With property values consistently trending upward, many Florida business owners are deciding whether to purchase or lease commercial real property. Below are a few considerations to keep in mind before making your decision.
Cost of Borrowed Funds
While there has been a stream of positive news about the general health of the economy, the Federal Reserve has kept interest rates considerably low. Therefore, it is an attractive interest rate environment for commercial borrowers who are financing real property. Depending on the term of the loan and type of property, current rates range from 3.50% to 6.50%, while prime rate (a barometer for different types of interest rates and the rate which financial institutions lend to their most prominent and creditworthy customers) remains at 3.25%. To put this into perspective, prime rate was 8.25% in 2007. Lower interest rates obviously lower the monthly payment obligation, and can accommodate a move to a higher tier property.
Judged against lease terms, the comparison changes depending on whether the owner is leasing for use as retail or office space. The former is generally based on a percentage of gross sales generated at the site, the latter normally contains an “escalation clause” that annually increases the rent obligation by 2-3%. Additionally, a commercial tenant (particularly a retail tenant) is likely liable for the real property taxes, utilities, and other expenses, which negates some of the perceived advantage that leasing may have over ownership.
Thus, a lease payment may initially have a lower payment burden but over time could exceed the payment obligation of a loan.
Beyond the Financing
Real property acquisition is usually not an organization’s principal business; rather, it serves as the space to conduct its primary operations. The decision to purchase or lease should be considered with a view toward the company’s long term growth plans. A younger company, for instance, could quickly outgrow a building in the first five or ten years of its acquisition. Or, a company may need more flexibility, and thus responding to market shifts could be more challenging when owning real property rather than leasing. A company that is considering purchasing must also consider whether a commercial mortgage on its balance sheet will preclude future borrowing, such as a working capital line of credit, which many companies need for monthly expenses like payroll.
A company that leases has reduced autonomy with the leased space and is subject to the landlord’s future plans for the property; this can be problematic, for example, in retail businesses, where location and co-tenancy concerns are crucial. A tenant may establish a profitable retail business in favorable location and find a landlord unwilling to extend a lease at the end of the term. A tenant may also want to retrofit a space for its specific business; this involves negotiating the type of improvements in the premises, the amount the owner is willing to expend on the improvements (if any), and which party controls the construction.
Overall, an enterprise should consider the need for autonomy and mobility, the effect on cash flow, early termination penalties in leases, maintenance obligations, and the forecast for property values.
Without getting into the intricacies of the tax code, generally, lease payments and operating expenses (utilities, property taxes, and maintenance costs) are tax deductible for tenants. For owners, interest payments on the mortgage loan, building depreciation, and operating expenses are deductible. However, the tax code, generally, gives a commercial building a lifespan of thirty-nine years. For owners this means that building depreciation and capital improvements to the building are spread annually over the thirty-nine year lifespan. When deciding to purchase or lease, a cost analysis should be done on an after-tax basis, with future appreciation in the land being a major component in the analysis.
From a broad perspective, those are some of the primary factors companies should consider. However, every company, and its circumstances, is different; business owners should elicit guidance from a real estate attorney and other professionals to assist with the decision-making process.