If you’ve already established a successful business and are looking to expand your available space, you’ve got a couple of options to consider: buying or leasing commercial real estate.
There are benefits and downsides of each and carefully investigating aspects of both is your best way to make an informed decision.
When to Consider When Leasing Commercial Real Estate
If you’re taking your next step in business growth or just got your first round of financing and looking to expand, a commercial real estate lease is probably your best option. Not only are landlords and property owners less strict about financials and business history than financial lenders, you don’t want to get stuck in a 30 year mortgage payment if your company doesn’t survive a sudden market shift, economic downturn, or other insolvency situation.
Most commercial lease agreements range between 3-10 years depending on the real estate market in your area, so your business analysis and growth potential should be mapped out to at least the ten year mark before approaching a property for lease.
When You Should Consider Buying Commercial Real Estate
You’ve built a business, shown consistent growth, and have plenty of cash on hand, but your current space isn’t doing what it needs to do for future growth. Now is the time to consider purchasing a permanent location for your company.
Especially if you’re in an industry with specific requirements for space to accommodate specialized equipment or handle heavy warehousing and shipping, purchasing or building on land you own could be the better option in the long-term. But these types of purchases require more significant planning, preparation, and savings in order to justify in the eyes of a financial lender.
Banks want to ensure that their investment will pay off and that your company will be in business long enough to see the loan through to completion.
Pros and Cons of Buying vs. Leasing Commercial Real Estate
Benefits of Buying Commercial Real Estate
As with any real estate transaction, the owner of the property will benefit from any increase in value according to market conditions – and that means equity, or perceived value, from lenders.
Should your company need an urgent cash flow increase, you may be able to use the equity in your commercial property as collateral against a business loan or mortgage. This isn’t possible if you’re leasing a commercial property and will limit your ability to grow or adjust as market conditions change, so if you’re able and ready to purchase a space, you’ll have a greater financial advantage moving forward.
Assets and Collateral
Having a commercial real estate property on your real estate portfolio is a nice boon – as long as the property appreciates.
Potential for Rent and Additional Income
Most companies that purchase commercial real estate occupy at least 51% of the property, renting the remaining space out to other companies and tenants. While the additional income potential is obvious, you’ll also be acting as the landlord for each additional tenant unless you hire a property management company, but that will cut into your profit margins.
When owning your own property, you can calculate your pax benefits by deducting interest expenses, any depreciation expenses, and anything you pay toward the property outside of the monthly mortgage payment. But compared to commercial real estate leases, where you can deduct the entirety of the monthly rent payment, you can’t deduct mortgage payments.
Complete Control Over the Property
While landlords can dictate (within certain terms) the amount of monthly rent increases you’ll pay, having a fixed mortgage loan payment means you’ll be able to budget the exact same payment number every month for the length of the loan. Furthermore (and perhaps more importantly), you’ll be able to change any features, make upgrades, or simply add a new coat of paint to the property without asking permission.
Downsides of Buying Commercial Real Estate
Increased Upfront Financial Requirements
Compared to leasing a commercial property, you’ll need to invest substantially more in upfront costs when purchasing a space. Because of the nature of the loan, lenders require a down payment and/or collateral against the loan. This typically consists of 10-20% of the loan, but depending on your credit, you may need to provide even more upfront. Additional costs include any due diligence you need to perform before the sale goes forward and closing costs when you complete the transaction.
As the property owner, you’ll be responsible for the health and safety of the people inside it as well as dealing with the repairs and maintenance of the space. And if you decide to rent any portion of the property to other tenants, you’ll be liable for their actions, making additional insurance policies an must-have financial burden.
Risk of Market Depreciation
While investing in real estate is typically a smart move, getting locked into a mortgage and then having the market go south can be a painful pill to swallow – especially if your lender is unwilling to refinance your mortgage loan. And should a market adjustment affect your business and force you to sell the property, you’ll be on the hook for any loss in value incurred.
Compared to commercial lease agreements, which can last between 2-10 years or so, a mortgage on a commercial property can be between 15-30 years or more. With that kind of long-term commitment, it can be difficult to adjust to your company’s needs should you have to expand.
Benefits of Leasing Commercial Real Estate
Increased Liquidity and Fewer Financial Requirements
There’s significantly lower financial requirements when leasing commercial real estate than attempting to buy a property. You’ll need some cash on hand for inspections, attorney’s fees, and whatever deposits the landlord requires, but ultimately, your credit and financial requirements will be much more lax compared to applying for a mortgage loan on a commercial property.
Just as with purchasing commercial real estate, you’ll have tax benefits associated with leasing a space.
When calculating your taxes, you’ll be able to factor in:
- Monthly lease payments
- Contributions to property taxes and insurance
- Utilities and maintenance costs factored into your lease agreement
However, unlike purchasing a property, you’ll be able to deduct the entirety of your lease payment when calculating your taxes. That means more savings overall than you’d see if you owned the property.
For a medium-term lease agreement (5-10 years), you’ll have greater flexibility in changing to a smaller or larger space should your company’s needs demand it. When compared to purchasing a space outright, you’ll be able to adjust your needs more quickly than being locked into the same property for a 30+ year mortgage.
Downsides of Leasing Commercial Real Estate
No Equity or Real Estate Investment Opportunity
Because you won’t own the space in which you occupy, you won’t recoup any money on a sale should the market value increase during your occupancy. Any money you put toward a monthly payment won’t ultimately benefit you in the long-run.
Higher Monthly Payments
Depending on your lease agreement, you may be contributing to property taxes, insurance, and utility costs your landlord passes along to you. Plus, if property taxes increase alongside your monthly rent after the first year (again, depending on the terms of your lease), you’ll be paying more than a monthly mortgage loan payment on a comparable – or better – property.
If you choose to lease a space, you’ll be at the whims of the landlord as to any changes or alterations you might need to make your business more comfortable and successful. Furthermore, there’s the common practice of annual escalations, which say the landlord may increase your monthly rent up to a certain amount each year, making it difficult to budget appropriately.
What to Ask Yourself About Buying or Leasing Commercial Real Estate Space
Whether you’re planning to purchase or lease commercial real estate, you’ll want to consult with a tenant representation broker to help guide your search and help with the negotiation process. And while you may need to take out a line of credit or business development loan to secure a commercial lease agreement, it’s a different beast to apply for a commercial real estate mortgage. For that, you’ll need a longer business history, more detailed business planning, tax and financial statements for several years, and a substantial down payment and/or collateral in order to secure the mortgage.
As with any substantial business decision, you’ll want to do a cost/benefit analysis before you make your choice. But between leasing and buying commercial real estate, you’ll also want to consider the following:
- The current size of your company
- Current space limitations (and how it hinders future growth)
- Average monthly cash flow
- Financial capital and lending potential
- Availability of space in your area
When you’re considering the potential pros and cons for either leasing or buying commercial real estate, the number one determining factor should usually be costs. But you’ll also want to consult with a commercial real estate broker, lawyer, mortgage adviser, and an accountant before making a decision one way or the other.