Buying or Leasing Commercial Real Estate as a Small Business

By on May 5, 2015

If you are having trouble deciding whether to lease or buy commercial real estate for your business, then this article is for you. We cover the pros and cons of each option, and give you a step by step breakdown of how we calculate the cost of leasing vs. buying using a real-life commercial property as an example. After reading this article you’ll have all the information you need to decide whether leasing or buying your location is better for your business.

Of course, many small-business owners can only afford to lease retail or office space when they’re just starting out — and that rent often consumes a large part of their monthly budget. However, money isn’t the only reason to choose renting or owning.

To determine whether leasing or buying would work better for you, consider three big advantages of each:

Leasing Commercial Property

When you lease a property, there is no downpayment required (a security deposit you will get back). You typically need a downpayment to buy property, which can take a huge chunk out of your startup budget or cash reserves. By leasing, you can invest that capital in growing your business — and keep the option of buying open for later, when your finances are stable.

When you lease space the repairs are handled by property management. If the air conditioner breaks (as it eventually will), all you will have to do is call the property manager and wait for someone to show up and fix it. If you own that same space, you are responsible for paying sometimes thousands of dollars on repairs when something major fails.

You have short-term options. As your business expands, it may grow out of its space. By signing a lease of one to five years, you’ll have the option to move to a new spot as your needs change. Leasing also gives you the opportunity to try out an area of town to determine whether it’s a convenient location for your clients and staff.
Owning Commercial Property
Property is an investment that pays off over time. In fact, given the low interest rates and prices of late, it’s never been a better time to buy commercial real estate.

You can save money. Although a down payment can tax your budget, buying a property gives you the option of refinancing and eventually paying off the mortgage balance (after which there’s no monthly payment). Because rents are subject to increase over time, owning can be better than leasing in the long run.
You are your own landlord. When you own a space, you have control over what you do to it. If you want to paint the walls purple or update the windows and doors, you can — without needing anyone else’s permission.

Buying vs. Leasing: Out of Pocket Costs
When comparing out of pocket costs only, leasing costs more than buying over a 15 year period or longer. However, this does not take into account the value of the building (which is paid off and owned in full at the end of the 15 years), tax savings, or opportunity costs. When the value of the building is taken into account, leasing costs nominally more over 15 years than buying.
Tax Savings
When leasing commercial real estate, you can generally deduct all your costs. This is not true when buying commercial real estate. When you factor in these tax savings leasing costs you a great deal more over 15 years than buying.

Weighing the Opportunity Costs

Buying costs much more upfront than leasing, because of the down payment required for a mortgage. Typically the down payment for a commercial mortgage ranges from 10 to 30%, in this example we use 20%. There is an opportunity cost to tying up this money in the building instead of investing it in your business. The lease payment was also higher than the mortgage payment so there is also an opportunity cost for leasing.
How The Time You Occupy The Building Affects The Numbers
If you plan to stay in the building for seven years or more, you will want to work with your trusted financial advisor to determine if buying is still a viable option. We know that typically, the longer you plan to stay the higher your savings becomes encouraging you to buy. However, if you occupy the building for less than 15 years, your calculations will vary greatly based on your business and location.

When looking at out of pocket costs and the value of the building only, leasing could cost around $150,000 more over a 7 year period than buying. When factoring in tax savings leasing may only cost $50,000 more over the 7 years than buying. When factoring in other remaining opportunity costs, leasing may only cost $5,000 more over than buying.
Upfront Costs For Leasing Commercial Property
Landlords generally require a security deposit that is at least equivalent to one to two-month’s rent. In this case, your monthly rate as well as your security deposit, is around a few thousand dollars.

If you have used a broker, there is also a broker fee that you must pay, generally around 10% of yearly lease total time the number of lease years. If you assume an initial lease of 3 years, your broker’s fee could be around $1,000 or more.

Brokers are not paid again if the lease renews so this is a one-time fee. Check with your local commercial real estate broker to see how they calculate their fees.

