Ultimate Guide on Lease vs. Buy Analysis For Commercial Real Estate
Many businesses use commercial spaces, regardless of whether they are offices, factories, or storefronts. You will need to decide whether you rent or owning commercial real estate if you are launching or expanding an existing business.
You have two options when you purchase a property. One is to pay cash up front, and the other is to finance it with a loan. A lease lets you rent the property for a fixed term. After that, you can renegotiate your agreement to continue using the property. Many factors go into choosing the best strategy for your business. These include cash outflows and recurring costs, tax implications, property value, and business equity.
The pros and cons of buying commercial real estate
As long as the property is maintained well, commercial real estate will retain its value over time. It's a long-term investment. These are the advantages and disadvantages of buying commercial property.
The pros of buying
You can build equity by paying all cash. Your down and monthly payments will build equity in your property if you take out a loan. Your equity is the difference between the property's market value and the remaining loan balance. It helps to build your business's overall value.
Capital appreciation: Commercial real estate is an asset that can appreciate over time. The inflation rate, local supply-demand conditions, and interest rates all affect the rate of appreciation.
Rent income: A business that purchases commercial property typically occupies at most 51%. Lenders consider real estate and investment property if the owner share is less than 50%. This makes it more challenging to get a loan. You might consider renting out space that you don't need to use to create secondary income streams. For example, if you purchase a small building, the ground floor might be rented to a restaurant, shop, travel agency, or other business.
Tax breaks: As a tax break, you can deduct the interest and depreciation of your commercial property.
You have complete control: You can have full control (within the limits of zoning restrictions) if you own property. This means that you won't need to negotiate with the landlord if you wish to reconfigure it. In addition, instead of paying rent that can be modified at the end of each lease, you will make fixed mortgage monthly payments.
Cons of Buying
You will need to pay a 10% to 40% down payment. In addition, closing costs, origination, appraisal, and other fees will be required. For example, on a $1,000,000 property, the down payment and any additional fees can be anywhere from $100,000 to $400,000 outside of your pocket.
If your company is not approved for bank financing, you may have difficulty qualifying for financing. Hard money lenders may charge up to 10% for commercial real estate loans. However, the best loans are typically below 4%. It may be cheaper to lease in this instance.
Prepayment penalties: Commercial real estate loans often come with high prepayment fees. Also, you will need to pay any title transfer fees involved in the purchase.
Liability: If someone is injured on your property, you are responsible. To protect yourself against lawsuits, you will need to purchase a liability policy. You are also subject to property manager liability if you rent out a portion of the property. This will require additional insurance as well as property maintenance. A personal guarantee may be required for some loans. This means that you are personally responsible for repaying the loan if your company cannot.
Capital loss or liquidity: You might lose capital if your property is sold. You may also face liquidity problems as your money is tied up in the property. You would have to either sell the property or refinance partial cash out to recover your money. You could also have used the money you held on to the property for other purposes if you leased it instead.
Leasing Commercial Real Estate: The Pros and Cons
Commercial leases usually last between five and ten years. After that, the lease allows you to use the property, but there are restrictions.
The pros of leasing
There is more liquidity. You don't have to make a down payment to get into the space. However, you should expect to pay upfront fees such as an attorney, broker, and pre lease inspection, along with a security deposit.
Fixed monthly cost: You won't be required to pay any significant maintenance, repairs, or upkeep of the property when leasing. However, you might need to pay for minor repairs. Instead, you will know exactly how much you have to pay each month without worrying about unexpected, costly repairs. Additionally, it will be a lower monthly lease payment.
Tax breaks: These costs can be deducted as they are incurred: Property insurance, lease payments, property taxes (depending upon the type of lease), utilities, and maintenance. You can deduct the entire lease payment instead of the mortgage interest-only deduction.
Flexibility: A lease allows you to choose from a variety of spaces. The lease does not require you to sell the property. You can also move out of the property when it is over. It is possible to rent a property that is too costly to buy. This can allow you to get into prime or strategic locations.
Cons of Leasing
There is no appreciation or equity: You don't build any equity when you lease. However, some leases have a lease-to-own commercial property feature, which allows you to use a portion of your rent toward the purchase of the property. Capital appreciation is not possible without equity.
There is no passive income: You cannot collect rent from other people since you are not the landlord. This could lead to secondary gain that you would lose from property ownership.
Rent is costly: The Monthly payment can often exceed mortgage payments for the same property, meaning you will have higher monthly payments. In addition, a triple-net lease agreement places tenants on the hook for their monthly retail insurance, property taxes, and utilities. Therefore, your costs will be higher if you add the lease payment. However, after-tax costs vary depending on the situation.
No control: Leases may contain restrictions or early termination clauses which limit the tenant's control over the rental space. Rent increases are not your responsibility after the lease ends. If you close your business, you will have to continue to pay rent until the lease term expires or face penalties.
What are the best times to buy or lease commercial property?
It is more sensible to buy if you have sufficient cash to pay the down payment and six monthly mortgage payments. This will ensure that your business does not suffer from a cash crunch. If you have the following:
- You may rent out a portion of the space to generate secondary income.
- Build equity in your property
- You may want to organize the space in your way.
On the other hand, leasing might be the best option if you have the budget.
- Flexibility to end the lease early
- You can avoid locking your money up in the down payment.
- Leasing costs are subject to additional tax deductions
- Your lease gives you freedom from the responsibility to maintain the property.
- To operate in a space that is too costly to buy