Weighing The Options: Owning Versus Leasing Commercial Real Estate
Weighing the benefits of leasing or owning real estate is important for any business, but Nevada real estate professionals said there’s no definitive answer to which option is best.
Both leasing and owning real estate offers businesses advantages and disadvantages and the decision of which route to take is up to the leadership at each company, said Jeff Jenkins, executive vice president and statewide real estate manager at Nevada State Bank.
“A lot of the factors are dictated by the company and what they want to do,” Jenkins said. “Some companies don’t want real estate debt, they’d rather leverage for business debt and focus on the core business and capital needs.”
Benefits of Leasing
While there are no hard and fast rules, different types of companies can be more apt to lease or own, based on where the capital expenditures make the most sense. For example, a fast food chain with aggressive expansion plans likely will choose to lease while a manufacturer leasing equipment will chose to buy for fixed real estate costs, Jenkins said.
“If you’re a fast food company trying to expand here in the Las Vegas Valley and want to open 60 new stores, it costs a lot of money to do that with working capital,” Jenkins said. “Plus, if you have a landlord, they will contribute, assuming you’re credit worthy, for tenant improvements. That can help the finances so you can build the business.”
A successful business can yield 20 to 30 percent in equity based on its core business functions, whereas owning real estate might yield 7 to 10 percent, said Todd Manning, regional manager at the real estate firm Marcus & Millichap. The drastic difference in numbers is one reason a company might choose to lease and reinvest into business operations rather than tying it up in real estate.
Leasing also provides an organization with the ability to leave when a lease is up.
“If after five to six years, there’s no return, they can walk away from a lease and find a better site or better rate,” Jenkins said.
Benefits of Buying
However, a downside to leasing is businesses don’t build any equity or reduce payments by staying in a property longer, the property will always be an expense.
An owner with a business not planning to expand, grow or reinvest in operations can see cost advantages by purchasing a building.
“They could be content with being a half billion dollar revenue business and be there for 10 to 15 years or more; that makes the cost advantage much greater,” Manning said. “The flexibility isn’t the same as in leasing and it is subject to the swing of the economy, but you do have tax benefits.”
If a company has its money in leases of equipment making widgets, it might make more sense to fix the real estate cost so leases don’t increase.
“If I’m leasing and the lease comes up, I don’t know if the landlord will increase the rents so much it will affect my profits,” Jenkins said. “Then it can come down to it making sense for me to control everything in terms of real estate.”
Both leasing and owning have advantages when it comes to taxes. “You can write off depreciation and mortgage debt,” Manning said. “You can often deduct the whole lease payment, which can be even more advantageous. It simply comes down to what the client is looking to do with their business.”
Small businesses can also find a positive in owning, said Chris Hunter, senior vice president at TMC Financing, a firm specializing in small business lending, Hunter, who heads up the Nevada market, said business is trending up with an increase in small business lending production of 20 to 25 percent this year.
“Every indicator is we’re going to be this busy for the next two to three years,” Hunter said.
A business can qualify for a Small Business Administration (SBA) loan if it occupies as little as 51 percent of the real estate space. The remaining space could be leased to other companies, generating passive income to help offset the loan payments, Hunter explained. Buying a larger building and renting out unused space also provides business owners an easy route to expansion within their own asset. An SBA loan can be obtained for as little as 10 percent down, he added.
Sometimes running the numbers of leasing versus owning can sway a decision, said Brad Lancaster, vice president of the Reno office of the real estate firm Kidder Matthews.
“I sold five or six buildings like that,” Lancaster said. “I run a few scenarios on types of loans and what it means on an overhead basis and interest rates are still low enough they can have a lower monthly overhead than if they lease. Then it comes down to the down payment.”
Effects of the Recession
As the economy continues to perform well in the recovery of the recession, small business owners are increasingly making the pivot to real estate ownership.
“During the recession, the landlords had to put people in the spaces to get revenue in some shape or form,” Hunter said. “Now we’re coming out of those incredible lease rates where tenants had all the leverage and now they’re going up 3 percent on average and these small business owners could sit there and negotiate or go out and purchase their own space.”
