One of the common discussions we have with clients is should I buy or lease? It’s important as a business owner to conduct your own analysis or have an experienced professional to help you make the best decision. Below is our in-depth guide to help business owners understand the pros, cons & complexities of each option and ultimately help guide you in making the right decision for your business. If you’re not able to find the answer to your specific question or would like help buying or leasing real estate, please contact Robert Stratton at 661-212-5699.
What’s the difference between buying and leasing?
When buying commercial property, you are purchasing real property (land and all structures commonly referred to as improvements or fixtures) from a seller with cash or financing (Stay tuned for our guide on commercial financing options and programs available to small businesses!). Leasing commercial property requires signing a lease agreement for the tenancy of real property or a portion of real property for a specific period of time. Tenants are bound by obligations outlined in the lease agreement between the landlord and tenant. Some properties will offer a lease option or lease with option to purchase. This type of contract grants the tenant the option of purchasing the property at the end of the lease period.
Tip: If you’re unfamiliar or overwhelmed with lease agreements your associate will be able to produce a lease abstraction or condensed version of an original lease document, providing a summary of specific and crucial points.
Now onto the pros and cons of buying and leasing…
Advantages of Buying Commercial Property
When you purchase commercial property, you get P.A.I.D. This is an acronym Stratton International created to help clients understand the financial advantages of buying real estate.
- Equity. When you pay your mortgage, you are paying interest and principal. The more principal you’ve paid off, the more your ownership stake will grow. The difference between the property’s FMV (Fair Market Value) and the remaining loan balance is your equity. If needed, you can use the equity in your property for future financing needs.
- Capital Appreciation. Property appreciates or increases in value at an estimated 2-3% annually. This will vary depending on the submarket and the specific asset, contact our associates for a historical report on specific property types in specific markets. There are many factors that impact the rate of appreciation; inflation rate, local supply and demand conditions, interest rates, and more.
- Tax breaks. As a property owner, you can deduct certain expenses on your commercial property; interest, depreciation and non-mortgage related expenses. You cannot deduct your monthly mortgage payment. Expenses such as origination fees or closing costs, that are associated with a mortgage, can not be deducted. The only portion of your mortgage that is deductible is your interest.
- Rental potential. As the owner of a property, if you have extra space on the premises, you can bring in additional income by renting out to other tenants. To qualify for traditional business financing, the business purchasing a commercial property will generally have to occupy at least 51% of the property. If you occupy less than 51%, most lenders will view the property as an investment which will change the financing options available to you. Renting out space has the ability to net you significant proceeds, depending on the demand for space in your location. Owners should be aware that leasing out space means you now have the responsibility of a landlord and with that comes many new tasks and challenges. This is why many properties owners choose to rely on a property management company to handle the management & marketing of their asset.
- Control. This one may seem obvious but as the owner of a commercial property, you have complete control over your property. No landlord negotiations should you want to change your properties build-out. This includes up-keep as some landlords are prone to “budgeting” by neglecting certain necessities, such as maintenance, security, and capital improvements.
- Fixed overhead. As lease costs fluctuate year to year, owning your business premises allows you to be confident in what your future costs will be. When you decide to lease a space, there is no guarantee that your lease will be renewed at the end of your lease agreement term and your lease is subject to change or renew under different terms.
Disadvantages of Buying A Commercial Property
- Higher up-front Investment. When deciding to purchase commercial real estate, you will be required to make a sizable down-payment. The average down-payment can be anywhere from 10% to 40% of the property’s value. You will also be responsible for the closing costs and due diligence fees. Expect to pay anywhere from $100,000 to $400,000 on the down payment and additional fees for a $1 million property.
- Liabilities. As a property owner, you are now responsible for it all; property taxes, insurance, repairs, maintenance and more! If someone gets hurt on your property, you want to make sure you are protected from lawsuits. This means you will have to pay for liability insurance to make sure you are properly covered for any incident on your property. If any part of your property is rented to tenants, you are now subject to an additional cost for an optional property manager plus the additional insurance needed.
- Lack of affordability. Tight markets with high demand and low supply can make it very difficult to afford a property. Additionally, qualifying for a commercial mortgage loan with a reasonable rate can be difficult without good credit.
- Lack of flexibility. Mortgages are generally much longer terms than leases and don’t offer the same flexibility leases do.
- Cost savings may be negligible. The costs of property taxes, maintenance, repairs, security, parking, insurance, and more! If you decide to purchase a property, these expenses are now your responsibility. When leasing a property you are able to negotiate your lease terms; rate, lease period, service type and improvements to the premises.
- Do you really want to be an owner and landlord? Make sure you take into consideration how time consuming being an owner AND landlord is going to be. Your time may be better spent focusing on your business activities instead of dealing with leaky pipes and rent collection.
Advantages of Leasing a Business Property
- Lesser down payment and lower upkeep costs. Leasing space usually requires a security deposit but this will be significantly less than a down payment. Purchasing commercial property using a conventional loan which requires a 15-35% down-payment or SBA loans at 10-15% down-payment. Repairs and maintenance will be taken care of as agreed to in the lease agreement, which are usually the responsibility of the landlord and not the tenant.
- Flexibility. Generally the market will offer more options when it comes to picking a space for lease and at the expiration of your lease you have the freedom to negotiate new terms or vacate and find a new property.
- Tax breaks. Your monthly lease as well as any additional costs are tax deductible; lease payments, property insurance, property taxes, utilities and maintenance.
- Focus on your business. Now that you aren’t worried or distracted with the responsibilities of being a landlord or property owner, you may find you have much more time to focus on growing your business.
Disadvantages of Leasing a Business Property
- Lack of equity opportunity. When leasing you will not be accumulating any equity. Some lease contracts have a lease-to-buy option that allows a portion of your rent to be applied towards the purchase of the property. You do not benefit from capital appreciation unless you have ownership over the property.
- Exorbitant rent. In some areas, it is not unheard of for lease payments to exceed mortgage payments for the same or similar property. Receive a market report on what is available in your area and the average pricing for any type of property.
- Lease Payment Fluctuation. Most commercial leases use a flat rate for rent escalation year to year. But be aware that a lease with the option to extend will commonly be re-negotiated to current market rent.
- No passive income. Leasing space does not afford you the same control and flexibility you have as a property owner. In some cases you may be allowed to sublease your space.
- No control. Some leases may have restrictions or even early termination clauses. You have no control over your increases in rent when your lease is up. If you go out of business, you are still obligated to continue to pay rent. If you choose not to do so, there are serious penalties.