Leasing commercial real estate for your business may seem like throwing money away, but buying property can also carry risks. Before making a decision about whether to lease or buy, it’s wise for business owners to weigh the risks against the rewards to determine the best way forward.
The pros and cons of leasing vs. buying
Owning commercial property isn’t for everybody. Leasing offers a lower upfront cost, and lease payments can reduce a company’s taxable income. Leasing can also be beneficial if your company will only be in a location for a few years. And leasing doesn’t tie up capital that could otherwise fund growth.
But with a lease comes the likelihood that property costs will increase. In the industrial market, for example, rents increased by 4.4% annually in recent years. In what’s widely expected to be a rising rate environment in the future, this trend isn’t likely to go away.
Real estate ownership comes with a higher level of commitment, which translates into a higher level of risk. But ownership also offers tax benefits, and you may gain predictability and usually substantial investment value. The 25-year average return for privately held commercial real estate is 9.4% annually, according to the National Council of Real Estate Investment Fiduciaries (NCREIF).
What to consider before you buy
Fortunately, your banker can help you assess buying vs. leasing to determine which is right for your business. Here are four things to consider before making a real estate purchase:
1. Assess all the risks. Buying can be more advantageous if you know and can tolerate the risks. Savvy buyers will pay special attention to a property’s location and whether it makes sense for the industry you’re in. Also consider future conditions. Are you confident your prospects are strong enough to cover payments for the long term while leaving adequate liquidity for other needs? What are your plans for the future, and how do they fit with property trends? Office space may be plentiful now, but a CBRE survey revealed that 2 out of 3 large companies and almost 1 in 6 small and medium companies anticipate decreasing their office space in the future. Will the building offer good reuse value if and when you retire, go out of business or sell?
2. Increase your income with a lease-back arrangement. While buying the real estate your business occupies increases complexity, it is a means to accumulate wealth. Suppose you lease the property back to your business instead of paying rent to a third-party landlord. That gives you an asset you can depreciate — and the ability to pay yourself instead of someone else. Before diving in, it’s a good idea to consult your banker and other trusted business advisors for details about how this setup could affect you.
3. Understand who should buy property. Depending on your industry or business model, owning real estate may not be the right choice for you. A nonprofit organization typically wants to put money into its mission rather than commercial real estate. But owning a property can also make one of your biggest costs more predictable and might offer tax advantages. For service professionals, however, buying a property that you can sell at the end of your career could be a good move. You may have a variety of financing options, including commercial real estate loans and SBA 504 loans, which offer up to $5 million at attractive rates to invest in major fixed assets that promote new jobs and business growth.
4. Beware overbuying. Wise buyers will be a little leery of buying a building that’s too large for your business in hopes that rental income from the portion you’re not using will help pay your mortgage. What if you can’t find a tenant? How much time and attention do you want to commit to being a landlord, and what happens if your tenant defaults? Bear in mind, though, that this arrangement works well in some instances, such as when you have a long-term tenant lined up in an industry that’s relevant to your own.
Your expert banker can help you make smart choices about your business, including making plans to buy or lease a business property. To learn more about how we can be part of your team of trusted business advisors, contact your Western Alliance Bank relationship manager.