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Many businesses operate out of commercial spaces, whether they be storefronts, factories or offices. If you are launching a new business or expanding an existing one, you will have to decide how to finance the acquisition of commercial real estate. When you buy a property, you can either pay cash upfront or finance it with a loan. With a lease, you rent the property for a set term, at which point you must renegotiate the lease if you wish to continue using the property. As we show, several factors go into choosing the right acquisition strategy for your business, as each situation is unique. These factors include cash outflows, recurring costs, tax implications, property value, business equity and more.
Pros and Cons of Buying Commercial Real Estate
Commercial real estate maintains its value over time as long as it is maintained properly—it is a long-term asset. Here are advantages and disadvantages of buying a piece of commercial property.
Pros of Buying
Building equity: If you pay all cash, you own 100% of the property right away. If you take out a loan, your down payment and monthly payments build equity in the property. If you refinance or sell the property, your equity is the difference between the property's fair market value and the remaining loan balance. Your equity in the property will help build the overall value of your business.
Appreciating asset: Owning commercial real estate gives you the opportunity to benefit from capital appreciation—the increase of your property's value over time. The rate of appreciation varies with the inflation rate, local supply and demand conditions, interest rates, and other factors.
Rental income: Typically, a business that buys commercial property occupies at least 51% of it. This is because lenders classify the real estate as an investment property when the ownership share is less—a factor that makes it harder to qualify for the loan. If you have leftover space, you might want to rent it out to tenants and create a secondary income stream. For instance, if you buy a small building, you might rent out the ground floor to a retailer, restaurant, travel agency or other business.
Tax breaks: You can deduct interest, depreciation and nonmortgage-related expenses on your commercial property. For example, if you are in the 20% tax bracket, you'll reduce your tax bill by 20 cents for each dollar deducted. You can't deduct expenses associated with a mortgage, such as origination fees or closing costs. Only the interest portion of your mortgage payment is deductible.
Control: When you own property, you have control over it—within the confines of zoning restrictions—which means you don't have to negotiate with a landlord if you want to reconfigure the space. You'll also make fixed monthly mortgage payments, not a rent payment that can be changed whenever a lease expires.
Cons of Buying
Upfront spending: Typically, you will have to make a down payment of 10% to 40% of the property's value. You'll also have to pay for closing costs and due diligence fees. For example, on a $1 million property, you can expect to pay anywhere from $100,000 to $400,000 out of pocket for the down payment and other fees.
Difficulty qualifying for financing: You may have trouble qualifying for a commercial real estate loan with a reasonable interest rate if you or your business is unbankable. While the best commercial real estate loans can have interest rates as low as 4% or 5%, loans made by hard money lenders can have rates of 10% or more. In this case, it may be more cost-effective to lease. In times of economic recession, it will be more difficult to obtain financing, regardless of your creditworthiness.
Prepayment penalties: Many commercial real estate loans come with hefty prepayment fees or other penalties, in the form of yield maintenance or defeasance, if you prepay the loan balance.
Liabilities: You are responsible if someone is hurt on your property, which means you'll have to pay for a liability insurance policy to protect yourself from lawsuits. If you rent out part of the property, you are subject to property manager liability, which will require additional insurance. You also will have to pay for upkeep and repairs. In addition, many loans may require a personal guarantee, which makes you personally liable to repay the loan if your business cannot.
Capital loss: There is always the chance that your property's value will decline and that you might take a capital loss if you decide to sell.
Loss of liquidity: Your money is tied up in the property, and to recover it, you'll have to sell or do a partial cash-out refinance. What's more, the money tied up in the property could have been used for other opportunities had you leased instead.
Pros and Cons of Leasing Commercial Real Estate
Commercial leases typically run from three to 10 years. You'll get use of the property during the lease, subject to any restrictions built into the lease agreement.
Pros of Leasing
More liquidity: You tie up significantly less of your cash because you don't need to make a down payment to move into the space. However, you should expect to pay upfront fees for an attorney, broker, prelease inspection and security deposit.
Focus on your business: Managing a commercial property can be complicated as there are insurance requirements, maintenance costs and other issues that can distract you from your business. Leasing allows you to focus solely on your company.
Easier to budget for: When leasing, you generally won't have to pay for any significant maintenance, repairs or upkeep to the property, which can amount to huge unforeseen costs (though you may be expected to pay for minor repairs). Instead, you'll know exactly what you need to pay each month.
Tax breaks: You may deduct these costs as incurred: lease payments, property insurance, property taxes, utilities and maintenance. You can deduct your entire lease payment, in contrast to a mortgage's interest-only deduction.
More flexibility: Qualifying for a lease is oftentimes easier than qualifying for a commercial real estate loan, so you have more options when it comes to picking a space. You can also move when the lease is up without having to sell property. You might be able to afford to lease a property that is too expensive to buy, which can help you get into a prime or strategic location.
Cons of Leasing
No equity or appreciation: You don't accumulate any equity when you lease, although some contracts have a rent-to-buy feature that allows you to apply a portion of the rent you've already paid toward the purchase of the property. Without equity, you don't benefit from capital appreciation.
No passive income: You can't be the landlord and thus cannot collect rent from others, losing secondary income you could gain from owning property.
Rent is expensive: Your monthly rent payments will usually exceed mortgage payments on the same property. The typical triple-net lease agreement makes tenants responsible for monthly retail insurance, property taxes, utilities and maintenance costs. When added to the lease payment, your costs are greater, although after-tax costs depend on the situation.
No control: The lease may have restrictions and even early termination clauses that hamstring tenants' ability to control the rental space. You have no control over rent hikes when the lease expires. And if you go out of business, you must continue paying rent or face penalties.
When Should You Buy or Lease Commercial Property?
Typically, it makes more sense to buy if you have enough cash for the down payment and six months' worth of mortgage payments without causing your business to hit a cash crunch. Purchasing might be a good option if you:
- Want to rent out part of the space to generate a secondary income stream.
- Think you'll remain in the space for at least seven years, which is often the breakeven point for purchasing versus leasing.
- Plan to build equity in the property.
- Want to reorganize the space as you see fit.
On the other hand, leasing might be the right answer if you want:
- The flexibility to move out at the end of the lease.
- To avoid tying up your money in the down payment.
- More tax deductions on the leasing costs.
- Freedom from the responsibility of maintaining the property.
- To operate from a space too expensive to purchase.
If you are interested in purchasing commercial real estate, you should consider a loan guaranteed by the Small Business Administration (SBA) as a first option. The SBA offers two loan programs that can be used for commercial real estate: 7(a) loans and 504 loans. While 7(a) loans are general-purpose loans, 504 loans are specifically designed for the purchase or refinance of commercial property.