San Antonio Commercial Real Estate – Lease vs Purchase –
Lease vs. Purchase – San Antonio Commercial Real Estate
One of the most common questions I hear from business owners when considering office space is…
Should we Lease or Purchase Office Space?
Many business owners reach a point in the growth of their companies where they question whether it would be an intelligent decision for them to purchase office space rather than continue to lease office space. Unfortunately, due to the countless variables associated with this type of decision, there really is no “box” answer. While every company is unique there are several factors that should be taken into consideration when evaluating whether purchasing office space would be better than continuing to lease office space.
Cash Investment Considerations between Leasing Office Space and Purchasing Office Space
You can expect to make a down payment of between 5% and 25% of the purchase price for owner occupied commercial real estate. The amount of down payment typically involves your “relationship” with your lender (strong deposit accounts at your bank can help), your business P&L Statement, tenure in business, your current rent payments versus the proposed mortgage, the quality and location of the property, and your personal credit (most owner occupied CRE purchases involve personal guarantees for the principals in the business). Owner Occupied Commercial Real Estate purchases typically allows for less down payment than purchases where the buyer is purely an investor. This is largely based on the lending institution’s perception of reduced risk. (Depending on the Asset, expect 35% to 50% down for Investment purchases). When you lease office space you won’t typically have as much up-front cash out of pocket. With good credit, the usual cash investment to lease office space is the first and last month’s rent + moving cost + any space modification costs. Second Generation office space can often dramatically reduce the tenant’s capital outlay because of reduced space modification costs. If you find a second generation office space that suits your needs in the location you desire, you may incur a fraction of the capital outlay to lease office space versus own. If you are considering shell space (1stgeneration office space) due to location needs of your office space or you have a very specific use (hard to find 2nd generation spaces that match your desired floor plan) then it is possible that you could spend more cash up front to lease than you would to own your office space because the lender will often wrap the interior and exterior cost into the loan for a purchase…where it could be difficult to obtain a sizable loan to finish-out lease space since the lending institution wouldn’t have the added security of the real estate asset to back up their investment in the case of a default.
Type of Business – How Can Business Type Affect the Decision to Lease or Purchase Office Space?
The type of business you own could dramatically affect the decision to lease office space or own. For example, retail uses are often very dependent on their neighboring tenant’s traffic. Unless your retail use is a destination, it
might be a better decision to sign a long term lease in a retail center with many tenants so that you can capture a ROI on your capital outlay to finish-out your space’s improvements. On the contrary if you own a physician practice, industrial business, or general office concept that intends to work in the same area for 10+ years purchasing could make sense.
Fixed vs. Variable Cost – Is it Easier to Forecast Expenses in Leasing or Purchasing Office Space?
Assuming that the idea of purchasing office space makes sense for your business type, an advantage of owning your office space is that you are in more control of your destiny regarding monthly expenses. If you can lock in long term fixed rates with your lender (more possible on owner occupant purchases) you can more easily forecast your monthly expenses. When you lease office space, the market will determine your future base rent. One area that I see owners make mistakes is in forecasting property taxes, insurance, and maintenance. As a tenant, the business owners typically budget for rent escalations…AND triple net (property taxes, insurance, and maintenance) increases.
Often when a group transitions to ownership and the ability to “fix” mortgage payment, they forget about the other operating expenses increasing over time. Although your operating expenses may be less as an owner (management fees can often be eliminated) it is important to understand that it is likely that you will incur increases in property taxes, insurance, and maintenance in the future.
Expansion and Relocation – How do Expansion and Relocation Relate to Leasing or Purchasing Office Space?
Commercial Real Estate is very different from Residential real estate regarding liquidity. For example, if you purchase a home this year and in 2 years you have two children and need a bigger home…or you are relocated for your job…and need to sell…it is likely that you will be able to sell quickly to meet your expansion and relocation needs. Commercial Real Estate is a much “less liquid” investment. If your company is in high growth, leasing office space or buying a larger land tract (to allow for expansion) are viable considerations to combat the liquidity issue. Potential relocation is another concern to consider when contemplating a purchase because commercial real estate is much more difficult to sell in a timely fashion. Many specialty physician groups and other office users are tackling the liquidity issues in commercial real estate by opening smaller satellite offices that they own in different parts of the city. Their expansion plans are to open more small offices in new areas versus expanding the corporate office.