Developers have also emerged who help provide a one-stop shop to build-to-suit an industrial space. In many markets across the country, the standing inventory of industrial real estate is depleted, but building from scratch is a path filled with pitfalls for business owners, which can be an eye-opening experience, Hunter said. The developers get the land, build a pad and provide a gray shell, along with helping secure contractors and fixed construction costs.
“It’s like buying a prebuilt home you customized the finishes on,” Hunter said. “You own the building, so it’s the same end game with fixed costs.”
Hunter also added that the locking in of a fixed mortgage payment for 20 to 25 years can be tantalizing for a company that doesn’t expect to outgrow their space. Buying in today’s economic climate makes more sense than the few years prior to the recession.
Leading up to 2007, investors were purchasing properties considerably above replacement value. “These days, it’s more in line and a healthy stable market,” Hunter said. “Growth trends are still healthy.”
Owning a property allows for a company to know it has longevity in the building it’s in, making it a great choice for companies looking to maintain their size, Jenkins said. While owning, the payments stay the same and only slight changes in taxes and utilities are the unknowns. He also said making the payments and reducing the debt, a company will gain equity and, depending on the economy, pick up some appreciation.
Equity in real estate is the only reason big box retailer Sears is currently worth any money, Manning added.
Real estate ownership also means all tenant improvements fall on the business’ bottom line, which can provide for large, unexpected payments, Jenkins said.
The real estate market can also dictate owning to be a negative. “The downside is that market conditions can be such that you have no equity when you want to get out of it,” Jenkins said. “There’s also a lag of selling, which ties up capital, if you want to sell to downsize or grow the business.”
Location, Location, Location
Some business owners don’t have a choice with the space they want, Manning said.
Office users are often in line to lease a Class A real estate space and they can be prohibitively expensive to buy.
“If you’re a professional services company and you want to be in a high rise tower, you don’t have $100 million to buy the building,” Manning said. “You also don’t want to be a landlord with 20 to 50 tenants. There are greater opportunities if you’re leasing to get into a flagship or Class A space you could not afford if you’re looking to buy.”
Similar circumstances can pertain to retailers as well, Manning explained. A client might decide to buy or lease based on what properties are available at the location the business owner desires.
“For a lot of clients we work with, location is really important,” Manning said. “Location is paramount and then it becomes about what’s available and if not, how willing are they to move off of their preferences?”
Changes in the future of commercial real estate might come with advances in technology, especially in retail, but the exact effects are yet to be fully seen, Jenkins said.
In the Reno-Sparks area, Jenkins said investments by Switch, Tesla and Google are making it a hot bed for industrial activity. Those in turn are heating up the multi-family and single-family residential market.
“Single-family up there, the pricing is extremely high,” Jenkins said. “A lot of it has to do with the influence of Northern California where prices are even higher.”
The Reno area is “white hot” with the lowest industrial real estate inventory since the metric has been tracked, Lancaster said, making it difficult to find leases.
According to Jenkins, Las Vegas is the next Nevada hot spot when it comes to commercial real estate. Multi-family and industrial are very strong in the Valley.
“We’re highly influenced by Southern California,” Jenkins said. “The Las Vegas Convention Center does such a terrific job, it’s an amazing amount of people who come here for a convention and then decide to move a business, open an office, buy real estate or second home.
Las Vegas is a “very active investment market,” Manning said.
Parts of the Valley, which once were avoided, are now becoming attractive for real estate buyers. “There’s stuff going into North Las Vegas now. People used to mock [North Las Vegas as] a dead zone,” Hunter said.
“A business owner might want to tie up money in real estate because they like the ability to see appreciation and want to control rent and on the flip side, you have owners who want to reinvest in operations,” Manning said. “Also, some people just enjoy owning. They know rent’s not going up every year or they want to park their money.”
No matter what the business is, there are advantages to owning and leasing property. It all depends on how the business leaders view money and what they want to do with it. According to Manning, when he sits down with a client, most already know whether they want to lease or buy.