Lease or buy?

With so many factors to consider,
businesses naturally need a little
guidance when it comes to whether or not to buy their commercial space.
Leasing can seem like throwing money
away. But buying has its own perils.

“It’s a common process of comparison
and evaluation that the management of
most businesses go through,” says Michael
Verrill, Senior Advisor with CresaPartners
in Philadelphia. “The first thing you need to
decide is exactly where you are in the business life cycle.”

Smart Business asked Verrill to break
down some of the considerations that business owners need to make before entering
into a new real estate venture.

When should a business consider buying?

Ideal conditions to buy would depend
upon a number of variables including, for
example, a business’s ability to anticipate
its growth in a relatively expert fashion for
a long period of time. Are you in a growth
mode? Can you predict where your business is going to be in the next five to seven
years? Are you in a consolidation (‘right-sizing’) mode or status quo? In the purchase of a facility, management would
need to be prepared to make a commitment for seven to 10 years in a particular
location. Ideally, in a healthy market, that
new asset would experience appreciation.

In addition, a business should be able to
forego the opportunity cost associated
with investing the likely significant upfront
capital for a purchase back into the business. These costs are often greater than
those associated with typical lease options.
The direct out-of-pocket costs could range
from 20 to 35 percent of the purchase
price.

The third thing is to have an exit strategy.
When purchasing that property, the business should understand how it’s going to
get out of it, because it is an investment. It’s
a longer-term investment, but an investment nonetheless. Like all prudent holdings, you should have an understanding of
how to recognize your maximum return.

How does the commercial real estate market environment fit in?

A lot of companies, over the past few
years, have considered the buy option because interest rates were so low and
investment capital was readily available.
When the cost to borrow money is cheap,
it seems to many buyers that the amount
they’d be spending on a monthly basis for
rent in a lease, without building up any
equity, is imprudent. So the environment is
definitely a factor.

In Philadelphia’s Center City market,
where there’s obviously a larger concentration of office towers, the trend is to lease
office space. However, we’re seeing some
smaller tenants looking for opportunities
to buy smaller office buildings that either
nearly fit their needs or require one or two
additional tenants to fill out the space. This
is still an active segment of the market.

Can you give an example of when leasing
would be preferential to buying?

We had a restaurant client that was interested in owning its own building when the
investment market was very hot. Our client
was strictly focused on an emerging area in
the city, and there was a lot of competition
between buyers for the available product.
The client was advised to pull back from
the purchase consideration and look at its
leasing options. As a result of a thorough
understanding of all its alternatives, the
client was able to get into something much
more quickly with substantial contribution dollars from the landlord. When you’re an
owner occupant depending on the real
estate to support your business, you need
to be a little more conservative when evaluating an opportunity — particularly from
a zoning and environmental standpoint.
Obviously, if you can’t get the zoning you
need in a particular location, you aren’t
able to open your business. In this particular case, it was a seller-favorable market,
and sellers were limiting the buyer’s due
diligence time to 30 to 60 days. In the best
of circumstances, this wasn’t enough time
for the client to make a prudent decision.
However, by introducing leasing scenarios,
the client wasn’t assuming as much risk
compared to buying something that was
not going to be approved for their particular use.

What else factors into the decision of leasing versus buying?

Businesses need to consider the potential
distraction that owning a piece of real
estate may create — whether it’s property
management or constructing a new roof or
dealing with tenants. It can create a potential distraction away from their core business. If they think that’s not an issue, then
buying is certainly a viable option to consider. But if a business cannot endure this
commitment of time and capital, leasing
might be a better option.

When any business assembles the economics of a purchase scenario, it’s essential for the business to construct a proper
analysis including all costs to be considered. There are considerably more costs
involved in owning real estate than just the
purchase price. It’s important for a business to work with an expert to uncover all
the costs that are related to owning a particular property and offer an unbiased
analysis of its options, including a comparison to its lease alternatives.

Any shrewd businessperson hates to
throw dollars at something on which
they’re not going to realize a return — this
should include the business’s real estate.

MICHAEL VERRILL is a Senior Advisor with CresaPartners in
Philadelphia. Reach him at [email protected] or (610)
825-9109 ext. 118.