Property Management – How does Property Management Differ Between Leasing or Purchasing Office Space?
If you transition from a tenant to an owner of office space you have to remember that the building needs to be managed. This is a time concern that tenants do not have to worry about in most lease scenarios. Owner occupants can either manage the facility themselves (often a key employee is in charge) or hire a management company. Another alternative to handling expansion concerns in owning is for the business to buy more space than they originally need and lease out the excess space until they are prepared to expand. Dealing with tenant concerns in a multiple tenant building is another reason for considering the idea of hiring a management company.
Appreciation and Debt Repayment – How is Equity Acquired in Purchasing Office Space?
The main reason for owning a commercial property is to acquire equity. By making payments over a long term period, the owner’s equity typically grows as the debt is repaid. I often recommend for owner occupants to use debt to acquire an asset, but to pay it off sooner than required with extra principle payments. Unlike pure investment real estate, owner occupant real estate (commercial or residential) is still an expense while you are occupying it. The sooner you can eliminate the expense…the better. If you sell the business in the future and sign a lease with the new owner or lease the building to a different business, you transition to a cash flow (investor) position. Future cash flows without having to pay rent or the idea of selling the asset in the future for a profit is why purchasing office space might make sense. Owner occupant office buildings can serve as a nice retirement option especially if your business is already incurring the expense of leasing office space. The key is getting comfortable with the location of the asset and understanding historical trends of real estate values in your area. Commercial Real Estate often changes in value based on cycles versus annual appreciation. Understanding these cycles are important to determining how appreciation might or might not affect your property. As the spread between remaining debt and property value increases, the owner’s equity increases.
Tax Fact – What Are The Tax Implications of Leasing or Purchasing Office Space?
Note: Always consult your CPA and attorney before making any final decisions because tax laws are subject to change!
Office lease payments are usually fully deductible. Expenses of owning office space are typically written off over a 39 year period. On a purchase, you typically get to take depreciation on the improved portion of the property (building structure) and can usually deduct all of your interest payments. Cost Segregation is another topic to bring up to your accountant to determine if you might be able to speed up your ability to depreciate portions of the asset faster for tax purposes. You may also want to ask your accountant and attorney about the idea of owning the commercial real estate asset in one entity that leases office space to your company…to see if they feel that there might be additional tax benefits.
Cash Flow Analysis – How Do I Analyze the Cash Flow Differences between Leasing and Purchasing Office Space?
The best way to fully understand the financial aspects of purchasing office space versus leasing office space involves financial analysis. My recommendation is for you to hire an expert to prepare a comparative net present value cash flow analysis which takes into consideration your predictions on the future including holding period, anticipated appreciation vs. rental increase, interest rates, and cost of expenses increases. Most of the CCIM’s (Certified Commercial Investment Members) are armed with these analysis tools as well as many of the tenured brokers in the marketplace. I always recommend hiring a commercial real estate broker that can help you with the initial analysis while looking at deals…which can be reviewed/checked by your CPA and attorneys before any final decisions are made. I recommend starting with the real estate broker because they typically get paid on a transaction closing (not hourly). Once you feel good about an office space for lease or for purchase when reviewing with your broker, then engage your hourly paid advisers (CPA and Attorney) to review before making a final decision.
It is my recommendation to hire a seasoned commercial real estate broker that knows the market area you are considering well to represent you to find, research, and negotiate office space to lease or purchase. Make sure to spend plenty of time discussing your goals before you go out to look at space. After deciding who you are going to work with and formulating goals, I recommend committing to your broker in the form of a representation
agreement. Commercial Real Estate Research and Analysis can be very time consuming and brokers don’t typically get paid unless a deal consummates. If you want your commercial real estate broker to dedicate the time necessary to aid you in fully analyzing one of the biggest decisions of your life, my opinion is that you will have much more success if they feel comfortable knowing that they have a signed agreement spelling out the terms of their compensation if a deal goes down. Regardless of the decision you make, it is my final recommendation to make sure that you involve your CPA and attorney before making any final decisions.
Contact a Commercial Real Estate Expert today:
Luke LeGrand, ePRO 210-843-5853
Lease vs. Purchase – Office Space – Commercial Real Estate San Antonio
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