“The idea of paying rent to yourself and building equity in commercial real estate rather than paying rent to a third-party landlord and helping him or her build equity can be appealing on the surface,” says Patrick Duffy, president of Colliers Arnold. “The question is: Which alternative is right for your business?”
There is no absolute answer to this question. The majority of commercial space is occupied by tenants and owned by investors. Fortune 500 companies have, for the most part, adopted the theory that “core assets” such as major manufacturing plants and corporate headquarters tend to be owned, while assets like smaller branch office facilities and distribution facilities are leased. High-growth companies tend to lease more than they own.
Smart Business spoke with Duffy about how to weigh the options to make the best decision for your business.
How do capital availability and deployment options affect your choice?
Capital availability and deployment deals with several issues: What return on equity (ROE) do we expect from our business? What are the future capital requirements of the business unit? Do we have what’s required excess cash beyond the requirements of the business unit for the down payment? What is the financing market doing? What is the current cost to lease?
If you are looking for ROE in your business of 20 percent to 30 percent, if your business is expanding rapidly and will need cash, if your current asset base is just adequate to meet those expansion plans and if the current return desired by third-party landlords is running in the mid-teens, you will probably want to lean toward leasing.
How does impact on business operations of owning versus leasing affect your choice?
You need to ask yourself how long the facility will support your size, which reflects on growth plans. You also need to ask yourself, ‘What happens to our income if we move out before we sell the property?’
You also need to determine what the real estate does to your balance sheet, income statement, taxes, etc. Real estate is not a liquid asset; it takes time to market and sell the property; and transaction costs are relatively high. If you know you are going to need to move into larger quarters in three to five years, you may be better off leasing. At the end of the lease, you are free to just move without the baggage of selling your property first.
What impact does ROE versus risk have on an own-lease decision?
Return on investment and the relative risk of the return is the benchmark that most people use in making the decision.
The ‘correct’ approach to the math is to take the total cost of occupancy between the two alternatives on an annual basis and calculate an internal rate of return or yield on the two alternative cash flows. This includes the down payment at the beginning of the purchase option and the return of equity after the sale (with an assumed sales value in the future). It also includes the deposit on the lease. If the option is to lease or own the same asset, the other costs of occupancy taxes, maintenance, utilities, etc. will be roughly the same whether you lease or purchase. In Florida, we have a sales tax on commercial leases (6.5 percent to 7 percent, depending on county) that must also be considered.
A simple model for this calculation may look like the accompanying graphic.
This model assumes that you purchase a 7,000-square-foot facility for $1.3 million and five years from now sell it for $1,366,300 which assumes only that the market is as good in five years as it is now. The alternative is to lease the same facility for $16 plus the same operating expenses you would have if you owned the facility.
In this case, if the assumptions hold true, you would be 18.8 percent better off to own the facility than to lease or you would earn 18.8 percent annually on the upfront cost difference ($323,280) over the entire five-year period.
If you have the excess cash and if owning the real estate will not get in the way of your business making money, owning may be a very good idea. If you need the cash for your business, need flexibility and want someone else to have the headaches of ownership, leasing may be the way to go. In either case, smart decisions take as many factors into consideration as possible to make the smart business move.
PATRICK DUFFY, MCR, is president of Colliers Arnold. Reach him at (813) 221-2290 or firstname.lastname@example.org.