June 30, 2019

Commercial Real Estate: Should You Buy Or Lease?

 

Whether you’re looking to open a brand new business or move to a fresh space, the first big question that comes up is, “should I buy or lease?” Making the right decision for your business will help set you up for success both now and down the road. So, how do you determine what the right decision is for you? What considerations do you need to make, and what advantages and disadvantages do you need to weigh? As a trusted advisor on Vancouver Island, Devin Jahelka of Jahelka Real Estate Group at Royal LePage Nanaimo Realty delves into the details, and provides insight into the advantages and disadvantages of leasing and buying commercial real estate in today’s market.

How is leasing vs. buying commercial real estate similar to buying vs. renting a home?

There are a number of similarities here, but also some differences. Firstly, there are financial considerations, leading with a required down payment. With commercial real estate, there is not a fixed percentage-down requirement, it would be dependent on the specific business, their financial profile, and industry involved. The similarity is that more often than not, a down payment is required, so without one, leasing/renting may be the only option.

A second consideration is that purchasing either residential or commercial real estate serves as somewhat of a forced savings plan, where over time your equity is increasing and eventually the mortgage will be paid off and you will own an asset outright. On the flip side, 100% of the rent or lease payment is gone once you have made your payment, in fact, you are helping your landlord build equity and their financial future. When looking at a commercial lease, a difference to highlight from renting a home where the landlord typically is responsible for maintenance, taxes and home insurance, is that usually these costs are passed on to the lessee in a triple-net lease, over and above their base rent. As such, the perceived benefit of keeping it simple by leasing and just paying your monthly rent while the landlord takes care of everything, is not quite accurate.

Another notable difference between commercial and residential real estate regardless of whether it is a lease or purchase situation is commercial space is needs are user-specific, so more often than not there is a substantial investment needed for tenant improvements to set-up the space for the business moving in. Further, because of this, it is typical that new commercial space is often sold as a “shell space” which means users can custom design the space for their business. Unless you are having a custom home designed, typically homes are more designed for mass-market appeal, and there won’t be a requirement for an initial investment to customize the space once a purchase has been made.

How do you know if you’re ready to make a downpayment on a commercial real estate purchase?

Firstly, speaking to a knowledgeable commercial lender should be one of your first steps in order to get a realistic idea of their lending parameters, including an idea of the required down payment amount and options for financing the likely tenant improvements to fit out the space to your business’ needs. From there, if the financial requirements seem feasible, it is always a decision for the owners of whether they are better reinvesting the money back into the business with a higher expected return, or diversifying into real estate ownership. You have to look at it as: would the owner be better injecting the required down payment into the business, or investing in owning their space? For professional practices that don’t require as much operating capital to run the business, investing in space can make a lot of sense as they are not diverting capital that they should be investing back into the business (such as inventory) towards their down payment. I would also recommend business owners get their accountant involved early on in the process to discuss how purchasing their own space may impact their overall financial picture, as well as any potential tax implications that should be factored into the decision.

What are the pros and cons of buying?

As noted earlier, the advantage of buying commercial property is that you’re building equity in your own assets and it is an opportunity to diversify from other financial assets or categories of real estate. It can be a potential nest egg or passive income source in the future, lowering your occupation costs over the course of your time in the space, you eliminate the risks of escalating lease rates, or being evicted at the end of your lease from a space that you have invested heavily into and your clients are all familiar with, and there may be some tax advantages–you should consult an accountant for more information.

For additional reading, I’ve listed advantages to buying in a blog about the top five reasons businesses should consider a move. A couple possible disadvantages would be you will be tying up cash that could potentially be used elsewhere to grow your business, and for some growing businesses, their space needs may change drastically, so there is a risk that they could be making a substantial investment in a space that may not be suitable in just a few years. In this case, it could leave the owner trying to find a new tenant or sell the space and there may be a limited pool of buyers or tenants looking for the type of space they have designed. If a sale is required in order to purchase the next space, this could really hold up the process, whereas the advantage in this scenario for a lessee is once they leave the space, it is the landlords problem to find a new tenant.

