Should I buy or lease commercial real estate?
This is probably one of the most common questions I get asked by my business owner clients. Although there is no “one-size-fits-all” answer, I start by sitting down with my clients to learn about their unique situation so I can help them make the best decision based on their business and personal goals. In this article, we will weigh the advantages and disadvantages of each option and then I’ll round it out by providing a recommendation based on my experience in the business.
Buying Commercial Real Estate
To start, there are quite a few benefits associated with owning your own commercial property. Like buying a home, owners of commercial real estate will benefit from an increase in equity as they pay down their loan (known as amortization). Below I’ve provided a table that illustrates this point:
As you can see, with each payment made, your principal balance is reduced. Thus, with each passing month, you own more of your building which positively contributes to your overall net worth.
Second, commercial property owners also experience equity build up as appreciation occurs. Historically, commercial real estate has experienced an average appreciation of roughly 3-5% each year. Therefore, the longer you hold the property, the more likely you are to experience the benefits of this phenomenon.
Third, there are many tax advantages to owning commercial real estate. Business owners can deduct mortgage interest payments from their yearly gross income. This can add up to a sizable deduction, especially if your loan carries a higher interest rate.
Owners of commercial properties can also depreciate “improvements” over a 39-year period. Improvements are defined as “developments of land or structures on property”. For example, a commercial building may be worth $1,000,000 with the value of the building and land being $800,000 and $200,000 respectively. In this scenario, you as the commercial property owner could take a portion of the building’s value ($800,000) as a deduction each year.
However, there are also some cons associated with owning commercial property that should be addressed. First, when you buy commercial real estate, the bank will usually require you 10 and 20% down payment prior to issuing you a loan. As an example, if you want to purchase a property that is listed for $500,000, you will need $50,000 - $100,000 to do so! Some business owners may not feel comfortable tying up that much liquidity over a long period of time.
Second, there’s a lack of flexibility. For example, let’s say you purchase a 5,000 SF commercial building to operate your business out of. If your business expands rapidly, you may find yourself needing additional space to fulfill this increased demand. Because of this, you’ll be forced to either:
- Sell your existing building and buy another larger one.
- Keep your existing building and buy/lease another larger location.
In either scenario, there is a sizable amount of hassle involved. On the other hand, if you leased commercial space, you would only be tied to the building for the duration of your lease term. Afterward, you could seek out a larger space without having to worry about your previous location.
Leasing Commercial Real Estate
One of the biggest pros associated with leasing a commercial property is the flexibility it affords you. In most instances, business owners seeking to lease commercial space will only be required to sign a three to five-year lease. This means that if after a few years, you outgrow the space, you have the flexibility to leave your existing location seamlessly.
Second, depending on your lease type, you may be absolved from having to cover expenses associated with owning a building. For example, if you sign a full-service gross lease, you will only be responsible for making a single rent payment each month. Therefore, you don’t have to worry about paying property insurance, property taxes, operating and general maintenance expenses for the building. These expenses, as well as many others, will be paid for by the landlord. Cons:
On the other hand, there are some cons associated with leasing commercial space. First, you don't get to experience equity build up over time. Essentially, you're paying rent for 3,5 or 10+ years and at the end of your lease term, you have nothing to show for the years of payments you made.
Second, another significant con is that you as the tenant, have no control over the property. By this, I mean that after your lease term expires, the landlord can decide to force you out of the space by either raising your rents significantly or moving in another business. This can be extremely detrimental to your business, especially if you have already established a strong brand in the area.
Now that we’ve reviewed the pros and cons of each option, let’s discuss what the best approach would be given your situation. If you’re an established business that wants to commit to a location long-term, it’s probably wise to consider buying a commercial building. That way, they can benefit from the equity build-up, tax advantages, and stability offered by owning your own commercial property.
On the other hand, if you are a startup or you have only been in business for a year or two, then maybe leasing space in the short to immediate term is a better option. This is because it affords you the flexibility to easily move to a different location if your business expands rapidly and limits the initial investment you must make. Once you stabilize your growth and you commit to an area for a long period of time, then you can consider buying.
I hope this article provided you with valuable insights that will help you make a sound business decision as you look at commercial spaces. If you’re interested in buying and/or leasing commercial property in Louisville, KY, and its surrounding areas, I’d be happy to help! Feel free to reach out to me via my cell at (502) 536-7315 or send me an email at email@example.com. I look forward to helping you reach your business goals!
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