When considering whether to lease or own commercial real estate, there is one simple question for every business owner to understand: Where does your capital earn its greatest return? Understanding whether your capital earns a greater return in your business or in a potential real estate investment will help you to determine where to place your money. Ultimately, having a professional real estate advisor with your best interests at heart will help you make the right decision for you and your business.
Opportunity Cost of Capital
We all have limited capital (yes, even large corporations) and if we choose to invest our limited capital in one place, then we choose not to invest it in another. And if we choose not to invest in another place, are we foregoing a higher and better opportunity elsewhere? If so, should we re-allocate our capital there? These questions drive all investors to place their money where it can earn the highest returns. This basic concept is called the “opportunity cost of capital”, and it holds that investors make rational decisions so that their capital flows efficiently to the place where it earns the highest risk-adjusted return.
New Branch can help you determine whether the highest opportunity cost of capital is in your business (meaning you should lease) or in real estate (meaning you should purchase).
Many businesses choose to lease because it gives them flexibility and often does not require significant investment to move in. This flexibility enables the tenant to leave the space without significant penalty if and when they outgrow their space, or when the space no longer fits their needs. Businesses also tend to lease when they need to preserve their capital for use in the business rather than making a large investment in real estate. In additionAnd from a tax perspective, leases allow for the tenant to write off the full amount of the lease payment, versus owning, in which the owner can write off just the interest and depreciation.
Before signing a lease, it is important for the tenant to understand all of its lease obligations, such as maintenance and capital responsibilities. Who takes care of the HVAC, the roof, the landscape maintenance, the property taxes and insurance? A real estate professional can guide you through these questions, along with many other considerations, and add significant value to you and your business when making these decisions.
Owning real estate requires a more significant capital outlay than leasing and a clear understanding of all the costs associated with owning, such as maintenance and capital outlays. The obvious upside to owning is appreciation in value. By contrast, the obvious downside risk in owning is depreciation in value.
The most common mistake a prospective owner makes is underestimating the amount of capital expenditures that real estate requires. The roof, structure, parking lot and HVAC units are the big-ticket items. If these systems are not maintained, they can rapidly deteriorate, and they are key items to inspect during due diligence. Every system has a “depreciable life” and it is also important to talk with your real estate advisor and accountant when you re-invest in the property so that you properly book these assets. There are numerous other factors in considering owning, including how you finance your property, what external factors may affect value, and market timing.
This article touches on a basic framework for considering a lease versus purchase. There are many other factors, and we invite you to reach out to a New Branch Real Estate professional who provides guidance daily to clients. Each business owner has a unique circumstance and a unique business, and our advisors will provide tailor-made advice to help you make the best decision for you and your business.