If you choose to lease, would it also need to be customized from a “shell space” to suit the business?

Whether leasing or purchasing commercial space, each business has unique space requirements and budget parameters to consider. At any given time, there is always the chance that the right space may be available for sale or lease that would be the perfect fit for the business looking for space However, more often than not, this is just not the case, and some level of tenant improvements will be required to prepare the space for the new occupant. Shell space is available for both purchase and lease situation, but it’s often the budget that will dictate whether it will be an option.

The best case scenario for a small professional office on a limited budget, such as a financial planner, would be to try to find a space that had a similar business in it previously to limit their TI costs if they can move right in. Sometimes, this just isn’t possible. Depending on the lease terms and tenant, landlords will sometimes kick-in a TI allowance to help offset some or all (if they are minimal) of the costs. For those with a more substantial budget or corporately imposed requirements for their space (such as a franchised business), shell space often makes the most sense, allowing businesses to start with a blank slate, and custom design their space in their ideal configuration for their business.

What other return-on-investment considerations should a business owner have in mind when choosing between leasing or buying commercial real estate?

When looking at the growth plan over time, it’s worth thinking about what the space requirements will be in five years, or 10 years, etc. While investing in your own commercial real estate space can be a wise investment over time, if you think you may outgrow your space in a few years, it often wouldn’t make sense to purchase–unless you are hoping to keep the property as part of a growing investment portfolio down the road should you acquire more space.

Commercial real estate is typically quite occupant specific, so an owner-occupant would most likely invest a substantial sum in setting up space specifically for the needs of their business. Cost recovery is the key issue here, as it can take a number of years to realize a return on that initial investment. Further, once a commercial space has been customized for one type of business, it often won’t be suitable for other businesses when the time comes to sell, so there can be a reduced pool of buyers who will be looking at their own renovations to fit out the space for their needs. The result of this is cost recovery on the TIs at the time of re-sale is rarely achieved.

How do monthly leasing costs compare over time to the cost of buying commercial property?

Expected duration of occupancy plays a significant role. It is tough to provide any concrete figures when looking at comparing the costs of buying commercial property vs. leasing over time. However, what purchasing does is provide you with an element of cost certainty. While interest rates do fluctuate, owner-occupants will not be subject to escalating lease rates over time, which generally rise with inflation. Again, very situational based on the category of real estate, location, industry, financing terms and conditions, down payment amount, etc., but it would not be uncommon when comparing a five-year lease term vs. a mortgage payment for the monthly costs of occupation to be similar under both scenarios.

In an extremely low-interest-rate environment, in some cases, it can cost less to own than to lease, and this is during the first five-year term. When that lease comes up for renewal, most likely lease rates are going up, and this will continue with each renewal for the duration of the holding period. On the flip side, their monthly mortgage payment in years five to 10 of occupancy is tied to the initial amount borrowed, not current market lease rates impacted by inflation and economic cycles. More importantly, for a long term hold, the owner-occupant will eventually pay off their mortgage.

When leasing, would maintenance get taken care of by the landlord, similar to renting a home?

Responsibilities for maintenance will depend on the specifics in a lease agreement. In most cases, a commercial lease would have the lessee responsible for the cost of regular maintenance during their lease, so this is a bit different than a residential tenancy. Where this is important is that it takes this factor out of the equation in a commercial lease vs. buy decision as maintenance is a cost that the occupant will be responsible for in a commercial scenario, whether they own or lease their space, that they likely wouldn’t be responsible for in a residential scenario–which most people are more familiar with. It is just a cost of doing business! On that note, typically the commercial landlord or lessor will be responsible for major capital improvements, such as a new roof, refacing the building, etc., but again, the particular lease will dictate the specific responsibilities.

Aside from financial considerations between leasing and buying, do you think there are aesthetic priorities to consider, like employee productivity being higher/lower in certain spaces?

