If your company’s current lease is within 6 months of expiration it is time to start considering alternatives and planning for your future space needs. I recommend stepping back and taking a macro-level view of your situation. Do your current facilities portray the image you wish to project? If clients visit, do they leave with a positive impression of the company? Is your current space efficient, or are you paying rent on a lot of under-utilized square footage? Does the physical layout of the space maximize the productivity of your operations and employees? Are your building and related common areas well managed and maintained? Do you have enough parking? Is the building environmentally and physically safe? Are you in the most suitable location possible for you, your employees and your business? Do the utilities (e.g. power, internet speed, etc.) fit your needs? Are the operating expenses reasonable? Are you paying market rent? Should you consider purchasing?
While all these questions are important, this article will focus on the frequently asked question of leasing versus buying commercial real estate.
Leasing office, retail or industrial space is a very common practice. One of the reasons for this is the ease of entry in comparison to the more complex process of purchasing. When purchasing, a bank loan is often involved and lenders have fairly consistent and rigorous standards that buyers must meet in order to qualify for the purchase money loan. With leasing, different landlords will have very different standards. One may require a credit score above 700, strong tax returns over the past 3 years, and a personal guarantee by the tenant, while another may accept just a simple one-page handwritten lease with no security deposit. A tenant can generallyfind a landlord willing to lease them space, even if it is not the most ideal property.
When purchasing, a buyer must typically have a sizeable cash deposit on hand equal to at least 10-25% of the purchase price. Many business owners and start-up companies simply do not have this level of funding available. Or rather than saving for a down payment, their priority may be to invest all profits back into the business in order to achieve growth. In addition to an easier qualification process, leasing space generallyrequires much lower start-up costs.
Flexibility is a very important consideration for many business owners. With fast paced and ever evolving technological change, our economy today is very volatile and unpredictable. As a result, many companies must stay extremely agile in order to remain competitive. When properly structured, a lease may provide more flexibility than a purchase. Lease terms can be as short as month-to-month or as long as 10 years or more. Options to renew or extend can be negotiated which provide tenants with the right, but not the obligation, to extend the term of the lease (often at a pre-negotiated rent). Leasing can provide for an exit strategy as simple as moving-out the furniture at the end of the lease.
Leasing may also provide maximum flexibility with regard to growth. If space is leased in a building with additional available space, a “right of first refusal” or an “option to expand” may be negotiated providing the tenant with the right to expand into the additional space prior to any other tenants being given that right. If you own your building and start to outgrow it, the building could be sold or transitioned into an investment property and leased; however, this process could be much more complex depending on current market conditions.
What then are the benefits of buying? Buying is a great alternative for established companies with consistent operations and suitable financial resources. Purchasing can be more financially attractive than leasing due to property appreciation, cost recovery/depreciation, positive leverage and principal reduction (paying yourself instead of your landlord). Especially in today’s market, with still very low financing rates and bottom-of-the-market pricing, becoming an “owner/user” and purchasing your own building represents an opportunity worth considering.
To demonstrate, I have prepared the following Lease vs. Buy Analysis based on purchasing a hypothetical 5,000 square foot office property with the following market-based assumptions: 1) a purchase price of approximately $700,000 (i.e. $140/sf); versus, 2) a lease rate of $1.00/sf triple net. In this example, it is clear that both the monthly cash outlay and the effective after-tax costs are much lower when purchasing than when leasing. Of course, this is a hypothetical situation and different factors and assumptions can contribute to much different results. If you are considering leasing or buying commercial space, this type of analysis could be quite helpful in your decision-making process.
Lock Richards is Managing Director of Highland Commercial Real Estate and can be reached at 530-470-1740, or on the web at highlandcre.com.