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When It Is Time to Buy Instead of Lease
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I spoke with Karen Klein, writing for BusinessWeek, last month about owning property versus leasing. Karen is a writer based in Los Angeles covering entrepreneurship and small business matters. A business owner wrote in with a question about whether or not purchasing property right now is a good idea. The following brief article is essentially a question-and-answer, and worth the quick read. Let me know what you think about the prospect of commercial property ownership in light of the current economic environment by leaving a comment at the end of the post.

When It’s Time to Buy Instead of Lease

By Karen E. Klein
Published December 12, 2008 | BusinessWeek

Q: My business lease is nearly up and I planned to renegotiate for a lower payment. However, now I’m wondering if we should try to buy office property instead, with interest and prices so low? – I.N., Prescott, Ariz.

A: Meet with your accountant and look at your long-term business plan for help answering this question. Is yours a growing company likely to eventually need more space than you can afford to purchase now? Can you buy more square footage than you need and sublet until your company expands? If you outgrow the place, will you be able to sell it, or will you be happy becoming a commercial landlord?

Purchasing commercial property builds equity in an appreciable asset that offers both tax advantages and income-sheltering opportunities, says Chris Hurn, president of Mercantile Commercial Capital, based in Altamonte Springs, Fla. If you foresee that you’ll pass your business on to your children or eventually shut the doors if you can’t sell, paying yourself “rent” now and owning equity in a tangible asset later can be a great advantage. And commercial interest rates are at historic lows, Hurn says, between 6% to 6.5% for a 20-year fixed mortgage vs. an historical average around 8.5%.

Still, taking on substantial debt, subleasing, and supervising property maintenance is not for every entrepreneur. And all real estate is profoundly local: While some parts of the country are seeing large discounts from commercial developers, other choice locations will always be very costly.

CREDIT CRUNCH

Then there’s the problem of credit availability, which continues to be extremely tight. “The days of going to a large national bank for a loan are pretty much over for now,” Hurn said. “Smaller community banks and specialized lenders like our firm are where business is being done.”

He offers his clients some tips when they are considering the purchase of commercial property; you can take many of these steps now and even if you can’t get a loan immediately, you’ll have a jump on the process when money becomes more readily available:

Get organized. Ask a potential lender to give you a checklist of required documents. “Full-documentation loans are worth spending the extra time on. The more thorough you are, the better you look to a lender,” Hurn says. “You may also be able to secure a better interest rate, saving thousands of dollars during the life of the loan.”

Get pre-approved. Knowing what you’ll be able to afford early on will save time later. “Lenders have become especially efficient with issuing pre-approvals for commercial loans quickly, assuming they receive the documents they need,” he says.

Know your local market. Talk to an experienced real estate broker who specializes in commercial property and can go over prices, comparable lease rates, and demographic information with you, so you’ve got an idea whether buying is worth it and what the best locations in town are.

Consider financing options. Hurn is a big fan of the SBA 504 loan program. “It provides up to 90% loan-to-cost financing with longer amortizations and below-market interest rates, will preserve more of your capital for better uses, keep your cash flow high, and allow you to redeploy your capital savings into other profit-generating business activities,” he says. Not every small-business owner will qualify for this program, but most do, Hurn says.

Establish an ownership entity. You should own commercial property through a separate real estate holding company, not through your current business entity. That way, “If you decide to sell your operating business later, you can maintain your real estate company,” Hurn says. The property can eventually become a retirement asset for you, generating regular monthly rent checks.

Another thing to think about, if your assets are not sufficient to provide the downpayment on a property you’d like to buy, is partnering with another successful business owner. Two or more of you could form the real estate holding firm to purchase the property together.

5 Comments

  1. Sheryl Page says:

    Thank you for the article…we’ve been deciding whether or not to invest in property or continue leasing (after 15 years). Still not sure, but like your ideas/thoughts. Thanks again!

  2. Jerry Chautin says:

    Herald-Tribune published Jun 5, 2005

    Let’s Talk Business
    Jerry Chautin

    Leasing space is best option for most business owners

    If you saw Stephen LeBlanc’s portraiture photography and his commercial graphic designs, you’d say he’s pretty darn creative.

    But what you might not expect is that this artsy-you-know-whatsy photographer also has savvy business sense.

    When I first met LeBlanc, he was photographing a Greater Sarasota Chamber of Commerce function. And since he was too busy for us to talk, he invited me to visit LeBlanc Studios at 3103 Fruitville Road.

    The contemporary, two-story building reflects many of the features that LeBlanc was previously missing.

