About twenty years ago, we had a dream of owning our own building to move our company into. We scrimped and saved and after three years we purchased a 6000 square foot building. It was a great building and we owned it for about eleven years then we outgrew it, sold and moved into 13,000 square feet of leased space which this year we reduced to 11,000 square feet because with computer efficiencies we got rid of all of our filing cabinets and did not need as much room. In this article, I will layout the advantages and disadvantages of leasing and owing there are benefits to both.
Advantages of owning your own building
As you might expect there are many reasons to own your own building.
- Building your net worth – Typically (not always) * buildings appreciate in value, especially if you hold them over the long term and you are located in a growing area. This value growth then is reflected in your personal financial statement. * Building appreciation depends on the economic cycle and location demand for and quality of a building.
- Debt reduction – As you make payments on your loan the balance on your loan decreases by the amount of the principal reduction, which increases your net worth.
- Rent out part of the building – You might have the opportunity to rent out part of your building either to a company you own or to a tenant. This will generate rental income and offset your operating and finance costs.
- Hedge for the future – As your business grows you have room to grow (in other words you buy a building that is bigger than you need an then you can absorb more space over time).
- Tax breaks – You can deduct interest, depreciation and building operating expenses, which you can’t do when you lease space.
- Control – When you own a building you control the use and any tenant improvements in the space, you don’t have to ask a landlord for permission. On the other hand, you have to pay for those improvements as well. You might also have it located close to your home so you can bike to work.
- Building your retirement – as you build your business you can pay off your building and have it available to either rent out to your business or to others as part of your retirement plan.
- Marketing – The other benefit of owning your building is that you can install building signs with your corporate name and have all of your customers and potential customers see it increasing your marketplace visibility.
- Harvesting cash as the building value increases – depending on the loan you have in place (and prepayment penalties), you might be able to refinance and harvest equity growth to buy other real estate or use for continued business operations.
- Easy to do – Buying a building is not really that difficult if your business makes money, you prepare and pay your tax returns on time.
If you have good credit buildings are pretty easy to buy. You can either finance a building using conventional financing (25 – 30% down) with your bank or credit union or with the help of SBA financing; the government has made getting a loan simple by using an SBA direct underwriter. There are basically two programs, the 504 and the 7(a) and they typically ask you to put down 10 -15% for a down payment and fees. One thing to bear in mind is that you need to occupy 50% or more of the building you are buying.
With an SBA 504 loan, proceeds can be used to buy a building, finance ground-up construction or building improvements, or purchase heavy machinery and equipment. Seven(a) (7a) loan proceeds can be used for short-term or long-term working capital and to purchase an existing business, and building refinance existing business debt, or purchase furniture, fixtures, and supplies.
Disadvantages of owning a building include:
- Down payment – you need to find the money for the down payment, which means you need to have the extra capital available.
- Partners – If you have partners that don’t get along with you or you with them, do you really want to own a building with them?
- Qualifying – You and or your partners may not qualify for financing, maybe you had a recent bankruptcy or other credit problem.
- Capital trapped – If you company is growing very quickly you may need the capital that was used for the down payment and maintenance of the building to help fund your company growth instead it is trapped in the building.
- Prepayment penalties – These penalties make it hard for you to refinance you building early if you need to use some of the appreciation to help fund your company growth.
- Reduced rent – The danger in owning a building is that you might subsidize your company operations and not charge yourself market rent, thereby reducing the appreciation in the value of the building.
Leasing a building or part of a building
Advantages of leasing
- More liquidity – You have to make lease payments (which uses up cash) like rent payments, but you do need to put a chunk down to buy a building earning you more liquidity and no trapped equity.
- You have a partner in the building – The landlord is your business partner. This can be a plus. Depending on the lease, the landlord might be making all the repairs to the building (including your lightbulbs), this saves you a lot of time, energy and money, and makes taking care of your space someone else’s problem. Freeing up your time and money for growing your business.
- Tenant improvements – As you rearrange your business and staff to adjust for your business growth, your landlord might pay for a portion of the tenant improvements of the space – in trade for a longer-term lease. This is a huge expense saver.
- Flexibility – Most important is that when you lease you have flexibility. If your business grows or shrinks, you can adjust the space you need in a building, something that is more difficult and more expensive to do in a building you own.
Disadvantages of leasing
- Rent is expensive – When you buy a building you can get fixed-rate financing and can control the expenses over time. This is not the case in space you lease. The landlord will be looking for annual increases to the rent (unless you are located in a place where this a dearth of tenants and many buildings).
- Lack of equity growth – The property does not grow in value because you do not own it.
- Lack of Rental Income – You don’t have the opportunity to lease out the space and make rental income. (Yes, you can sublease space, but you end up paying the landlord the rent, not yourself so no real upside to you).
- Rent increases – The landlord can choose to increase to a level that is higher than you can afford.
- Not renew lease – The Landlord can choose not to renew the lease, forcing you to incur significant moving costs when you don’t have the money.
- Specialty Building – If you have a specialty use, like an aircraft manufacturing plant, or chemical storage, it becomes more difficult to find a building that you can use and you may have to build one and lease it to yourself.
How to make the right decision to rent or to own
As you have noticed making this decision is not simple. Most important is though are the fundamentals.
Primarily, you need to focus on your business making money. Once you have stabilized your business and it has a long term (at least 10 years) future, you should ponder the idea of owning real estate rather than leasing. Owning real estate can help grow your net worth and make banks feel more comfortable lending money to help fund the growth and day to day operations of your company.
That being said, it makes total sense to lease as well, especially when your business is young, or your growth is hard to forecast. Five years after we bought our building, we outgrew it and had to find a building nearby to lease. As we outgrew that space (conference rooms in basements), we decided to lease rather than own, so we could have a larger space. Many years later we became more efficient in use of our space and we shrank down. This was easy for us to do since we leased the space rather than owned it and we had a cooperative Landlord. We used the equity from the building we owned and decided to buy investments separate from our company.
As you home in on this decision, look at both the long term and short-term view for your business. Clearly owning real estate will help your net worth grow, the question is, does that decision fit into the business plan for your company. Additionally, if you have partners and involve them in real estate investments, it gets much more complicated as they have issues in their personal life (like bad credit events, illnesses, and divorces) that might affect your partnerships.
Take your time making these decisions. Involve all your advisors, lenders, CPA’s, attorneys and real estate agents as you try to get to the best decision for you, your family and your business to find success as you make your decision. You can always change your mind as your business and life situations change.
Bluestone and Hockley Real Estate Services