To buy or to lease? It can be a tough decision for businesses, especially in California, with our notoriously volatile rental rates and property values over the past decade. Buying property can be risky — but commercial real estate leases may feel like you’re throwing money away. Before you make the vital decision to lease or buy, it’s wise for business owners to weigh the risks and rewards.
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 nationwide increased by 4.4% annually in recent years. Near port areas, the increases were higher — 6.9% in Los Angeles and 8.2% in the Inland Empire. In a rising rate environment like the one we’re liable to face in the future, this trend isn’t likely to go away.
Real estate ownership comes with a higher level of commitment (and higher risk). But you may reap tax benefits, as well as predictability and usually strong investment value. According to the National Council of Real Estate Investment Fiduciaries (NCREIF), the 25-year average return for privately held commercial real estate is 9.4%.
What to consider before you buy
Your banker and other trusted business advisors can help you determine whether buying or leasing is right for you. . You may wish to consider these four points before making a real estate purchase:
1. A lease-back arrangement might increase your income. Buying the real estate that houses your business typically offers a means to accumulate wealth. As the owner and the tenant, your business can lease the property instead of paying rent to a third party. Then you can depreciate the asset while you pay yourself instead of someone else. It’s wise to speak with your banker and accountant to get a clear picture of how this setup would affect you.
2. Purchasing may not be right for your business or industry. Owning real estate isn’t the right choice for everyone. For service professionals, buying a property that you can sell at the end of your career could be a good move. On the other hand, a nonprofit organization may find it tough to raise 30% to 35% to put down and may prefer to invest in its mission rather than real estate. In any business, owning property can also make one of your largest costs more predictable and might offer tax advantages. Remember, if you decide to jump, 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.
3. Overbuying can leave you in a difficult spot. Some business owners lean toward buying a larger-than-needed building in hopes that they can rent out the unused portion to cover part of the mortgage. Before making this choice, ask yourself, What if you can’t find a tenant or your tenant defaults? How much time and attention do you want to commit to being a landlord? In some instances, though, this arrangement can work well. For example, our bankers work with a medical professional who bought a building and leased half of it to a laboratory. He is a landlord, but he understands his tenant’s related field — and he might even know the tenant.
4. Understanding the risks leads to better preparation. It’s important to pay special attention to a property’s location and whether it makes sense for your industry and clientele. When you think of the future, are you confident your prospects are strong enough to cover payments for the long term while leaving adequate liquidity for other business needs? How do your plans fit with property trends? 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?
Your expert banker can help you determine credit options and parameters and even advise whether your plan is realistic, based on what they know about you and your business goals. To learn more about how we can help you decide between buying or leasing business property, contact your Torrey Pines Bank relationship manager.