Congratulations! Your business has grown and you’ve identified that you need industrial facility space to meet your needs. Your next decision point should be whether to lease or to own. There are advantages and disadvantages to each option, some are strategic and some are at the tactical level. Keep in mind that there is more to the decision making process than just pure financial analytics. For example, even if your financial analysis indicates that the ownership option costs less, you may choose to lease because of strategic reasons such as an exit strategy requirement in your business plan.
Whether your business requires you to expand in your existing market, downsize, reconfigure or move into another geographic region, there is no doubt that the outcome of your lease versus own decision can significantly change your business’ future cash flow, tax strategy, and net equity on the balance sheet. Let’s take a few minutes to explore some of the advantages and disadvantages associated with leasing versus owning and in a later post we will cover some recommended techniques for decision making.
When considering your next facility move, I recommend taking some time to analyze whether leasing or owning makes the most sense for your business and personal investment strategy. There are advantages and disadvantages to each option, some are strategic and some are tactical. Let’s take a few minutes to explore some of the advantages and disadvantages associated with each and in a later post we will cover some recommended techniques for decision making:
Let’s define leasing. Leasing is a process where lessors (or landlords) provide lessees (or tenants) the physical use of a real property for a specified period of time without granting a specific ownership interest in the property. Leasing provides certain advantages and disadvantages for you, the business owner:
- Less upfront capital required – Leasing can provide more flexibility for business owners that may require or prefer to keep cash invested in their businesses. In many cases it may make more sense to keep cash invested in the business than to invest in real estate assets. Less cash required upfront keeps the cash available for other uses.
- Operating Lease costs are tax-deductible. Lease payments are operating expenses and are fully deductible against earnings. If the lease is a net lease and the lessee pays operating expenses in addition to rent, the operating expenses are deductible as well.
- Excellent Financing – Most lease arrangements have fewer restrictions than loan agreements, providing flexible financing. Leasing is sometimes the only source of financing for a startups or small businesses with marginal credit. Essentially, leasing provides 100 percent financing to the tenant with little or no upfront cash, while most borrowing requires a down payment.
- Movement Flexibility – Leases are typically much easier to get in and out of than ownership scenario where the owner must acquire, improve, occupy, and dispose of a site as an alternative to leasing. Lease expiration time frames and lease options provide flexibility and benchmarks where the user has an opportunity to plan and reevaluate space needs
- Focus on core operations – being an owner adds a layer of work and responsibility you don’t have as a tenant. Leasing allows the business owner to direct more attention to operations without concerns related to facility ownership.
- Cost Stabilization – Leasing tends to stabilize and smooth a user’s monthly facility expense versus ownership where large expenses can impact a firm’s monthly cash flow statement due to annual expenses and major maintenance and repair expenses.
- Cost – As the industrial market moves into expansion and hypersupply, market rents will go up. If your firm is well capitalized and has a history of strong earnings with good access to capital, it may end up being more expensive to lease than own. Performing a financial analysis is the best way to make that determination.
- No control over your neighbors – Leasing will not allow you control over other tenants. New neighbor tenants may not be compatible with your business image or they may create demands on your facility that you were not expecting. An example would be your landlord leasing the suite next door to a call center and now every parking space in the business park is now taken by call center employees
- No control over your own facility – You may be forced into a position to accept changes to the building that the owner wants, but you oppose. For example, the landlord decides to wait another year to replace that leaky roof, but you would like to replacement this quarter since there is current disruption to your business caused by the situation
- Limits on what you can do with the facility – You may have an issue getting an approval for property improvements on leased real estate if the improvements substantially change the space or reduce its potential for reuse after you are gone. Although the lessee considers the improvements important—such as technological changes necessary to the business, physical changes to accommodate staff, or cosmetic changes to impress customers—the lessor may be reluctant to allow them.
- No equity accumulation or asset appreciation – Leasing does not provide participation in property appreciation
Owning is a way for you to obtain full physical and economic use of a property in perpetuity. If you own a commercial property in the United States, you are generally are free to use the property as they wish, within the limits of the law. Owning also has some clear advantages and disadvantages. Here are some of the advantages and disadvantages to consider when analyzing whether to lease or own:
- Control – As the owner, you have the right to operate your facility however you wish (within the limits of the law). You can invest as much or as little as you wish and carry out your own strategies with the facility that suit your specific interests and support your business plan objectives.
- Stable investment – Overall, real estate can be a great place to invest your money in the long term. Owning commercial real estate can be an excellent hedge against inflation and a good way to diversify your investment portfolio.
- Accumulation of equity – As the owner of commercial real estate, you are entitled to all of the appreciation in value.
- Potential tax benefits – As the owner of commercial real estate, you are entitled to tax savings from cost-recovery deductions and the mortgage interest expense during the entire holding period and when you sell the property.
- Potential Income – You can rent out a portion of the property to other users if you wish, providing an additional source of income to you and your business.
- Pride of ownership – Intangible benefit resulting from pride and status a business will perceive as a result of owning its own facility.
- Distraction from core business – being an owner can divert your energy and take time away from managing your core business
- Capital Required upfront – Initial investment of Down payment and other improvement costs can require cash that could normally be used to fund company operations and primary business requirements
- Interest rate risk – Depending on financing terms, ownership could be subject to increase cost of capital associated with increase in interest rates. Also, your company’s ability to obtain financing at favorable rates is not just a function of creditworthiness, but also availability of financing in the capital markets.
- Asset value fluctuation – while in the long run, commercial property valuations have risen over time, there is always a chance that the value of your facility could go down. If you are forced to sell during a recessionary period, there is a chance that you could end up having to sell below the basis of your investment.
- Risk exposure – Ownership can be subjected to facility related risks of environmental issues, structural issues, and other building related matters. All of these concerns can be investigated and mitigated upfront during due diligence (see due diligence checklist blog post). Other concerns that cannot be resolved prior to acquisition could be exposure to potential damage during ownership, building obsolescence, and the lack of liquidity associated with commercial real estate ownership as compared to other forms of financial investment.
- Balance Sheet Debt – The Financial Liability of a mortgage can negatively impact your balance sheet by increasing long term liabilities and negatively affect your debt to equity ratio. This can have a further negative impact on obtaining other forms of financing for your business at favorable rates and terms.
- Lack of Flexibility – It is possible that the facility could be inflexible and difficult or impossible to expand or downsize based on requirements of the business. In this situation with a lease, you could simply move on to the next facility at end of term or seek early termination or modification options. When you own a facility that doesn’t work for your business, your options are more limited.