By Michael Merino, CCIM, SIOR
Fledgling entrepreneurs, owners of accounting firms, machine shops, print shops, distribution companies, dry cleaning establishments or any other small businesses face the question of whether to lease or own the property housing their business.
Unfortunately, for those seeking a quick fix, there is no “right” or “wrong” answer. A variety of factors pertinent to the individual business and the owner’s objectives, as well as local market factors, must be taken into account before an informed decision can be made.
The company’s growth potential and future sustainability are two of the principal factors influencing the lease versus own decision. If the business is expected to grow dramatically over the next three to five years, owning is probably not a good option.
By leasing, the entrepreneur avoids the prospect of purchasing a building that is too large and finding itself stuck with (costly) empty space. Alternately, the business may stumble by purchasing a building that only accommodates current space needs, which will be too small in a few years.
Availability of flexible lease terms is key to an optimal leasing situation. Landlords in many markets offer a long-term lease of 5 to 10 years with a clause allowing the business to exit the lease after five years with six months notice. In this case, the tenant would pay the unamortized, or remaining landlord costs of tenant improvements, brokerage commissions and fees, before leaving the property. For example, if the landlord financed some specialty improvements on behalf of the tenant and the tenant exercised its option to terminate, then the landlord, per the terms of the lease, would re-coup the remaining amount in one lump sum. This lump sum would also include brokerage commission and most likely a termination fee.
That said, leasing as opposed to owning real estate does offer a business the option to occupy a property while utilizing capital in other ways – if the lease has proper flexibility and provisions for the tenant.
Leases should provide the tenant with an acceptable level of control over the asset. These control issues include assignability (the ability to assign lease or responsibility to another party if the tenant decides to leave), reasonable condemnation (not having to pay if the building is untenantable for any reason), and purchase options (which gives the tenant the option to purchase the building at a pre-negotiated timeframe and/or price). Lease rate escalation clauses should be manageable and ideally tied to sales growth in order to lessen downside risk.
With regard to ownership, tying up valuable capital in real estate assets can be a drain on small business owners who are focused on making payroll. Leases tend to lower utilities and maintenance costs, where a tenant is paying its pro rata share in a multitenanted building, versus shouldering all of the cost in a freestanding building.
An outright purchase of a business property would best be considered by an entrepreneur who has been in business for a few years with concrete projections to grow the business significantly. If a business owner knows he or she can manage the company effectively in the same building for ten years or longer without requiring additional space, then he should take a hard look at the cost of differences between leasing and owning.
However, even ownership has its pitfalls. If you purchase the property and ten years in the future the business gets into financial difficulties, you as the owner do not have the flexibility a lease would offer. If you file for bankruptcy as a tenant, you’re likely to tear up the lease and claim you need to move to a lower cost building in order to get back on your feet. An owner simply does not have that flexibility. Another problem with ownership is that it carries a potential “opportunity cost” of tying up capital that might otherwise be invested in the business’ expansion or renovation.
The main question to consider is, will your business make more money out of putting money into the business or into real estate assets? Even large, successful companies choose to lease because they can be more profitable putting money into their business; others may not want the responsibility of property stewardship.
If the entrepreneur opts to purchase, determining when to make that purchase is paramount to getting the best price. Analyzing current market conditions and available sales comparable information provides the buyer with valuable insight. Sales comparables show buyers what to expect by compiling examples of comparable sales, which are similar either by location or by property type. A broker who can analyze regional markets, how varying property types are performing in those markets, and the kind of rents these assets can capture helps to quantify and compare options. The CCIM/Landauer Investment Trends Quarterly, an analysis of transaction data, is an excellent source of regional market data.
Whether the entrepreneur opts to lease or own, he or she would be well served to get a realistic analysis of the business’ growth potential, and compare costs with trusted advisors.
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Michael Merino serves as vice president at NAI Norris, Beggs & Simpson in Portland.