To Buy or Not to Buy
September 2010 – As seen in SmartCEO Magazine. Print Article
The Great Recession has toppled lofty real estate prices. Commercial rents have dropped 20 percent or more, and the prices for vacant buildings in some DC area locations have dropped even lower. Businesses facing the expiration of their current leases are asking whether they should sign new leases or buy their own buildings. While having a landlord can be a nightmare, real estate ownership also can be a disaster.
So how do you decide? Start with some time-tested ground rules. Never let the tail wag the dog. Youve got a business to run, and you shouldnt let a real estate investment interfere with your company. This means you should only consider buying a building for your business if you pass the following tests:
First, there must be buildings available for sale in the right location for your business. Dont pick a location that is bad for business just because it provides you with the opportunity to buy. Your business is a golden goose, and you dont want to kill it with long commutes or a seedy location that scares off customers.
Second, you should have a longterm need for space. If you are a government contractor with a one-year contract that can be renewed at the pleasure of the government, dont buy. On the contrary, you should be leasing space with an option to terminate if you lose your contract. The market for selling commercial real estate is just too illiquid and the transaction costs to buy are too high for you to even consider a situation where you might need to sell in less than five years.
Third, make sure you wont need to relocate your business. Again, when you buy property, be prepared to make a minimum commitment of five to 10 years. If there is any real risk youll need to move sooner, stick with leasing and try to get termination and assignment rights.
Fourth, your space requirements should be stable or steadily rowing. You can buy a building that meets your current size requirements. Or you can buy a larger property, try to rent out the extra space and grow into the building over time. But if the amount of space youll need in the future is unpredictable and could grow or shrink dramatically, youre much more likely to find the flexibility you need in a well-negotiated lease.
Pros and Cons
If you pass these threshold tests, then youre ready to evaluate whether buying versus renting works for your business. Each choice has pluses and minuses. Generally, leasing is the choice with lower risk and more flexibility. Buying presents greater risk, but also more control and often far greater rewards. Consider the following major issues:
- Cost. Historically, it costs more to own than it does to rent. However, real estate prices for empty buildings are depressed. Better still for buyers, interest rates are bouncing around their lowest point in almost 50 years. Sure, many lenders are imposing stringent loan requirements. But one of the easiest commercial loans to obtain is an owner occupied loan. This is exactly the loan youll want one to buy a building for your own business. Even so, lenders are requiring down payments of 20 percent to 30 percent of the purchase price, so you will need a chunk of cash just to close the deal. But you may find that your monthly mortgage payment is even less than your rent would be on a comparable space. However, once you own a building, you face the possibility of incurring additional costs like an expensive roof replacement that you might not have to bear as a tenant. In the current market, though, cost can be a toss-up when it comes to buying versus leasing.
- Flexibility. A well-crafted lease generally provides you with more flexibility. If you have sufficient bargaining power and know what to ask for, you can get the option to expand your space into adjacent premises, the right to renew your lease and the power to assign or sublet if you outgrow the space or sell your business. Sure, some of this flexibility may come at a price. That right to renew may require you to pay some unknown market rate in the future. But, when you buy, youre locked in. You own the building, have a mortgage to pay and can’t escape without significant losses unless the economy is strong. You do retain some flexibility. If you outgrow the building or dont need as much space, you can rent it to others. You also have a lot more control. You can make alterations without landlord consent and possibly even operate the building more efficiently, lowering your costs. Overall, though, the average lease provides far more flexibility than the typical purchase.
- The Hassle Factor. If you purchase a building, youre also acquiring a lot of responsibilities. You need to take on everything from trash removal to landscaping to repairs. You can’t just call the landlord you are the landlord. On the other hand, there is no greater hassle than a bad landlord. One clients landlord wouldnt fix the air conditioning and wouldnt even meet to discuss the problem. Until we sued, we didnt get any relief. Another used jackhammers outside the premises during business hours. There are countless horror stories produced by real-life landlords that have no business owning real estate. Still, most landlords do a good job, making a lease far less burdensome than a purchase.
- The Pay Day. There is almost never any big payoff to leasing. You pay your rent and when your lease is up, you move on or renew. The end. Occasionally, you get the chance to assign your lease for a profit. Even more rarely, someone wants to buy you out of your lease because they need your space. Dont count on any of that. Leasing space is like renting a car or a hotel room. Youre paying for what you need, not investing. On the other hand, buying the right building at the right time can produce tremendous rewards. And now there are opportunities to buy right. Prices are low and loans if you can get them are cheap. If you buy in a good location now and hold for five to 10 years, you have a chance to build equity and sell the property at a big profit.
Understand, though, that the decision to lease or buy is just the first step. A smart business owner will start the process early enough to maintain all options, assemble a team of skilled advisors, conduct due diligence and negotiate a deal that protects your business.
Jack Garson is the author of How to Build a Business and Sell It for Millions.