While construction industry professionals know how a high-quality commercial facility should be designed and constructed, navigating the complexities of commercial real estate strategies for their own businesses can present an entirely new set of challenges. One of the most important decisions construction-related business owners face is whether to lease or buy a facility for their own operations.
Leasing versus buying is a choice that can significantly change a firm’s future cash flow, tax strategy and net equity on the balance sheet. Both approaches have pros and cons, and it is important to understand the potential impacts of each option before making a decision.
LEASING ADVANTAGES AND DISADVANTAGES
To start, leasing requires less upfront capital. In many cases, it makes more sense to keep cash invested in the business rather than in real estate assets so it is available for core operations.
Plus, operating lease costs are fully tax-deductible against earnings. If the lease is a net lease and the lessee pays operating expenses in addition to rent, the operating expenses also are deductible.
On the financing front, most lease arrangements have fewer restrictions than loan agreements, providing more flexible financing terms. For a small or marginally profitable firm, leasing is often the only available option.
Additionally, leases typically are easier to get in and out of than ownership. Lease expiration time frames and lease options provide flexibility, along with benchmarks where there are opportunities to plan and reevaluate space and geographical needs.
Finally, leasing a property comes with fewer monthly costs and expenses related to maintenance and repairs, so facility expenses are more predictable than with property ownership.
In addition to a lack of property appreciation or equity accumulation, leasing disadvantages include:
- Market rental rates ebb and flow. With the U.S. economy still expanding, rental rates are rising and could continue to increase for some time. If a business is well capitalized with a history of strong earnings and good access to capital, it may be more expensive to lease than own.
- No control over neighbors. New tenants may not be compatible with a company’s image, or they may create unexpected strains on the facility, such as contributing to a lack of parking. Tenants also may be forced to accept undesirable changes that the property owner makes to the building.
- Limits on improvements and renovations. Tenants may have problems getting approval for property improvements if they would substantially change the space or reduce its reuse potential after the tenant leaves.
OWNERSHIP ADVANTAGES AND DISADVANTAGES
Ownership comes with the right to operate a facility, however, one wishes (within the limits of applicable laws). Owners of commercial facilities can choose how much to invest in a building, matching their business objectives.
Owning commercial real estate can be a good long-term investment, an excellent hedge against inflation and a way to diversify investments. Plus, the property owner is entitled to all the appreciation in its value.
Owning provides tax savings from cost-recovery deductions and the mortgage interest expense during the entire holding period. And if desired, owners can rent out a portion of the property to provide an additional source of income.
Ownership disadvantages include:
- Capital required upfront. The initial down payment and other improvement costs tie up cash that otherwise could be used to fund company operations.
- Interest rate risk. Depending on financing terms, ownership could be subject to rising interest rates as time goes by.
- Asset value fluctuation. While commercial property valuations have risen, there is always a chance of the property value decreasing. If forced to sell during a recessionary period, an owner might have to sell below the basis of the investment.
- Risk exposure. Ownership could have facility-related risks, such as environmental and structural issues. While such concerns can be mitigated upfront with proper due diligence, other risks such as damage during ownership and building obsolescence may be unavoidable.
- Lack of flexibility. While leasing allows a company to move when the lease is up or seek early termination, ownership comes with fewer options.
It is important to understand that there is more to the decision-making process than financial analytics. For example, even if it’s determined that ownership costs less, leasing may still be the better option because of the need for a simple exit strategy in a business plan.
Business owners also should consider their company’s growth plans and how they will affect future space requirements and geographic needs. Other factors include evolving technology and how industry changes such as new racking systems, manufacturing techniques, equipment advances and safety requirements could affect the commercial space needed.
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