As businesses grow and seek additional space to house their expanding operations, a question they must frequently consider is whether to buy a building and enjoy the benefits of a rising real estate market or lease a structure and leave the chore of maintenance to someone else.
Business owners often make a default assumption that leasing is the best alternative, says Kenneth Dill, vice president at Cresa Partners Orange County, a corporate real estate advisory firm. But purchasing a building could be a wiser choice, and only a thorough financial analysis can reveal the risks and benefits of ownership.
“Most executives know the ins and outs of their business line extremely well, but are less skilled at making conclusions about the real estate market and developing strategies that help them get the best deal on a property,” Dill says.
Smart Business spoke to Dill about how companies should approach the decision of owning versus leasing commercial property.Why would someone want to lease a property instead of purchasing it?
Basically, leasing seems attractive because you can execute a lease with no money down, you have no responsibility for the management of the building, and you often have the right to find a sub-tenant to absorb unused space. Also, there are some tax benefits to leasing, and the monthly payment even with escalation clauses is predictable.
However, more and more leases are created with increases of 3 percent to 4 percent a year, regardless of where inflation stands. Even under such a scenario, for someone who needs a new building right away, the whole approach just appears less cumbersome. In fact, a business owner who would never consider renting an apartment for his personal use will often consider leasing a building.
What are the benefits of ownership?
In some ways, it’s no different from you or me deciding to buy a house. But often the value is not readily apparent to a business. Among the most obvious benefits are that you can make renovations to the structure; the operating hours are flexible; the problem of complaining neighbors is eliminated; and the costs are better defined and static because your payments stay the same while the mortgage interest is tax deductible. Additionally, you can enjoy the benefits of depreciation, even if it is spread out over decades. And you never have to worry about the landlord not renewing your lease, an especially common problem in markets with strong demand. Remember that there might be someone who will be willing to pay more for your space.
If you believe that the market for real estate will increase, and you can project your company’s space needs for the next five to 10 years, it’s to your benefit to buy.
What are some of the barriers to buying?
The biggest hurdle is securing a down payment while the next-biggest challenge is managing the building. The first issue could be overcome with Small Business Administration loans and other financing mechanisms. However, the key determinant in the decision to buy or lease is the ability of a business to keep generating a good cash flow. What we do is make projections over a 10-year horizon based on market conditions and a firm’s cash flow to determine which option is the best.
How do you do that?
We look at a number of factors such as maintenance costs, the cost of servicing a loan versus a lease, and the net present value of future cash flows. In other words, by understanding all the risk parameters that we can, we’re able to break out in a spreadsheet the costs associated with each option.
Then, there’s the matter of ‘kicking the tires.’ After we personally identify a series of properties, we preview these alternatives to arrive at a short list. The next step is to send out an RFP to select building owners that asks a series of questions about the possible uses and condition of their building. This is valuable because we always want to have something in writing from them in which they assess the quality of their structure. Based on their answers to our questions, we narrow down the facilities to consider. We will tour the building jointly with our client, allowing him to ask the owner questions such as how to re-configure the building to house his operations while we then pinpoint the various real estate issues that could arise from the deal. We also get experts to evaluate the integrity of the buildings under consideration. In the process, we hope to identify areas of concern to a buyer, such as the state of the HVAC units or the electrical wiring.
KENNETH DILL is vice president at the Newport Beach offices of Cresa Partners Orange County. Reach him at (949) 706-6630 or KDill@cresapartners.com.