This article is part of a larger series on Business Financing.
When your business decides to acquire commercial real estate, you must decide whether to buy or lease the property. If you buy the property, you’re either paying cash upfront or financing the cost of ownership of the property. Once the payment is made in full, you own the property outright. With a lease, you’re paying for the right to use the property for a period of time. At the end of that term, you must negotiate the right to continue using the property.
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The following table includes a side-by-side comparison of buying versus leasing commercial real estate:
Buy Commercial Real Estate
Lease Commercial Real Estate
Own the property outright
Use the property without ownership
Down Payment Requirement
Down payment required of at least 10%
No down payment required (small security deposit instead)
Cost of Ownership in Existing Developments
More expensive to buy into existing developments
Easier and cheaper to lease a building in an existing development
Fixed or Variable Costs?
Costs of ownership much more fixed
Costs can go up when lease is renewed
Who Has Equity and Gets Passive Income?
Equity in property and passive income are earned by you
Equity in property and passive income are earned by landlord
More flexibility about what to do with the property (renovations/changes)
More flexibility to walk away from the property if it doesn’t meet your needs
When to Consider Buying Commercial Real Estate
Purchasing commercial real estate allows you to obtain ownership of the property, whether you pay cash upfront or you finance the purchase with a commercial real estate loan. The following are pros and cons to consider when purchasing commercial real estate.
|Earning equity in the property||More upfront costs|
|Asset appreciation||Increased liability|
|Rental potential||Risk of property depreciation|
|Potential tax benefits||Lack of flexibility to move your business|
Pros of Purchasing Commercial Real Estate
Earning Equity in the Property
When you purchase a property, you have the chance for that property to earn equity in a couple of ways. If you financed the property with a loan, the property will earn equity as you repay the loan. If you improve the property with renovations or expansions, the property’s value will increase, increasing the equity. With a commercial real estate lease, the benefits of equity go to the landlord instead of you.
Not only will improvements in the property increase its equity, but also its value. Another way the property will increase in value is by the general appreciation of the commercial real estate market. According to greenstreet.com, commercial property values have increased by 21% over the last 12 months.
While businesses that purchase commercial real estate typically occupy at least 51% of the property, the remainder of the building can be rented out. This will bring in rental income, but it also means you’ll be responsible as a landlord for the tenants that rent the space. You can also hire a property management company, but this will further use the profits gained from renting.
Interest expense, depreciation expense, and non-mortgage-related expenses can be deducted from your taxes. As always, consult your tax professional for more information on how to best take deductions when purchasing commercial real estate.
Cons of Purchasing Commercial Real Estate
More Upfront Costs
Because of down payments, closing costs, and due diligence fees, you’ll likely pay up to six times as much money upfront when purchasing real estate instead of leasing. Most lenders will require at least 10% down, but that can go as high as 40% down. This requires your company to have liquid capital upfront to complete the purchase.
Because you own the building, you’re responsible for the health and safety of the people inside it. You’ll also have to cover the costs of maintenance and repairs of the building. If you rent out other portions of the building, you’ll be liable for them as well, which will require additional insurance policies.
Risk of Depreciation
While the increase in commercial real estate values has provided building owners with increased equity and value, the values might not continue to increase. Many experts believe a correction in the real estate market could come in the months ahead, which would cause your property to depreciate just based on market conditions rather than anything you did with the property.
Lack of Flexibility to Move Your Business
One huge advantage of a lease is the ability to not renew at the end of the term and move into a property that fits the new needs of your business. Whether your business is growing or shrinking, when you own the property, it can be difficult to sell and move into a new building. Lease terms of three years give you the chance to reassess your business needs more often, as opposed to the longer mortgage terms of 15 to 30 years.
When to Consider Leasing Commercial Real Estate
Depending on the needs of your business, it may be to your advantage to lease commercial real estate instead of purchasing. There are many things to consider when leasing commercial real estate. The table below shows some of the pros and cons of commercial real estate leasing.
|More liquidity||No investment potential|
|Potential tax benefits||Higher monthly payments|
|Greater flexibility||No property control|
|Easier and cheaper to get into existing development||Costs can increase when lease is renewed|
Pros of Leasing Commercial Real Estate
Compared to a commercial real estate purchase, you’ll need far less money upfront for a lease. You’ll need money to cover a security deposit, pre-lease inspection, attorney fees, and possibly, a broker’s fee. These combined costs are significantly less than the amount needed with a purchase, meaning less of your liquid capital is tied up in acquiring the property.
Potential Tax Benefits
Tax benefits are something that both real estate purchases and leases share. However, the benefits they share are different. With a lease, you should be able to deduct lease payments, property taxes, property insurance, and utilities and maintenance. Again, consult your tax professional for more information on the tax benefits of a commercial real estate lease.
With lease terms lasting between three and 10 years, you have more flexibility with a lease than a 15- to 30-year mortgage. It allows you to move out of a development and into a new one that meets the needs of your changing business. In addition, it might allow you to occupy a building with a lease that you cannot afford to purchase initially but might be able to purchase a few years later.
Easier and Cheaper to Get Into Existing Development
If you’re looking at moving into a building that’s part of an existing development, it’ll likely be easier to lease one of the buildings from the property management company instead of trying to buy it from them. Purchasing the building might not even be an option. A lease can allow you to get your business into an ideal location that might otherwise be shut off because a building isn’t available to purchase.
Cons of Leasing Commercial Real Estate
No Investment Potential
Because you don’t own the building, you won’t benefit from the price appreciation of the building if it sells. You can’t build equity in the property, which hurts your income potential compared to a building you own. Also, you won’t be able to earn rental income. These are hidden costs of a lease compared with a commercial real estate purchase.
Higher Monthly Payments
Since a commercial real estate mortgage is spread out up to 30 years, your monthly lease payment can be higher than a mortgage payment. Some lease agreements, such as a triple net lease agreement, require tenants to pay monthly property taxes, retail insurance, and utilities and maintenance costs. These also increase the costs of a lease compared to a mortgage associated with a purchase.
No Property Control
Because you don’t own the property, your landlord will be making crucial decisions that can affect your business. Agreements can have escalator clauses that trigger increased lease payments each year of the agreement. Also, there can be clauses in your agreement that can trigger a lease termination, such as an anchor tenant leaving the property. This adds so much more uncertainty to your business than an outright purchase.
Costs Can Increase When Lease Is Renewed
The biggest uncertainty with a lease comes at the end of the term. The landlord can significantly increase the monthly payment on a new lease, which you might not be able to afford. They could also decide not to renew the lease, which might leave you scrambling for a new property.
Acquiring commercial real estate is a huge step in developing a business. Once you decide to begin the acquisition process, you must consider the pros and cons of purchasing commercial real estate compared to leasing. There’s no blanket right answer for businesses. You must assess your needs, your business’s financial stability and liquidity, and your short- and long-term business plan to decide which path is best.
If you decide to purchase commercial real estate, check out our financing guide for more general information on how to get a small business loan. You can also check out the latest interest rates for commercial real estate loans.