real estate deal carries some risk of environmental liability. For much of the 20th century, the standard method of waste disposal was to bury waste or dump it in a nearby waterway. This resulted in thousands of contaminated properties nationwide. A purchaser or lessee could be held responsible for remediation costs, even if it did not cause the contamination.
Remediation has the potential to be very expensive and time consuming. Before acquiring or leasing a site, be sure to conduct an effective audit by referring to a records review or invasive testing. Also consider environmental liability insurance, which can be designed to protect the buyer, seller or both against unknown risk. Another option is a cost cap or stop loss policy, which puts a ceiling on the actual cleanup cost of the site.
It’s a good idea to consult an attorney to negotiate provisions in the contract or lease that minimize your exposure and risk of environmental liability. Some possible protections include lengthy due diligence periods, representations and warranties regarding hazardous materials, indemnification provisions, carefully drafted provisions regarding responsibility for cleanup, remediation and monitoring, and holdbacks or other security for future performance.
Loans subject to credit approval. Equal Opportunity Lender. Associated Bank N.A. is a Member FDIC and Associated Banc-Corp.
Gregory T. Warsek is senior vice president/regional manager, Commercial Real Estate Division, Associated Bank. Reach him at Gregory.Warsek@associatedbank.com.