In business, stronger cash flow means less risk and more opportunity to invest in the company's future. Deciding where to place hard-earned cash begins with infrastructure decisions. That is, should my business buy or lease its real estate? The decision must include a close look at cash flow, down payments versus lease rates, tax implications and how business operations and strategic plans would be affected by the different options.
The single largest factor in occupancy today is the question, does the space work? If tenants or buyers can move in with little cost, that normally breaks the tie between the lease or own question. The trick is determining what the costs of leasing and owning are, both monetary and otherwise, and determining the best option.
The Land Beneath You
There are a disproportionate number of business owners who wish to buy their occupied space rather than lease. Most of the time the decision to purchase is a subjective one. A chief reason is control. Ownership offers the ability to add space, subtract space, paint, carpet and put up signage however the property owner wants, without asking anyone (excluding condominium bylaws and town restrictions).
Strategic position also comes into play. Many firms take the tack, own what is strategic to the business, and lease all of the tactical locations. This could play out for a brewery that owns the location where it brews the beer, because of an aquifer it can tap into, and leases the distribution warehouse. It could also be the service provider who owns its headquarters and leases satellite locations. In each case, the business has the ability to maintain the property that makes the firm who it is, and have flexibility of leases on its other assets.
But owning is not always the best option. Owners can choose when they purchase property, but not, in many cases, when to sell it. Outside factors, such as business growth, business closure or redevelopment may ultimately decide the timing and the market cycle of your investment, whether the market for commercial real estate sales is strong or not.
Owning space also ties up time and money. If you have additional space to lease, or even if you occupy all of the building, owning real estate can be time- and energy-consuming. Think of the time spent clearing snow from roofs this past year. Real estate is one of the least liquid assets you can have. If you have several retail locations, you may want to lease them so you do not have all of that down payment capital tied up in dirt or buildings, when it could be put to use in your business.
Leasing ties up less money, but it has downsides. What if your business expands (or contracts) rapidly? Does your lease agreement make room for taking additional space (or subleasing)? While options to renew a lease are quite common in lease language, it is important you know what the rent will be. Also, if you are in a triple net lease and have to pay all of your expenses, a lease may not afford you a voice on how to control those expenses in the way that ownership may.
Weighing Financial Pros and Cons
There is no easy answer to the question of lease versus own. Ownership offers financial benefits, such as interest deduction (normally at a declining rate over the hold period), depreciation and residual value. Leasing requires no down payment and provides the ability to deduct all lease payments from your taxes.
So which is better? It depends on your company. The robust way to analyze a lease versus buy scenario will take into account all tax deductions and the most important item, your down payment. By reviewing your after-tax cash flow with that initial down payment, you can then find out how much return you will make on your real estate investment. Keep in mind the assumptions are fairly broad and based on the value of the property, the length of hold period and your tax structure.
To make it simple, let's say the projected return on owning the building and leasing it back to yourself is 10 percent after taxes, including a residual value. How much do you make on your business? Is that down payment better spent on real estate, or other aspects of your business? If you run a grocery store and make 3 percent on every purchase on average, then you should own this hypothetical investment. If you run a software firm that makes 20 percent margins on everything you sell, then you should spend that down payment on people, product and business development as you will make more money on the business.
There is no secret that there is an abundance of lease space available. As a result it would be advisable to take advantage of lower rental rates and lock them in for longer periods (with reasonable rent escalators). This will provide financial stability to the landlord, and fixed lease payments for your business.
Of course, all of this assumes that this hypothetical building is available for lease or purchase. Many times we are pitting two different buildings against one another or even dirt for development against existing product. So people need to carefully analyze whether they are better off as owners or tenants.
Chris Norwood is the executive vice president of NAI Norwood Group, a commercial real estate firm based in Bedford. He can be reached a cnorwood at nainorwoodgroup.com.
Current Issue - May 2024