I am a huge believer, especially for serviced-based, professional practices, that your physical office space can often serve as a great visual representation of the work that is being produced within its walls. If the business cares enough to invest in the little details when designing their space, it can help to attract a strong calibre of employees and help support the desired culture in the business. Optimizing space for collaboration, workflow and specific needs of the business, can certainly go a long way in driving productivity.

Whether leasing or purchasing commercial real estate, owners and lessees in most cases will be investing in making the space their own to a certain extent. As a generality, owners sometimes are willing to spend a bit more on their improvements if they are looking at a long term investment, so naturally, that can impact that “wow” first impression. With that said, a lessee could decide to invest in the same TIs as an owner would for the same space, so it really comes down to the situation.

What about available loans, or help with costs or tax savings with buying, that aren’t available in leasing?

Commercial lending is a lot more business-specific than residential lending. There is more variance in the offerings from different lenders, and there is more variance within lenders for what they are able to offer to different businesses, depending on factors such as their financial profile, profitability, industry, management team etc. It is not a minimum 5% down with a slight variance in rates as we see in residential lending. Typically the down payment requirements will be higher with commercial lending, however for some businesses, there will be options for up to 100% financing, it just depends on the business. In terms of tax advantages, I’d say yes, there are tax advantages not available in a leasing situation. However, I’d recommend buyers discuss the tax implications of buying vs. leasing with their accountant.

What about multi-unit or stratified vs. standalone commercial space. What are the pros and cons of multi-unit or stratified?

I would cite synergies, networking, and potential referral relationships amongst the businesses as notable benefits in a multi-unit of stratified commercial building. Locating in a stratified office building where there is a diversified mix of other respected professional practices drives exposure and drive new business, as clients and customers of the occupant businesses will often notice the other businesses in the building and associate them in a similar light to the business they are visiting, so perception and a positive first impression is definitely impacted by the surrounding businesses. On the flip side, possible cons of a stratified office building would be less control over the direction of the strata, including the common areas, parking, and costs associated with maintenance. There can also be rules and restrictions that can limit what is possible in a strata situation. It is always important when considering a strata to familiarize yourself with these rules so that you can make an informed decision.

What about leasehold improvements, when is it worthwhile to the tenant?

Leasehold improvements are primarily designed to increase the utility of the space for the occupant, in other words, to make it more suitable for the occupant. Interior improvements should have a similar impact on both owner-occupants and lessees. The primary difference is when the lessee leaves, the interior improvements generally stay, so it is somewhat of a sunk cost that must be justified and recovered during the period of occupancy. With that said, there are tax implications with leasehold improvements, so businesses should discuss those with their accountant. The reality is that the space needs are specific to each business, and there is only so much space available at any one time, so often it is not a question of “will tenant improvements be worthwhile?” but a case of necessity, as the current supply of space may not meet the requirements of businesses needing space at that time.

Can you lease-to-own?

Technically, yes. I don’t see it happening much in my day-to-day. More commonly, you would have a lease agreement for a commercial property where the lessee has an option to purchase written into their contract.

Can you get something similar to a building inspection before leasing or buying commercial real estate?

Yes, commercial building inspections are possible. There are some additional considerations when acquiring commercial space that are important, such as previous environmental impacts on the site, so there are also these types of inspections or reports that I’d recommend. For those considering purchasing commercial space, similar to when you purchase a home, a good commercial realtor will ensure you have the necessary subjects in place in your offer to protect you and will be able to guide you through the necessary due diligence to ensure you are protected.

In regards to leasing, yes, technically you could have an inspection done, but that is something you’d want to discuss the merits of with your realtor, as the costs are higher for a commercial inspection and an inspection is usually done so that there are no unexpected issues that would impact the value of the commercial real estate, which is primarily a concern for the owner. If you are wondering more about protections for someone leasing space, a good realtor will also ensure they have subjects to protect you written into your offer to lease.

For more information and resources on buying commercial real estate in the Nanaimo area, check out Westmark’s Pacific Station blog page.

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