Michael Bull, CCIM
The decision for companies to lease or purchase their real estate is critically important right now with favorable prices and low interest rates. There are many key criteria — including the expected growth of the company, location and the firm’s return when investing in their own business — that must be taken into consideration.
At this point in the cycle, there are some extraordinary factors to weigh. That is why we assembled a panel of experts on a recent episode of the “Commercial Real Estate Show” to explore the lease vs. purchase decision. That’s right, like LeBron James, we created a show around the decision.
Making an Informed Decision
“For most companies, their real estate is the means to an end — it’s there to serve the business,” said Eric Entringer, senior manager at Ernst & Young's San Francisco office, during the show. “Businesses really need to understand where they are in their life cycle as a company and use real estate to support their overall objectives.”
For many businesses looking for space, owning their own real estate does offer certain perks, such as controlling occupancy costs. There is no concern about escalating rents. In fact, if you own, escalating rents increase your property value while your costs remain stable. The Urban Land Institute and Ernst & Young project that U.S. office rents will increase 4 percent annually in 2014 and 2015, according to Daniel Latshaw, principal at Bull Realty.
Additionally, there are three tax incentives to purchasing real estate: the transaction can be configured as a non-cash charge, there are cash-out refinances that are non-taxable and you have the option to enter into a 1031 tax-deferred exchange.
Leasing Offers Some Advantages
Leasing offers the flexibility to move, grow or shrink your space more easily, Latshaw pointed out. Owning real estate also comes with some responsibilities, including managing the property.
You also want to consider your firm’s capital and opportunity costs. If you can achieve a 30 percent return investing in your business and a 17 percent return in real estate, you should include those numbers in your analysis.
Leasing may offer more location choices. While there are more purchase choices than normal right now, it’s important that your business is in the right location and space.
Timing the Cycles
The commercial real estate market always cycles. We are currently in a recovery part of the cycle, which has historically been a great time to buy. In many markets, prices are below replacement costs. There has also been very little new construction. This all adds up to expected increases in rents and values over the next several years. It’s important to project how escalating rents and principal reduction will affect the decision.
There is a bifurcation of value in the current cycle between properties with vacancy issues and fully occupied properties. This can create an instant equity position for users buying vacant buildings. In some cases in the current market, a tenant can purchase a vacant building and lease the entire property to itself on a 10- to 15-year lease term, and the building immediately becomes a “very sellable” asset.
A sale-leaseback transaction might be a good way to go. “If you bought real estate and your company is strong and stable, that’s the best time to look at a sale-leaseback option,” said Entringer.
Change in FASB Requirements
Tenants should keep in mind the proposed change to FASB’s lease accounting requirements as well.
“FASB is proposing that real estate leases should be on company’s balance sheets, so if you are the lessee, you’ll be bringing leases onto your balance sheet and recording right of use and liability from a lease payment standpoint,” said Entringer.
This could be another factor for some companies to lean toward the purchase option.
Easy Money
For companies that are considering purchasing real estate, lenders are very interested in owner-occupied financing at the moment, since it offers a lower risk than many other types of properties. “We are seeing all kinds of different banks lending for owner-occupied loans and the competition is steep, especially if the operating company that’s going to be in the building is performing well,” said Deborah Possick Herron, CPA and senior vice president of Georgia Small Business Capital, during the show.
Required down payments are lower on SBA loans, which allow buyers to preserve their working capital. For conventional loans, down payments will fall between 15 and 25 percent, depending on the borrower and property type. With SBA loans, the down payment typically is 10 percent, so the loans are very attractive for borrowers, according to Herron.
Another factor for the decision: interest rates are still historically low. Many advisers are suggesting locking in low, fixed-rate loans whenever possible. Check with at least three lenders for quotes for your company and property.
Time flies when you are paying bills. Many business owners are surprised to see the amount of equity created by the principal reduction on a purchase loan. For example a $1 million loan amortized over 20 years at 5 percent interest will be paid down to $649,802 in the first 10 years and, of course, down to zero in 20.
“The best thing I can say is do your homework,” said Herron. “If you are looking to finance commercial owner-occupied real estate, you need to understand what options are out there and don’t be afraid to ask a lot of questions.”
“The Decision” show is available at this link.
Michael Bull, CCIM is the host of the nationally syndicated Commercial Real Estate Show and founder of Bull Realty Inc, a U.S. commercial real estate sales and advisory firm headquartered in Atlanta.