Although the decision to rent or buy has some connection to real estate market trends, a company’s stage in its business life cycle should have the largest impact on the answer to this question. Executives need to evaluate their organization’s current position and short-and long-term goals before making this choice.
“If company leaders are having difficulty making a decision on leasing versus buying, they can consult with a real estate professional who can lend a hand in providing the financial implications of each alternative,” says Douglas LeClair, director of the Financial Consulting Group at CB Richard Ellis in Atlanta.
While all companies have unique situations that require careful analysis, some general principles apply to all organizations as they compare their options.
Smart Business learned from LeClair some of the significant opportunities and challenges with leasing and buying.
What are the advantages and disadvantages of leasing real estate?
Leasing real estate makes sense for many companies, particularly when they find themselves in growth or decline stages. During these times, leasing offers businesses the flexibility to grow and to contract without major financial consequences. Some other advantages of leasing include:
- Monthly rent can be written off as a business expense.
- Credit ratings don’t play as crucial a role in completing a deal.
- Businesses can sublet or move at lease expiration with no risk of loss in property value from a poor market.
Leasing also has disadvantages, such as:
- Rental rates typically have annual increases.
- There is no built-up equity or residual value at the end of the lease term.
- Landlords can force tenants to move at the end of their lease terms.
What are the pros and cons of owning?
Many companies find owning facilities an attractive option, particularly when they sit in the mature stage of their life cycle. These businesses tend to have capital available for investment and typically desire a stable occupancy situation. Knowing these fixed costs can help them perform meaningful long-term strategic planning. Other positives of buying include:
- Businesses can make changes to suit their operations.
- Mortgage interest is tax deductible.
- Annual depreciation also decreases tax liability.
- Open space can be leased.
- There’s buildup in equity and possible appreciation in value during ownership.
Some potential negatives of purchasing real estate also exist:
- Initial cash outlay required to secure financing
- Inefficient property management by companies who don’t specialize in real estate
- Time and energy diverted from core competencies
- Delayed relocation due to an inability to sell property
What questions should decision-makers answer during this process?
When evaluating whether to own or to lease, several questions come to mind. Thoughtfully responding to these questions will help executives determine which alternative makes the most business sense for their company right now:
- Does your business have the cash to make a down payment? Purchasing real estate will have a significant effect on the liquidity of business assets.
- What is the opportunity cost associated with that investment? Locking financial resources into a property comes with the opportunity cost of not having the ability to put it back into the business or into other higher yielding investments.
- Where is your business in terms of the growth cycle? If a company currently operates in the new or high-growth mode, leasing might make more sense. A mature company might want to buy to provide assurance of stable, long-term occupancy and diversification of assets to hedge against inflation.
- Do you have the time, resources and the desire to properly manage the property? Many times businesses will buy more office space than they currently need so they have room for growth or expansion. This not only requires taking on responsibility for day-to-day issues that come with property management, but it also presents the issue of leasing additional space.
- What are your tax implications? Lease payments are usually fully deductible on the lease side. On the ownership side, business can deduct mortgage interest payments and depreciation on improvements. Discuss which side offers the largest benefits with financial advisers.
What other factors are there to consider?
The emerging cost segregation method of depreciation may make purchasing real estate more attractive to many companies. Instead of subtracting the land cost from the value of the building and depreciating that total over 39 years, businesses can front-load depreciation and realize all of it over a very compressed period of time. These cost segregation calculations come from a detailed analysis of companies’ improvements. This accelerated depreciation has potentially enormous tax benefits for businesses.
DOUGLAS LECLAIR is director of the Financial Consulting Group at CB Richard Ellis in Atlanta. Reach him at (404) 504-7903 or firstname.lastname@example.org.