Lease or buy? Featured

8:00pm EDT August 26, 2007

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 mverrill@cresapartners.com or (610) 825-9109 ext. 118.