Leasing vs. Buying Commercial Real Estate: Your Questions Answered
As a business owner, you’re under a constant barrage of capital budgeting decisions. And in a world of finite resources, the opportunity cost of certain decisions can have a significant impact on your business’s bottom line. There are various types of commercial real estate transactions you can engage in as a business, but without understanding the playing field, you're setting yourself up for failure.
We’ll dive into a discussion of the pros and cons of both buying and leasing real estate as a business, but first, let’s add some context to the decision.
Framing the Lease vs. Buy Decision
There are several important factors that businesses must understand and qualify before deciding whether to buy or lease their real estate:
1. Opportunity cost: Opportunity cost is measured as the potential forgone value by choosing one decision over another. In the context of our discussion, you can't invest dollars outlaid for a down payment in other areas of the business to generate returns. This represents an opportunity cost. In comparison, the all-in ownership costs over 20 years may be less than lease expenses. So, there would be an opportunity cost associated with leasing real estate over a long period.Opportunity cost is often not easily quantifiable. It should, however, be accounted for and incorporated into any capital budgeting decision analysis.
2. How a business should be capitalized: A business’s future growth prospects, capital needs, and profitability drive the blend of debt and equity held on its balance sheet. Creditors and investors draw inferences on a firm’s riskiness based on its level of indebtedness and outstanding obligations. An unfavorable capital structure could result in a business having a more difficult time securing future funding.
3. Real estate value is separate from business value: A business's value is merely a present-day dollar figure of the sum of all expected future cash flows. And if a company is buying real estate to house its operations, that real estate augments its core functions instead of driving business value.
This isn’t to say that real estate isn’t valuable to an operating firm. Instead, it should be regarded as a standalone investment, and any lease or buy decision should be viewed through this lens.
4. Tax Considerations: There are merits to both real estate ownership and leasing from a tax liability outlook. Interest payments and depreciation are both deductible as an owner, while lessees can deduct the entirety of their lease payments. The legal structure in which the real estate is held can have significant tax implications as well.
Businesses should be conversant in these topics, but ultimately a CPA can help navigate these situations depending on a firm’s unique needs.
Benefits of Buying Real Estate as an Operating Company
- Equity: If you have to pay rent anyway, why not instead pay down a mortgage and start building some equity. Your ownership stake in the property would grow over time, and as more equity is accumulated, you can use it to fund future growth. Real estate is also an asset that can be retained for passive income down the road or even be passed on to future generations.
- Asset appreciation: Value appreciation is not guaranteed. But the value of a properly positioned piece of real estate in the right market will likely increase. This appreciation in value will translate into capital gains in the future.
- Current interest rates: Interest rates are at historic lows, but the world hasn’t always looked this way. As rates currently stand today, monthly mortgage payments would likely be lower than market rental rates. A rate increase may be prohibitive to ownership or refinancing in the future.
- Diversification: Depending on your core business functions, real estate ownership adds an element of diversification from market disruptions. If your business needs to move out of the building, you can rent the building to other tenants; that passive income would supplement business revenue.
Benefits of Leasing Real Estate as an Operating Company
- Off-balance sheet financing: I’ve written previously about sale-leasebacks and the possible benefits of off-balance-sheet financing. Operating leases are not reported on a company’s balance sheet, and equity tied up in real estate may be inefficient capital deployment. Lenders are more inclined to provide financing for companies that aren’t saddled with existing debt obligations.
- Flexibility: As workplace strategy changes, the tenant market will demand greater lease flexibility. Shorter terms, favorable sublease language, and landlord-driven health and wellness upfit will all be requirements. A business won't have to spend mental energy on managing a property in a changing environment by leasing. The flexibility of a lease may also allow a company to adapt to the changing environment more quickly.
- High margin business: Real estate ownership is typically a 6-7% margin business. Company's generating higher returns may be better served to allocate capital to fund core business operations. Leasing also alleviates the potential burden of large capital expenditures on real estate.
- Unknown growth prospects: Projecting growth is difficult. Extrapolating your business’s space needs based on those growth projections is even more challenging. It may be easier to lease real estate if you don’t know how your space needs will look in the future. Real estate must serve a business – it shouldn’t dictate nor hinder operations.
So, Should I Buy or Lease My Business’s Real Estate?
There is no “right” answer to the question of buying vs. leasing commercial real estate. There are informed answers, however.
Many small businesses end up as commercial landlords by accident. The decision to lease or buy space should be deliberate. Acknowledging a property’s value as separate from business value is the first step. Undergoing program analysis and crafting a comprehensive workplace strategy and growth plan is the next step. A real estate strategy advisor can help.
If you have questions about your business's needs or want to begin shaping your strategy and growth plan, I’d love to help.
