Q. "It seems that everybody who owns a business wants to own real estate". "Why is that?"
A. "Well, youíre right. The general perception among business owners is that leasing or renting space or a leasing a building is just throwing money down the drain, making somebody else rich if you will."
Q. "Isnít it?"
A. "It sometimes is, however, a good question to ask is "if property ownership is such a good idea, why do major companies like AT&T, IBM, Boeing, Federal Express, Home Depot, Kroger, and even the US Government lease space". The answer to that question is "Real Estate ownership can be a great way to invest capital and a business owner can in some case cut their long term occupancy costs by up to 40%, but property ownership doesnít work for all businesses." A lot depends on the circumstances that are peculiar to a particular business."
Q. "But why pay rent for twenty five years when your can buy a building and have something to show for it at the end of twenty five years?"
A. "Given circumstances where monthly rent is equal to the monthly payment to invest in property, there is not much reason to lease. Unfortunately, those circumstances donít exist very often. Itís sort of like buying a car versus leasing a car. Many people lease cars today as opposed to buying them. There seem to be two major attractions to leasing a vehicle as opposed to buying a vehicle. First, little or no down payment is required when you lease. Second, the monthly outlay is often only about two thirds as high as purchasing a vehicle. Leasing has been prevalent in the auto industry for about ten years now, and everybody seems to understand that you can buy a Lexus today for about $600 a month and have something to show for it in four years, or you can lease for about $400 a month. For some reason, there exists a misconception that you can buy property for about the same monthly outlay that a business would normally pay in rent, however, that generally isnít true. In reality, just as is the case in automobile transactions, the monthly outlay to own a commercial property is about 30% higher than what it probably cost to lease commercial property, at least for the first five to seven years." On the other hand, with leasing you never build any equity.
Q "But wonít you save a lot of money by just cutting out the landlord profit, which Iím sure is not small piece of change?"
A. "We work mostly with clients who need what is termed "institutional quality real estate"- mid to better full service office space, industrial space, and manufacturing facilities. These are the types of buildings that are typically owned by insurance companies, pensions funds, REITs, and the average return to the owner of institutional quality real estate over the past ten years has been about 5% to 10% annually. Thatís a pretty low return and also one of the reasons that many major companies lease facilities as opposed to owning property. They feel they can earn a higher return on their capital by investing in their core businesses, not in real estate. Besides, yielding a fairly low return, capital invested in commercial real estate is somewhat illiquid. Once the money is invested in real estate, itís hard to get it out."
Q. "But arenít rents always going up?"
A. "They sure seem to have been for the past three years, but in reality, in many markets, rental rates have not yet reached the levels they were at fifteen years ago. Over the long haul, rents probably do increase at a rate equal to or slightly higher than the general rate of inflation. If you invest in owning property and stay in the building long enough, ownership of commercial property can reduce your occupancy costs substantially over the long term- often times by 30% to 50%."
Q. "How can a company be sure they will enjoy the benefits that can be achieved from property ownership?"
A. "There are no guarantees, but I can tell you that, but there are some general axioms. Weíve found, for example, that if a business owner cannot occupy and utilize a building for at least ten years, they should not invest in property. By the time you factor in things like roof maintenance, structural maintenance, functional obsolescence, sales costs when you need to sell the building, etc., youíd probably have come out ahead by leasing space, even allowing for an inflationary increase in the value of the property. Lets take a look at an example where weíll compare leasing a 40,000 square foot industrial building versus buying and renovating a 40,000 square foot building versus having a 36,000 square foot building built to the companyís specifications.
Q. "Wait a minute!" "Youíre comparing two 40,000 square foot buildings to a 36,000 square foot building."
A. "We are, and thereís a reason for that. Companies arenít interested in how much square footage they have, theyíre interested in "how functional is the building" and "what is the monthly overhead"? What we have found from talking to our clients is that if a building is built exactly to your specification, if every room is built ideally for your operation, (not the previous guyís business), you can usually get by with 10% less space than if you take over an existing facility" Also, when you go out to look for an existing building, you seldom find one that is exactly the size you wanted. Often times they are a little too small, which generally means that you pass on that building. In many cases, when buying an existing building, you ultimately settle for a larger facility than you really need because you canít generally buy just 90% of a building.
Q. "What other differences are there?"
A. "Well, beside the fact that a smaller build-to-suit will cost more than a larger existing building, an existing building can be financed in many cases only for eighteen to 20 years whereas a build-to-suit can often times be financed for twenty five years. With the shorter loan amortization, you own the building in less years, but your payment is a little higher than a comparable loan over twenty five years. Also, when buying an existing building, you need to make a larger allowance for functional obsolescence and for roof and structural repairs than when you have a building built-to-suit."
.Q. "What is functional obsolescence?"