It is advisable to get a pre-lease inspection to determine possible costs/problems (mold, structural integrity, etc). There may also attorney fees for lease negotiations — with most negotiations taking 2-4 hours, expect to pay between $400 – $2,000 in legal fees (depending on location and total time). Altogether then, leasing a building could cost you around $8-9,000 in upfront costs.
Upfront Costs For Purchasing Commercial Property
When buying commercial real estate, your initial costs will include due-diligence fees and closing costs. Due-diligence fees are all of the fees related to the legal side of getting your new building up and running, including your property assessment, attorney fees, permit fees, inspection fees, etc. Let’s estimate $10,000 in due diligence fees.

Closing costs include bank fees, processing fees, appraisal fees, etc. These costs vary widely depending on the area, property value, bank, etc. Closing costs could be around $4,000 for a building (will vary based on local property values).

Assuming a purchase price of $250,000 with a 20% down payment on the mortgage, you could expect an additional $50,000.

Assuming due-diligence fees of $10,000, closing costs of $4,000, and a down payment of $50,000, you could be paying $64,000 or so in initial costs for this building.
Recurring Costs For Leasing Commercial Property
Leasing commercial real estate can be very confusing, especially considering all the different leasing arrangements. There are three main one’s which you should familiarize yourself with: percentage, gross, and net.

Percentage – Monthly rental rate + set percentage of your monthly sales;
Gross – Rent is all-inclusive. The landlord generally pays for property taxes, maintenance, etc. while the tenant is only required to pay their monthly rent;
Net – Rent + some or all of other building costs such as property taxes, maintenance, etc. There are varying levels of net leases.

Triple net leases are considered the standard lease arrangement for retail spaces, which is why we assume a triple net lease in our example calculations. Recurring costs for triple net leasing include your lease payment, utilities, property tax, maintenance costs, and insurance.

Retail utilities average around $1.5/sq. ft/yr – $2.5/sq ft/year. As a safe estimate for a building, electric, natural gas and water could be around $8,500/yr. Then you will have to factor in property taxes, insurance and maintenance/improvement costs, which could run you around $5,000 annually. The total recurring costs for leasing may be closer to $35,500 for the first year.

Recurring Costs with Buying Real Estate

Recurring cost for commercial real-estate buyers includes mortgage payments, utilities, property taxes, insurance, and maintenance/improvements.

To calculate the mortgage we subtract out our 20% down payment ($50,000) on the $250,000 purchase price. Then use a mortgage calculator to determine your yearly mortgage payment.

Water and other utility bills add additional costs. A safe estimate would be around $8,500/yr. Property taxes could be around $6,000/yr. Insurance may cost around $1500/yr. And maintenance/improvement costs, can be expected to be around $5,000.

Buying Vs. Leasing: Out of Pocket Cost Difference

The above numbers do not take into account the fact that at the end of 15 years our mortgage is paid off, meaning you now own the building outright. Assuming an appreciation rate of 2% per year, at the end of 15 years the building that you bought for $250,000 could be worth $350,000 or more.

When factoring in the value of the building, the total cost for buying drops over the 15 years. This substantially increases the cost advantage of buying or leasing, however, don’t purchase and move your business into a property for the sake of owning real estate.

Only purchase a property for your business if you would lease it anyway. In other words, don’t resign to a mediocre location just so you can play landlord. If you want to buy property there are other residential investments you can explore. If your business isn’t making money within a few years you will simply end up selling the property and moving to a better location for lease, probably at a loss.

If you own the property, the perfect scenario at retirement time could be to sell the business but retain ownership of the real estate. This will provide a good source of reliable income for a long, long time to come.

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About David Leighton

FSN real estate investment journalist - Property can still be a great way for someone to secure or grow their portfolio. Any smart investor with a good education and understanding of the opportunities in the the market can buy their dream home, rental unit or commercial parcel. David wants you to have the tools and resources to make informed decisions in your real estate investments. Connect with David on !

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