Buying vs Leasing Commercial Real Estate

 

If you are starting a new business or expanding an existing one, a key decision is whether to rent or buy commercial real estate.
When you buy a property, you can either pay cash or finance it with a loan. With a lease, you rent the property for a set term, at which point you must renegotiate in order to continue using it.
Several factors go into choosing the right strategy for your business, including cash outflows, recurring costs, tax implications, property value, business equity, and your timetable.

Pros and Cons of Buying Commercial Real Estate

Commercial real estate maintains its value over time as long as it’s maintained properly.

Pros of Buying

Building equity: If you pay all cash, you own 100% of the property right away, so you immediately retain all the equity. If you take out a loan, your down payment and monthly payments build equity in the property. If you refinance or sell the property, your equity is the difference between the property’s fair market value and the remaining loan balance, but it gradually helps build the overall value of the business.

Appreciating asset: The increase in your property’s value over time allows you to benefit from capital appreciation, and this is the main value in owning commercial real estate. The rate of appreciation varies with the inflation rate, local supply and demand conditions, interest rates and other factors.

Rental income: If I business purchases commercial space for its own use and has leftover space, you might want to rent it out to tenants for a secondary income stream. Some investors rent out the entire building without occupying it themselves.

Tax breaks: Interest and depreciation on your commercial property is available as a tax break.

Control: When you own property, you have maximum control over it and can make your own decisions about reconfiguring the space. You’ll also make fixed monthly mortgage payments, instead of a rent payment that can be changed when leases expire.

Cons of Buying

Upfront spending: Typically, you’d have to make a down payment of 10% to 30% of the property’s value, and you’ll also have to pay for closing costs, origination and appraisal fees.

Difficulty qualifying for financing: You may have trouble qualifying for a commercial real estate loan with a reasonable interest rate if you or your business cannot get approved for bank financing. This may make it more cost-effective to lease.

Prepayment penalties: Many commercial real estate loans come with hefty prepayment fees or other penalties specific to commercial real estate, in the form of yield maintenance or defeasance if you prepay the loan balance.

Liabilities: You are responsible if someone is hurt on your property, which means you’ll have to pay for a liability insurance policy to protect yourself from lawsuits. Additionally, many loans may require a personal guarantee, which makes you personally liable to repay the loan if your business cannot.

Loss of liquidity or capital: There is always the chance that your property’s value will decline and you might take a capital loss if you decide to sell. You may also have liquidity issues since your money would be tied up in the property. The money tied up in the property could also have been used for other opportunities had you leased instead.

Pros and Cons of Leasing Commercial Real Estate

Commercial leases typically run from five to 10 years. You can use the property during the lease, subject to any restrictions built into the lease agreement.

Pros of Leasing

More liquidity: You tie up much less of your cash because you don’t need to make a down payment to move into the space. However, you may incur upfront costs for an attorney, broker, prelease inspections, and a security deposit.

Fixed monthly cost: Depending on how your lease is structured, you will generally know exactly what you need to pay each month without the worry of unanticipated, expensive repair costs.

Tax breaks: You may deduct the costs for lease payments, property insurance, property taxes (depending on the lease type), utilities and maintenance as they are incurred. You can deduct your entire lease payment, in contrast to a mortgage’s interest-only deduction.

More flexibility: Qualifying for a lease is often easier than qualifying for a commercial real estate loan, so you have more options when it comes to picking a space. You might be able to lease a property that is too expensive to buy, which can help you get into a preferred location. You can also move when the lease is up without having to sell the property.

Cons of Leasing

No equity or appreciation: You don’t accumulate any equity when you lease, although some contracts have a lease-to-own commercial property feature that allows you to apply a portion of the rent you’ve already paid toward the purchase of the property. Without equity, you don’t benefit from capital appreciation.

No passive income: You aren’t the landlord and thus cannot collect rent from others, losing secondary income you could gain from owning property.

Rent is expensive: Your monthly rent payments will usually exceed mortgage payments on the same property. The typical triple-net lease agreement makes tenants responsible for monthly retail insurance, property taxes, utilities and maintenance costs. When added to the lease payment, your costs are generally greater.

No control: The lease may have restrictions and even early termination clauses that limit the tenant’s ability to control the rental space. You have no control over rent hikes when the lease expires, and if you go out of business, you must continue paying rent or face penalties.

When Should You Buy or Lease Commercial Property?

Typically, it makes more sense to buy if you have enough cash for the down payment and six months’ worth of mortgage payments without causing your business to hit a cash crunch.

Purchasing might be a good option if you:

• Want to rent out part of the space to generate a secondary income stream
• Plan to build equity in the property
• Want to control and configure the space as you prefer

Leasing may be the preferred option if you want:

• The flexibility to move out at the end of the lease
• To avoid tying up your money in the down payment
• Tax deductions on the leasing costs
• Freedom from the responsibility of maintaining the property, depending on your lease
• To operate in a space too expensive to purchase