Lease or buy?

In most businesses, the question of whether it is better to own or lease your store space frequently arises. With start-ups, as capital is usually limited, renting is the only option. For the established concern, particularly one that wishes to expand the shop’s size, relocate, or add another outlet, it becomes a matter of weighing the options and selecting the best. Many business owners say owning is the only way to go.

Yet the big box stores and many industrial concerns lease. Since there are pros and cons to both, it comes down to determining whether the benefits of ownership outweigh the disadvantages.

The decision to own or lease should not be about occupancy, but rather the best use of available capital. You can always buy, build or rent the required shop space. Money is not made by owning an asset but by the use of it. I spoke recently to a business owner who leased a larger building than he previously occupied. As a subcontractor for some larger construction developments, there is increased demand for his limited capital. He is uncertain if buying at this time would be wise. He thinks, later, maybe, but not now.

If we are to assume that the average rental store has in the range of 5,000 square feet of floor space and requires about 7,500 square feet of land, an average-quality building in most of the country suggests an investment in the $400,000 range. If mortgaging, say $300,000 at 5.5 per cent for 15 years, the annual debt service would be approximately $29,000. Add to this the return on your equity investment of $100,000 at say nine per cent or $9,000 yearly, your property cost would be approximately $38,000 per year. However, were you to borrow the $100,000 from Aunt Jane at, say, six per cent for 10 years, the annual debt service would be approximately $13,000 for a total of $42,000. If leasing at $7 per square foot per year, 5,000 square feet would cost $35,000 per year. Property taxes, insurance, utilities and maintenance are additional in both cases. So, depending on your cost of financing, buying could cost you $38,000 or $42,000, whereas leasing would cost only $35,000 per year. This suggests that for the shorter term, leasing is the better way to go.

But depending on other considerations, it may not be. When buying using the demonstrated interest percentages you will have retired the $100,000 loan in 10 years and the $300,000 mortgage in 15. Assuming that the equity capital to buy is available, or if you borrow it all from Aunt Jane, in the short term it works to your disadvantage. With buying, over the longer haul, you will be money ahead. This suggests that owing the real estate is the better way to go if you plan to stay in the facility for a long time.

These figures are for demonstration purposes only. Do not accept them as gospel. You must work out your own cost of buying and financing or leasing. You might get a better deal on interest than what was shown. Interest rates are at an all-time low. It could be that the equity capital is not there or Aunt Jane says “no.” And, you might not be able to buy what you want for $400,000 or rent a good quality building for $7 per square foot. It is important that you undertake a complete cost analysis comparison, which would include all equipment, trucks, shelving, office furniture and equipment, leasehold improvements if renting, prepaid rent, and working capital. 

Leasing can create the nagging feeling you are making the landlord rich. But if you wish to avoid leasing, you have to ask yourself whether you are prepared to assume so much debt. Other forms of property financing carry requirements for personal guarantees and other financial commitments. If you are mortgaging the real estate and also leasing or financing equipment, how will your balance sheet, credit lines and borrowing ability be affected? Although leasing has some distinct disadvantages, it does provide 100 per cent leverage on your dollar and 100 per cent of the rent is tax deductible.

Real estate as an investment
Few investments provide a better long-term return on your capital than real estate. Your equity increases through mortgage pay-down and value appreciation. However, there are downsides. Real estate is land locked. It can’t be moved. If you pay too much, buy too big or finance too much it could be a loser. Leverage works both ways.

Consider setting up a separate company to own the property. Owning real estate should never be considered part of your store’s business. It often makes sense to keep your property a separate investment owned by a separate company and leased back to the rental operation. Although this could incur some income tax consequences, it protects your investment against any business-oriented liability. Rent to yourself at market rate, the same as if you were leasing to a third party. On paper, consider yourself a tenant. Separate property and store expenses. Compare the returns with other investments, and then determine if this is the best way to go.

Three considerations
When you buy, envisage not only your own requirements but the longer-term potential of the property. There are three important considerations. First, the functional design of your store where the most important criteria will be how the property fits in with your needs and your potential growth. Second, someday you may wish to resell the property. For this purpose you need to consider it from the perspective of a future buyer. The more adaptable it is for other uses, the better price you will receive. Only select a property that will be in demand. Third, you may wish to rent out the property in the future. It could be that you will sell the business and retain the real estate as an investment. So you will want to ensure the property is adaptable, and can provide a return comparable with other investments now and in the future. Avoid the temptation to build inflation into your calculations. Use constant dollars.

Clarify your objectives
Only buy real estate after you have considered all factors and decided owning your shop’s property is preferable to leasing. Good real estate is one of the world’s better long-term investments, yet is not without its shortcomings. Develop a strategy that will enable you to achieve your objectives and overcome your constraints. Should you own your own real estate? Yes, no, maybe, sometimes, and all with qualifications.

About the author
Lloyd Manning is a semi-retired business and commercial real estate appraiser and broker who now writes business books and articles for trade magazines and professional journals. His latest book, “Winning With Commercial Real Estate,” is available online from Booklocker Inc., Chapters-Indigo and Amazon.