To lease, or not to lease, that is the question (for your client):
Whether 'tis wiser to suffer
The slings and arrows of a volatile leasing market,
Or to take ownership and build equity against a sea of rising interest rates
The decision to lease or buy has never been a simple one for most businesses. In addition to deciding what’s right for a company from a cash flow perspective, there are a multitude of short and long-term implications to consider, a process further complicated by the post-pandemic market upheavals. And given that real estate is the second-highest expense (after employee costs) for most organizations, it needs to be well thought out — preferably with the guidance of a real estate advisor/broker.
The advantages to becoming a user/owner are well documented: Buying a property means the business owner can build equity, and assets tend to appreciate (post-pandemic office and functionally obsolete warehouses notwithstanding). There are tax breaks (interest, depreciation, and non-mortgage expenses) and the possibility of rental income from excess space in the building. The downsides lie mostly with upfront costs, a lack of liquidity, and liability issues.
Those opting to lease have the advantage of fixed monthly real estate costs, significantly more liquidity, some tax breaks on expenses, and the ability to walk away when the lease expires if they choose to move to a better location, expand, or find a better deal. Some disadvantages to leasing are that tenants don’t accumulate equity (unless it’s a lease-to-own agreement) and – as industrial users have found in recent years – dramatic rent increases.
We put the “to lease or not to lease” question to several SIORs working in major North American markets. The viewpoints run the gamut from heavily skewed toward leasing to strong advocates of ownership, with both industrial and office users represented. Whether you agree or disagree, these brokers provide a deep dive into the implications of either decision.
CHAD GRIFFITHS, SIOR, PARTNER AND ASSOCIATE BROKER, NAI COMMERCIAL REAL ESTATE, EDMONTON, ALBERTA, CANADA (INDUSTRIAL SPECIALIST)
“In most situations, it doesn’t make sense to buy,” says Griffiths. “I think leasing is the strongest strategy for most companies.” He believes tying up resources (mostly cash) in a building versus investing in a business that should be able to generate much higher returns makes little financial sense. “Whether they’re adding inventory, opening new locations, or adding a new product line, most companies should be able to earn a better return with their business than on their real estate, or why would they even be in business?”
Griffiths is a staunch advocate of sale-leasebacks for businesses that own their buildings. “It’s a great way to unlock capital while still getting the use of the building that you know works for your company,” he adds. The only scenarios he feels might make sense are when a business has excess capital to deploy or if the asset figures concretely into the company’s long-range plans.
Griffiths feels that too many decisions to own buildings rather than lease aren’t necessarily financially motivated. “I think sometimes it comes down to ego, to be honest, especially with smaller operators, because there’s a kind of pride of ownership,” says Griffiths. “There are a lot of stories out there about companies that have made a lot of money off of their real estate, but much of it is folklore. What doesn’t get taken into consideration is what that money could have made if it had been invested in the company.”
ERIC NORTHBROOK, SIOR, EXECUTIVE MANAGING DIRECTOR, VOIT REAL ESTATE SERVICES, SAN DIEGO, CALIF. (INDUSTRIAL SPECIALIST)
Northbrook is firmly in the ‘buy’ camp, even with the record-high industrial pricing and the uncertain interest rate environment. “If you’re in the industrial world, the rental rates just keep going up and up,” said the 30-year-plus veteran. “If you’re a 15,000 to 25,000 square foot user, and you know your growth is not going to explode, you can lock in your occupancy costs by purchasing a building.”
Northbrook emphasizes that it’s a relatively simple exercise to figure out occupancy costs versus rental costs to determine the feasibility of becoming an owner-user, and his firm provides an owner-user buying guide to help clients determine if ownership is the right path for them.
“A property can be purchased with as little as 5%-10% down, and rates are still competitive, with SBA rates at 6.28% (at press time),” Northbrook asserts, adding that users may be able to finance a building at a lower cost than they can lease it for in the current market. In addition, there are significant tax and depreciation benefits that come with ownership, “and if you're like most small business owners, it's also an opportunity to build equity and to diversify your portfolio,” he says.
