The quick, easy answer that most people would give to this question would be that it is always better “to own”. The next thing they might typically say is that they believe they cannot afford to own. Today, however, there are a number of financing vehicles available that can make ownership an easier alternative than they might expect. I am involved in an office project currently that can offer qualified buyers up to 95% financing. Over the years I have worked with a number of business owners who were considering purchasing commercial real estate. Most of those owners had successfully grown their businesses in leased facilities and had now felt that the portion of their cash flow that they allocated for “occupancy costs” would be better invested through equity payments for their space rather than lease payments. Those businesses have included health professionals with growing practices, office professionals, retailers, restaurants, service providers, distribution companies and manufacturing companies.
To make an informed decision, however, there are a number of considerations that a business owner must weigh. The lease versus buy decision is different for every business. How a company utilizes their capital is a function of many factors, among them, current profitability, plans for future growth, and the facilities required to operate their business. For owners that require multiple real estate locations, the need to use capital for business operations rather than real estate investments may be significant. These owners may question whether it is possible for company cash flow to sustain investment in both real estate and business operations. To weigh the decision on the merits of owning versus leasing commercial real estate, business owners need an understanding of the methods for comparing the financial aspects of each.
Lease or Own?
Helping a business owners decide whether to purchase or lease a property can be a complex process. In the long-term, owning commercial real estate usually is more cost-effective than leasing, assuming a modest amount of appreciation. No general answer, however, applies to all cases. Each individual situation requires an examination of the business owner’s specific circumstances, the operational objectives of the business (which will generally fluctuate from year to year), the local real estate market cycle (to estimate future selling prices and lease rates), and the availability and cost of capital.
As I indicated above, the majority of retail and restaurant clients I work with prefer leasing to ownership. They prefer to use their capital for the expansion of their businesses, rather than a real estate investment. They feel they can earn higher returns on dollars invested in additional stores and inventory rather than investments in real estate. By leasing their facilities, these companies are able to open several locations for what it would cost them to purchase land and construct a single facility. These retailers require superior visibility and exposure to generate their required sales volumes. When, and if, such a site were available, the cost of purchasing versus leasing space is typically prohibitive.
On the other hand, I have professional clients (doctors, attorneys, etc) who do not need or plan to open additional facilities. For them, the returns and benefits received from a real estate investment may be better than other alternative investments.
Preceding a financial analysis, business owners should have an understanding of the basic factors that contrast leasing and property ownership. Mathematically, the comparison is just a present value problem; discounting the cash flows for each occupancy alternative (leasing vs. owning) over a selected period. A business leasing space will deduct the lease payments as a business expense. A purchaser will deduct interest payments, depreciation, and other ownership expenses.
Generally, if a professional or business owner plans to operate their business in a given market for a number of years, the financial benefits of owning will exceed those of leasing a similar facility. Assumptions, however, such as operating space requirements, the cost and availability of capital, anticipated future lease rates, expected lifespan of the business and profit projections easily can skew the analysis.
Market Cycle Factors
Every real estate market goes through periods of expansion, contraction, recession, and recovery. Fort Bend County will be no different. Fortunately, however, Fort Bend’s well thought out master planned communities will make us a little more resistant to downturns in the economy. Nevertheless, the process of estimating a business owner’s position relative to the market cycle can have a tremendous impact on the lease vs. own decision.
Key factors which determine the position of the current market cycle include demand, supply, vacancy, rental rates, prevailing cap rates, and investor interest. During an analysis, it is critical to know if these variables are increasing or decreasing from previous periods, as well as the expectations for their future direction. Characteristics of an expansion phase include steadily increasing property supplies, strong demand, sharply declining vacancy rates, increasing rental rates, steadily decreasing cap rates, and strong investor participation. In contrast, the contraction phase has the inventory of space near peak levels, decreasing demand, rising vacancies, flattening or declining rental rates, increasing cap rates, and fewer willing investors.
In a recession phase, property supply decreases as new construction halts and frustrated investors pull properties from the market. Demand steadily decreases, driving up vacancy rates and driving down rents. Cap rates steadily increase which drive down property values. At the early stage of recession brokers and investors attempt to determine whether the signs truly point to a recession or to a temporary market glitch.
Finally, a recovery phase is characterized by a relatively flat supply of property but increasing demand, declining vacancies, rising rental rates, declining cap rates, and increasing investor interest, especially from astute bargain hunters.
Factors that favor ownership over leasing include:
- Financial reasons such as eliminating exposure to rent fluctuations, property appreciation (increase in value), additional rental income from tenants, the company’s ability to utilize financial leverage (financing), as well as tax factors such as deductions for depreciation and interest payments and potential favorable capital gains treatment upon disposition of the property;
- Space considerations such as the ability to build the property to fit the owner’s needs;
- Subjective issues such as promoting an image of strength and stability, the ability to control real estate operating expenses, and control over other tenants and uses within the building.
Some factors that make leasing an attractive alternative to real property ownership include:
- Financial benefits such as the ability to occupy and control a property without tying up capital and lines of credit, deductibility of lease payments for tax purposes, stability of occupancy costs, and enhanced control of cash flow;
- Space benefits such as flexibility of size and location over time, the ability to expand more quickly into new markets, and the ability to expand and contract as dictated by the business cycle; and
- Subjective factors such as removing ownership risks including economic obsolescence, losses on the sale of the property, and the freedom to concentrate on the owners core business rather than property management.
What is right for one business operator may not be right for another. Each business has circumstances which are unique to it, and which need to be considered in a lease versus purchase analysis.