In today’s low interest rate environment, many occupants of office, retail and industrial space may ask themselves, Would it be better to own rather than lease my space?
While financial aspects play a major role in this type of decision, there are other qualitative variables that also need to be considered.
Below is a summary of some of the more “intangible” pros and cons occupants should consider when analyzing whether to lease or buy.
Advantages of Leasing
Liquidity & Cash Resources. Leasing usually requires less cash out of pocket than ownership alternatives, leaving more capital to invest in the core operating business and other expansion opportunities.
Financing Source. Leasing can be viewed as an attractive source of financing, with the cost of leasing falling below the cost of ownership. For example, many small or marginally profitable firms may find traditional financing expensive or more difficult to obtain, while a commercial landlord may be more eager to sign a lease with them.
Cost Stability & Predictability. The long-term occupancy costs of leasing are usually easier to forecast and budget. While some leases may expose a tenant to minor capital expenditures, most commercial lease structures allow the tenant to avoid unforeseen capital costs such as the replacement of mechanical systems, structural repairs, and roof or parking lot replacement.
Tax Benefits. Unlike ownership, the occupancy costs of leasing are fully deductible, where as an owner is required to depreciate the property’s improvement costs, and cannot depreciate the value of the land itself. This benefit can help to shield the business’s operating income from federal, state and local income taxes.
Flexibility & Mobility. A lease’s expiration date allows users specific dates by which to plan and reevaluate their real estate needs. For this reason, leasing can provide greater flexibility to a user who many need to expand or contract, and mobility if this user needs or wants to relocate.
Location. Leasing can allow a user to occupy space at a premier or strategic location this user could not afford to own directly.
Focus. Leasing allows tenants to concentrate on its primary business without the distractions of the many types property management issues which come with ownership.
Disadvantages of Leasing
Control. Tenants tend to have little or no control over the types of the other tenants that lease space in the building. These other tenants can have an adverse impact on parking, hours of operation, use and compatibility, or building services.
Cost. For an established business with easy access to capital, leasing is could be a more expensive alternative to ownership.
No Appreciation or Equity Accumulation. By leasing instead of owning, there is no opportunity to realize profits from the appreciation of the property occupied. In addition, tenants are not able to realize any type of equity accumulation through the reduction of the property’s underlying financing.
Contractual Obligations. Even if a leased property becomes less desirable or unsuitable, or the tenant’s business become unprofitable, the tenant must continue paying rent or face penalties for any default.
Loss of Salvage Value. Most leases stipulate that certain improvements made by the tenant become the property of the landlord at the end of the lease term. Alternatively, the landlord may require that the tenant remove certain improvements made to the premises at the tenant’s expense.
Advantages of Owning
Appreciation. An owner is able to capture the upside of any asset value appreciation, whereas tenant would not.
Debt Reduction. Under an amortizing loan, an owner accumulates equity in the property as mortgage principal is paid down.
Control. Ownership of the property allows for direct decision-making and control, whereas leasing does not.
Income. If a portion of the property is leased, the rental stream from other tenants can be used to help pay the mortgage, reinvest, or distribute.
Tax Advantages. Ownership enjoys the benefit of interest and depreciation deductions in order to shelter income from taxes. In addition, upon any sale of the property, gains are usually taxed at a lower marginal tax rate than ordinary income. For example, the capital gains tax rate is currently 20% and depreciation recapture is 25%.
Disadvantages of Owning
Time Frame. Because of the transactional costs associated with the acquisition and disposition the property, these cost can offset or even eliminate the benefits of appreciation over a short-term hold.
Inflexibility. Because the property is owned by the business (or a related party) any decision to relocate for business purposes may be more difficult, as a then vacant property would need to be relet or sold. This process can take months, or even years to accomplish.
Capital Requirements. In most cases, commercial property requires a down payment of at least 20%, if not to 30 percent. This equity requirement consumes capital which could otherwise be invested in a user’s underlying business.
Management. Commercial property management issues are complex and cover areas such as legal compliance, health and safety issues, contractor management which can be both distracting and costly.
Financing. The sources and availability of debt may be limited in times of economic recession or depression, and rising interest rates may make refinancing difficult or impossible.
Debt Covenants & Restrictions. In most cases, commercial real estate loans require personal or corporate guarantees, along with some type of liquidity requirement (e.g minimum deposit balance with the lender). Alternatively, non-recourse fixed-rate financing often comes with other stipulations. One of the most common examples is having to pay yield maintenance or a break up fee, should the loan be retired early.
Downside Risks. As with every investment, there are numerous risks related to ownership. These include the value of the property declining because of the economy or market, financing risks, and unanticipated expenditures for repairs and maintenance.
While not all-inclusive, this list summarizes many of the intangibles that go into making the decision to lease or own a commercial property for occupancy.
This list of Pros and Cons is included in our Lease vs Buy Analysis Template, which can be used to evaluate the financial aspects of this decision. Download it here.