GRANT PRUITT, SIOR, PRESIDENT AND MANAGING DIRECTOR, WHITEBOX REAL ESTATE, DALLAS, TEXAS (INDUSTRIAL/OFFICE SPECIALIST)
Whitebox’s business is split evenly between industrial and office, and Pruitt says he has never seen such a high level of interest in becoming owner-users of buildings, although most clients are still in the talking stage. With office values declining, some businesses feel they can control their costs by purchasing buildings instead of subjecting themselves to rental increases. For most companies, Pruitt does not endorse this strategy.
“What we’re always concerned about is an exit strategy,” says Pruitt. “If you’re 100% confident that you're not going to grow and you're not going to shrink, it may be worth considering. But if your business grows or shrinks, your goose is cooked.” Pruitt jokes that many small business owners pursue building purchases based on the advice of their accountants, who typically underestimate the complexities of owning and operating real estate. If things don’t work out, the prospective owners’ reason, they can always sell the building or sublease the excess space. “And that’s a huge concern because they oversimplify and underappreciate what it costs to lease the space, especially if that space becomes functionally obsolete,” says Pruitt. “And they always think that their building is more liquid than it is. They don't understand how hard it can be to move a building.”
Pruitt feels that only a few types of businesses should own real estate. The first would be a manufacturing concern that operates in a building with a substantial amount of business-specific infrastructure within the building. Because the cost of relocating and replicating that infrastructure would be cost-prohibitive, the tenant has little leverage with the building owner when it comes to renewing their lease. Pruitt recalls one client being told by the landlord during renewal negotiations, “Where are you going to go?” Another case for buying versus leasing would be if “relocation would adversely impact the business,” says Pruitt.
For those that do opt to purchase rather than lease, he cautions buyers to avoid getting emotionally invested in a property. “Businesses typically get emotionally tied to their real estate, so the best way to look at it is as a true investor in real estate and to treat it like a stock,” says Pruitt. “If you're buying shares of Apple and the price goes way up, you can either sell it and recognize that value, or you can hold it and get a dividend because you’re not emotionally tied to the stock.”
TIM VI TRAN, SIOR, FOUNDER AND PRESIDENT, THE IVY GROUP, FREMONT, CALIF. (INDUSTRIAL SPECIALIST)
“We get this question quite often,” says Tran, who reports that competition for industrial properties in the Bay area is fierce due to low inventory. “When company owners we work with ask, ‘Should I lease or buy?’ I usually answer, ‘It depends.”
He tells business owners that if they need to preserve cash to expand their operations or if they’re start-ups testing out a new concept, then it doesn't make sense to buy a building. For most prospective buyers, Tran takes an analytical approach. His firm has developed a proprietary method that takes clients through the pros and cons of each scenario, including all expenses, projected equity growth, tax considerations, etc., to help them decide whether to buy or lease.
“The analytical stuff is very easy because the numbers don’t lie,” says Tran. “But I think there are other (considerations) that are more subjective, like where do you think your company is going to be in two or three years? Will you need more or less space? We can’t predict the future, but we can let them know what they’re looking at in the various buy or lease scenarios.”
SHOULD I LEASE OR BUY?
Clearly, there are differences in how CRE professionals view buying versus leasing. These variations are related to the local markets and the flexibility a business needs to reinvest capital into the core business. Taking the emotion out of the decision is important, as is considering the company’s growth projections and strategy.
As Shakespeare might have said, answering the ‘to-lease-or-not-to-lease’ question could turn out to be “Love’s Labor Lost” without a careful, strategic approach to a lease or buy decision.
This article was sponsored by the SIOR Foundation - Promoting and sponsoring initiatives that educate, enhance, and expand the commercial real estate community. The SIOR Foundation is a 501(c)(3) not-forprofit organization. All contributions are tax deductible to the extent of the law.