The lease vs. buy decision – Harder than ever? Or not?
As a business owner, the difficult decision of whether to buy or lease your company’s office space starts by determining whether you have the decision to make in the first place.
Think of it this way: You go to your favorite restaurant and you have a great dinner. You battle with deciding whether to have the cheesecake or the tiramisu for dessert. After a long back and forth with yourself (and your diet), you finally decide on the cheesecake only to have the waiter tell you he just sold the last slice. Bummer!
Deciding to buy and then being told by your lender that you can’t is no different. You find that great new building and you envision yourself toasting your first sale in the new spot with champagne, only to find that you can’t get the financing you need to do it.
Before you start daydreaming about your new digs, here are some questions to ask yourself and your lender. The latter is important because regardless of what you think your company can do, your lender has to also be convinced, and you have to fit their parameters. Therefore, make sure you know and are comfortable with the following:
1. Your personal credit score and net worth: As a small to mid-sized business, you will usually be required to sign a personal guarantee on the loan. Therefore you personally will go through underwriting along with your company, so your credit must be in good shape.
2. The appraised value of the building: Appraisals are all over the map right now and often defy logic. Make sure that you have an unbiased idea of what the building is worth before you begin the process of loan approval. If the building does not appraise, you will not be approved for the loan amount you need for the purchase. At that point, you are either not buying it, or you will have to come out of pocket for the difference.
3. Your company’s ability to afford the rent: You will be paying yourself rent. As you are going through underwriting, simply showing that your building is cash-flow positive when fair market rents are collected is not enough. You need to demonstrate that your company can afford the fair-market rent that makes the building cash-flow positive. If it can’t, you will not be approved in the underwriting process.
Once you have worked through these basics, only then can you sit back and make the decision to lease or buy. Here are some additional points to consider for each option.
What to consider when buying:
1. A pro is that it’s yours. A con is that it’s yours. Many business owners are currently strapped with above-market lease rates that they are paying themselves because they have to cover the debt. When you are your own landlord, there are many advantages. But, when you are your own landlord, there is no crying foul on rent increases. You pay what you have to pay to cover the expenses of owning the building regardless of where the market takes lease rates. On the positive side, you can pay yourself fair market rent and make the building profitable as your debt decreases. Alternatively, you could decrease the rent you collect from yourself if that makes sense for your financial and tax situations.
2. Buying offers tax write-offs that leasing does not. When you purchase a building, there are many different ways to record the purchase on your records. One is to throw the whole thing onto your tax return as real property. If you do this, the building will be depreciated over 27 and 39 years. A better way to record it is to do what’s referred to as a cost segregation study. This study breaks the building down into its parts and depreciates it accordingly. For example, a building can be broken down into fixtures, landscaping, paint, roof, electrical, etc.; all of which have a shorter life for depreciation purposes than that 39-year building plunked onto your balance sheet.
What to consider when leasing:
1. Your rent or lease payment is an expense and not an investment. No portion of your rent payment is paying down principal. The biggest downside to leasing is that you are not building equity in the property you occupy. Based on the above, this can be either an advantage or disadvantage depending on which way lease rates are headed. But at the same time, you have less commitment with a lease. While you do have to commit to a lease term while renting from someone else, if your company’s needs change after moving to a specific location, you are not married to that spot once your lease is up.
2. Landlords are offering very attractive incentives in the form of lease concessions and TI allowances. A TI allowance or tenant improvement allowance is a dollar amount that your landlord gives you for improvements you need to make to tailor the space to your needs. If you are tight on cash and can take the time to look for a motivated landlord, you can enjoy the benefit of reduced lease rates, and have the opportunity to have the landlord pay to get your new space ready for you. These concessions can be a set dollar amount or an amount per square foot and can be of huge value to a company when relocating. Beware though that there can be clauses in lease agreements that repay the concessions to the landlord over your lease term or in the event you terminate the lease. Sometimes the forfeitures of these concessions can be very expensive, so read all documents very carefully.
The decision to lease or buy has never been easy, regardless of the economic landscape. Knowing the pros and cons of each approach will help you decide what is best for your company’s continued success.
Tanya McCaffery is president of The CFO Group in Reno. Contact her through http://www.thecfogroup.com.
The rate effective Jan. 1, 2020, is 1.65 percent of wages paid to employees. That is two-tenths of a percent lower than the current rate, giving a significant break to businesses that pay the tax.