A. "Functional obsolescence is that hidden factor that reduces the value of buildings. Let me give you some
examples. The trailer portion of eighteen wheel rigs formerly were about 40 feet long. Now they go up to fifty four feet in length. The tractor portion of the rig is much longer today also. There are many buildings that were built 20 years ago that could adequately accommodate tractor-trailer rigs of the late seventies, but do not have adequate ingress or egress for todayís larger rigs. It probably doesnít render the building uninhabitable, but it makes the building less useful to certain users. Older buildings also may not be fully sprinklered (fire protection), but most new construction is fully sprinklered. Having a fully sprinklered building will lower your insurance costs over the term of occupancy, and will make the building more
valuable and easier to sell at time of sale. Some buyers just wonít purchase a non-sprinklered building. "Clear height" in the warehouse is another area where changes have occurred. New construction today may have a clear height today of 22' to 24' from the floor to the bottom of the bar joist in the warehouse; older buildings may have only 18' to 20' of clear height. Structures with higher clear heights hold more inventory per square foot of floor area and are easier to sell at time of sale. Functional obsolescence is one of the main reasons why many companies lease space as opposed to owning real estate. Ultimately, the landlord gets stuck with things like functional obsolescence, major roof repairs, structural repairs, etc. If you own commercial real estate for your business, youíre in fact a landlord and youíre in the real estate business."
Q. "How does a business owner know if owning a building is a good deal for his company?"
A. "We run a twenty five year comparison for the business owner, taking into consideration his building requirement and comparing that to actual available buildings (if possible) and against typical available lease space and typical available build-to-suit scenarios. First we look at the "up front" costs involved in property ownership versus leasing, then we take another snapshot with the assumption that the business needs a different building after ten years of occupancy. This could happen for a lot a reasons; they need a larger facility, theyíre having cashflow problems, and need greater liquidity, or perhaps they were bought out by another company that already has a larger facility. Finally, we look at what the economics might be if the company remained in the building for twenty five years and sold it at the end of the twenty fifth year. Additionally, weíre looking at the average monthly cost of the three options (buying and renovating, build-to-suit, and leasing) over the entire twenty five year period. Leasing is the easy comparison. You only put up the security deposit, generally an amount equal to one month rent. There are some maintenance costs over the term of the lease, but you have those same costs if you own the building also."
Q. "How do you factor in inflation?"
A. "We assume that rents will go up by 3.5% annually over the twenty five year period, and that the value of buildings will increase by a rate of 3.2% annually. Another assumption we make is that the building will only be worth 85% to 95% of what you have in it at the end of the first year, but the value will increase from that point. Some of the capital costs such as fees, etc. bring no value to the building. Itís kind of like the fact that a new automobile drops 20% in value the minute you drive it off the car lot. Assume that you can lease 40,000 square feet of mid-to-better office warehouse space at
a rental rate of $.32 per square foot per month ($3.84 annually), or $12,800 per month. The landlord pays the taxes and insurance, but the tenant pays any increases in the cost of taxes and insurance over the primary year of the lease. A fairly typical deal. Now lets compare that to buying a building, where you undoubtedly will have some costs for remodeling, refurbishing, etc., in addition to the acquisition and finance costs. Finally, lets compare that to having a building built to company specifications and financed over twenty-five years. In both of the purchase cases, weíve figured that the company can finance 80% of the value of the purchase. The cost of the equity, or down payment is included in the monthly cost of owning the two buildings. Think of it as if the company borrowed the 80% from a lending institution, and borrowed the other 20% from the owners of the company. Theyíre entitled to a return on the money, just as the institutional lender is."
Q. "It looks like leasing space is substantially less expensive."
A. "Well yes it usually always does, until somewhere between the tenth to fourteenth year. As inflation raises rents, the monthly outlay of leasing escalates to the point of equaling and passing the monthly outlay to own property. Remember, when you own property, it is essentially like you have a twenty five year lease at a rate that is fixed for twenty five years. In leasing, the building is essentially re-valued every three to five years, and the tenant pays on the new value, which usually is up. Then a little further down the road, the cost of leasing actually exceeds the monthly outlay of buying property. Also, when you are buying, you as the building owner are the one who benefits from any increases in the value of the property through inflation."
Q. "What happens if the company needs to sell the building in the tenth year?"
A. "As you can see, with leasing space you have paid out a lot less money over the ten year period but you have nothing to show for it. With owning property you have paid out more in debt service but conversely you have paid down the loan for ten years while at the same time the building has probably increased in value from the initial year of occupancy by the company. When you factor in all the sale costs and the payoff of the mortgage loan and equity loan following the sale, your average monthly occupancy cost is not much different than leasing.
Q. "So where do you make your money owning property?"
A. "Based on what we see, almost all the money that is made (or occupancy expense that is saved) is a result of occupying a building in years twelve through twenty five of a twenty five year period. If you look at the analysis continued to the point of selling at the end of the twenty fifth year, there is a big advantage for owning property, sometimes yielding an average monthly savings of 30% to 40%. In our example, rents continued to rise for tenants while the building owner saw his building rise in value as he was continuing to pay off the purchase money and equity debt. Now you can see why we tell our clients that property ownership is not for companies who donít think they can operate out a single location for periods of more than twelve years. If your business has been historically subject to fluctuations in the building requirement, you should probably lease space for three to five year periods and evaluate your needs as the leases come toward expiration."
Q. "In conclusion, what do you recommend? Leasing or buying property?."
A. Both, but not to the same client. Whether leasing or buying is the optimal situation for your business depends on your business and its particulars, and even those can change over time. Any time you attempt to make long term commitments in todayís volatile business climate, there is going to be some risk. We canít eliminate the risk, but hopefully through careful analysis we can reduce the risk and reduce the long term occupancy costs for our clients.
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