To Buy or To Rent?

In a hot real estate market, values are rising—so are rents. How to make the right choice.

Commercial real estate has been booming for the past few years in most parts of the country, pushing up property values—and rents. Average sale prices so far this year are up 18% over a year ago for office buildings and an even greater 26% for industrial buildings, according to Real Capital Analytics, a New York-based market researcher.

This creates a challenge—and an opportunity—for small business owners, for whom the cost of real estate is often the highest expense after payroll and employee benefits. Big companies, which have full-time real estate departments, long ago learned that they could help their bottom lines by treating real estate as an investment, rather than a cost. Small businesses can do it, too.

By taking the time to assess current occupancy costs and available options, you may discover that a change in real estate strategy can free up money to invest in the business. Conversely, if rents are escalating rapidly in your market, buying may be a better option, because it ensures that spiraling real estate costs don’t squeeze out investments for growth. Ultimately, the decision to rent, own or refinance will depend on market conditions and on the company’s expectations for growth.

Sale Lease-backs

For a business that owns its space, today’s market offers excellent opportunities to sell that property and then lease it from the new owner. Known as a sale lease-back, the transaction enables the seller to capture built-up equity and remain in the space as a tenant.

This may be the best moment in years for such a transaction—especially if you think that real estate values are peaking. “If a small business would ever consider a sale lease-back, they would want to consider it now,” says Bruce Quinn, CEO of Cushman & Wakefield Net Lease Trust in New York. “The values have never been better and there have never been more investors in the market” looking to buy.

With lackluster performance in the stock market, investors the world over have been clamoring for the better returns available from commercial real estate in the United States. That demand has driven prices to all-time highs, setting records on a price per square foot basis in at least 18 cities this year already, according to Real Capital Analytics, which tracks real estate transactions of $5 million or more. Office sales that closed in the second quarter of this year were priced 32.8%, on average, more than the properties’ true value, according to estimates by Reis, Inc. Reis is a commercial real estate information provider that tracks transactions of $2 million or more. Its estimates of “true” value are based on cash flow from rent.

In addition to the access to capital, a sale lease-back benefits the small business owner by removing real estate as an obligation from the company’s balance sheet; the new lease requires only footnote disclosure. The transaction may also reduce a company’s debt and free up credit lines by eliminating a mortgage. “There are clearly benefits to extracting capital from owned real estate,” Quinn says. Remember, there also are costs, including commissions and taxes (see more on taxes below).

Leasing Tip

When leasing a space you may someday want to buy, add a purchase option into the lease language, specifying either a purchase price or how that price will be calculated. “It’s a hedge against the continually increasing price of real estate,” says tax consultant Robert Demmett.

Buying time

Ownership may still be the best choice for some businesses, particularly where space is in short supply and rental rates are high. In the same way that readily available debt and low interest rates have helped renters become homeowners, a growing number of small business owners are taking advantage of low rates to finance building purchases. Again, this is a good time to make your move, if you believe interest rates are headed up.

“In the past year and a half, we’ve seen more clients with anywhere from 1,500 to 100,000 sq. ft. looking to buy their own buildings,” says Mike Kimball, a real estate broker who specializes in small business clients at CB Richard Ellis (CBRE) in Valencia, Calif.

And developers are responding to rising demand for small commercial spaces, by dividing large buildings into industrial condominiums. Recently, a CBRE client began developing a 60,000 sq. ft. project of 26 condominiums in Valencia and had escrow deposits on all the units before construction ended, Kimball says.

Companies with stable revenue are the best candidates for owning their space, says tax consultant Robert Demmett, a partner at Eisner & Lubin LLP in New York. Ownership will be less appealing to a growth company, which will be better able to expand with leases and may need its capital for receivables and inventory, rather than real property. Likewise, a company with declining revenues would be foolish to sink capital into a building purchase.

One of Demmett’s Manhattan clients, an upholstery shop, decided real estate was indeed the best use for its capital. It had leased property in the past, but with New York’s dwindling supply of manufacturing space—and sky-high rents—the owner decided it was time to lock in a permanent home. The company recently bought one floor of a condominium project on Manhattan’s west side.

Buying Tip

Property purchased by a business should be held in a separate legal entity. “If the business starts doing bad and creditors start coming around or sue, they can take any asset in that entity,” says tax consultant Demmett. “When you separate the two, they have no right to the real estate entity.”

The tax factor

A small business owner deliberating whether to rent or own should calculate taxes as a component of occupancy costs. Property owners can deduct real estate taxes and interest paid on a mortgage from the company’s taxes, and improvement costs are deductible either up-front or through depreciation over a number of years. Money paid down on the principal, however, is taxable. “On the other hand,” Demmett points out, “rent is purely deductible, so in a way, rent is more of a tax benefit.”

Capital gains taxes are a consideration when selling. But taxes can be deferred by re-investing sale proceeds in a similar property under a 1031 exchange, but most small businesses doing a sale lease-back are liquidating capital for other uses, not to buy more real estate.

Another way to realize gains on valuable property and avoid taxes is to refinance: “If a company has a big built-in gain in a sale, an easier way to go might be to continue to own the property, and add debt to extract capital,” says Quinn of Cushman & Wakefield. “The mortgage rate is going to be a function of the value of the property, and values are very attractive right now.”

Finally, seek professional help, like big corporations do, advises Demmett. “A lot of things come into play in a lease that a real estate professional is familiar with, including escalating costs. It’s something an owner can do, but I would rather have a professional do it.”