    “I had been leasing my former studios for the last 23 years.” He was “tired of not having the room to do my creative work,” he said.

    Consequently, LeBlanc bought the Fruitville site in June 2002, designed the building to his liking and took occupancy on Aug. 1, 2003.

    When I stepped inside the doors and ingested the ambiance, I knew that I was embarking on a unique experience.

    LeBlanc’s elegantly framed photography caressed the walls, accompanied by well-placed lighting and soft music to enhance the experience. The coming together of the aesthetic and business competencies were apparent. As I’d see later, LeBlanc’s adroitness was also reflected in the marketing brochures he created for his commercial clients.

    Understanding his business acumen, I asked LeBlanc why he decided to buy the site and erect his own building rather than the simpler process of leasing. LeBlanc felt he had no alternative.

    “I looked at a large number of commercial buildings in the area (to lease and) nothing that I looked at seemed to fit my criteria.”

    What’s more, similar land in the Fruitville Road corridor is selling for double to triple the price that LeBlanc paid.

    But even though the romance of owning real estate can be seductive, leasing may be a better option for most business owners for the following reasons:

    Precious working capital will be tied up in the real estate.

    The flexibility of expanding or reducing space is often easier and less costly to negotiate with a landlord than the alternative of being forced to sell the building in a soft market.

    Professionals are better at selling and buying real estate than novices. Inexperienced sellers too often buy at the top of the market and sell at the bottom.

    Business owners sometimes sell the real estate at the wrong time in order to accommodate the needs of their business, and the selling price suffers as a result.

    When it’s time to sell out, business owners may want to sell the real estate at the same time and the price for both may have a diminished outcome if the buyer only wants the business.

    Lease payments are 100 percent tax deductible, but mortgage amortization is not.

    Selling a depreciated building could incur taxable phantom income.

    Business owners should spend all their time making their businesses great, and not dealing with the day-to-day maintenance and management headaches of owning their building.

    Even though owning his own building has worked out well for LeBlanc, he observed, “I can now see that owning is not for everyone, but if the space you need is to be rather unique, then your only choice may be to own and remodel or build.”

    Jerry Chautin is a local volunteer business counselor with Manasota SCORE, “Counselors to America’s Small Business.” Contact Jerry with your business questions and stories through e-mail at jkchautin@aol.com. SCORE’s phone number is 941-955-1029 and its Web site is http://www.score-suncoast.org.

  3. Richard Reyes says:

    Great info. I get this question all the time from business owners and really, just like the article, there is no pefect answer. I would say that especially now due to the decrease in the price of real estate, it would be an opportune time to reevaluate this. I am sure it could really make sense to purchase if those were your intentions. The numbers would look sweet now.

  4. Chris Hurn says:

    In response to last post by Jerry Chautin:

    I couldn’t disagree more strongly with Mr. Chautin’s premise. Leasing space is a fine option is you haven’t established your business as a viable concern in your industry. But once you do, you can easily convert that leasing expense into a mortgage payment that builds an appreciable asset for you (commercial real estate). This is very analogous to home ownership versus apartment renting. Once you have a more “stable and steady” lifestyle, most Americans choose to own instead of rent. This becomes the largest investment most Americans ever have… but as business owners, you have another option as well.

    To his specific objections:
    1. Precious working capital may get tied up in owning commercial property, but when you finance with someone like us (who typically requires only 10% of the total project cost as our down payment as compared with ordinary bankers wanting two to three times that much), then you “get your cake and eat it too.” I’m all for the best utilization of capital, and that’s exactly why we always lead with the best commercial financing option available for business owners… unlike many of our banking brethren. This is also why I use my own loan product… again, unlike probably all of my banking brethren.

    2. While you might think leased space requires less capital, if you do any sort of interior build-out, virtually none of that can be taken with you should you later decide to move. With owning, of course, it’s all yours. This point was glossed over in the 2005 Herald-Tribune article that Mr. Chautin posted.

    3. I always encourage our borrowers to set-up real estate holding companies (otherwise known as “eligible passive concerns” or EPC’s) to own their commercial property in. That way, if they sell their business someday (or simple close it down), they retain ownership of their commercial property that their business paid rent to all those years. Again, this is my strategy of “having your cake and eating it too.” Why get absolutely nothing for your years of rent payments? That makes absolutely no sense as a business strategy or a wealth strategy, for that matter, once you have a viable going concern.

    4. We are near the bottom of the real estate market in my opinion and many others’, so Mr. Chautin’s 2005 comments about “market timing” and business owners being novices when they buy or sell, doesn’t readily apply. Business owners are no different than anyone else: they should hire competent professionals to represent them, especially when making large purchases like commercial property. Right now is the perfect time for business owners to be contrarian and purchase discounted commercial property (and other assets) with financing that is offered at near historically low pricing. Times like these are when substantial wealth is made: when everyone else thinks the sky is falling, that’s the best time to buy. When the business cycle recovers, as it always does, you’re in a much better situation and then should consider selling at the top, not buying at the top … which so many people naturally do.

    5. Amortization expense on commercial real estate IS deductible, unlike what Mr. Chautin’s article suggested. As are interest and depreciation expenses. What you pay for a lease monthly is treated as an expense, so it is expensed against your revenues. Not all one’s mortgage payment can be written off, but if you follow my advice of item #3 above, then you’re “sheltering” some of the income that you’re paying yourself by writing-off your interest, depreciation, and amortization expenses. This is another way to extract more money from your business in a relatively inexpensive way, but that’s another advanced strategy we don’t have the space to address right now.

    6. If a business owner owns their home, then making the “leap” to commercial real estate ownership is not that big of a deal. My personal experience as a commercial real estate owner, investor, developer, and financier is that maintenance costs shouldn’t be much different than in a leased property. There are few headaches involved if you buy a property that’s up to code and in dealing with a professional (see item #4 above), you shouldn’t run into any troubles in that area. Owning commercial property is another way for business owners to create wealth for themselves… and after all, that’s why I do what I do. It’s easy to criticize the idea of commercial property ownership, but there are more people on the annual Forbes 400 list who own real estate than nearly anything else. Other than ten-digit net worths (or more), it’s the single greatest commonality among them. If it works for them, it can certainly work for business owners and, in fact, it does. I finance them every day all around the country.

    Business owners have another option, besides just their business, for increasing their net worth and creating wealth for themselves … and it is owning the commercial real estate their businesses occupy. It is a very simply, yet profound, strategy that readily makes sense to most people… particularly because it is analogous to home ownership. This is a strategy that needs considered much more in the small business community.

  5. Martin Wong says:

    When is it time to buy instead of lease? Always an intriguing question for a small business owner.

    First, I have to agree with Karen Kline that a small business owner consult with their accountant. But, being a former corporate and SBA banker (now a commercial real estate broker) I would add that the small business owner should also include their banker, attorney, and real estate professional.

    Second, I agree with Chris’ steps that he list above.

    Third, for all, I believe that it was Mr. Paul Getty who was quoted..”If it depreciates, then lease it; if it appreciates, then buy it”.

    For Sheryl Page, I would suggest that it is time for you to seriously consider purchasing a building. I am sure that over the 15 years that you have been leasing your building you have experienced rate increases, perhaps a change in landlords, etc., all that may have had some impact on your operations. Not to say that you have probably been making the mortgage payment for your landlord. I would recommend that you do two things, first find out approximately how much a building that suits your business needs would cost and then look into getting a pre-approval for an SBA 504 loan (if you have been at the same location for 15 years, then have long term financing should be no problem). Once you have that information in hand you will be able to determine whether or not leasing still makes sense. My guess is that you business has stabilized and you are not in a significant growth pattern so working capital needed for growth is not critical, again, review it with your CPA.

    In response to Jerry. I, also, do not agree entirely with your article, as follows:

    The SBA loan program was designed to help the small business owner by allowing a minimum of 10% down payment, thus preserving working capital when compared to traditional financing where lenders are requiring 25-40%. And there are situations where a lender can offer a working capital line/loan through its SBA 7(a) program.

    There is flexibility under ownership to expand or reduce the size needed, as well; for one the owner can sublet a portion of the building, or in the case where the company has grown, why not purchase a second building? And, yes, they may be able to obtain another SBA 504 loan providing that they have not exceed ed the SBA guaranty limit.

    I did not understand your reasoning behind the professionals knowing when to sell and buy; coupled with small business owners selling too low to accomodate the needs of the business. Are all small business owners real estate investors?, if that is their business great, but if not then they should focus on their business operations. As a SCORE counselor, would you not agree that that would be the last resort, to sell? There are bankers that provide working capital lines and term loans for small businesses; and not to mention that if the building has appreciated it could be used as a solid secondary source of repayment or additional collateral that strengthens the lenders risk position.

    The comment that you make about a small business owner having a unique space requirement would be the only candidate, in your opinion, that should consider buying, it totally incorrect. Do you have a unique space requirement for your home? If not, then are you renting?

    Just a few other points to consider.

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