(As Published in the April 2013 Deer Valley Times)
Many business owners dream of owning the commercial property for their businesses. Real estate is one of the larger expenses in many budgets and it is a very attractive idea to turn that expense into an investment. While it can often be very profitable, it is also a long-term commitment and a significant investment with inherent risks which require thoough consideration and planning. I personally owned a building for a business of mine in the past and can tell you from experience that it was a wise investment, both for me and my business. But how do you know if the time is right for your business to invest in real estate? While everyone’s situation is different, here are few key items to consider before entering the process:
Capital – Buying a building is a significant investment which most businesses need to finance. The Small Business Administration has a loan program that can help you buy real estate with as little as 10% down, with conventional bank loans typically require 25-30% down. Capital needed for real estate must be balanced with the money necessary to grow your business. Talk with your real estate advisor, banker and CPA to review options and ideas that meet your needs. There are also creative ways to finance real estate like seller financing, lease-purchase options and using an IRA or a 401(k) retirement plan that all can help you achieve your goals and help keep needed cash in your business.
Business Needs – What are the physical requirements of your business for the real estate and how can you make your business be more profitable by owning property? Beyond the current basic needs of your business operations, ask yourself what are the goals and objectives of your business for the next 5-10 years and what kind of property can help you reach those goals and objectives? You may need to consider a building larger than your current needs to allow for growth. In that case you may want to lease a portion of the building for a few years which can provide additional income while providing for future expansion. Or you might consider constructing a building and buying enough land to allow for an addition in the future.
Market Timing – As many of us have seen over the past few years, market timing can have a significant positive or negative impact on real estate investments. Along with location, timing is also a key to real estate investing. The real estate market is cyclical and the best time to buy real estate is when the market is emerging from a down cycle. Our local commercial real estate market is currently emerging from a down cycle, signaling the time to buy is now. And with interest rates at all-time lows, the incentive for buyers to take advantage of this market is even greater and filled with huge profit potential.
Along with considering your own ability and timing for a real estate purchase, it is also important to understand some of the significant advantages and disadvantages of leasing or owning real estate and the impact each can have on your business and personal finances. Here are a few areas to consider as you make your decision:
Mortgage versus Lease – When purchasing a building, you have the opportunity to lock in a mortgage payment for a longer term, for example 10 years, knowing that your payment will not change during that time. And as you are paying down your mortgage balance each year, you are also increasing your equity in the real estate. When leasing, you will be subject to market changes in rental rates and probable increases over the long term. For example, a monthly lease payment of $5,000 today adjusted for annual inflation rate of 3% over a 10 year period can become a $6,720 monthly rent.
Appreciation – Over the long term, real estate values will appreciate. As discussed above, it is the right time of the market cycle to buy, which can provide greater than average appreciation. Remember the old adage, “buy low and sell high”. Leasing does not provide for an opportunity to profit from appreciation. In fact the opposite applies to leasing; as the market improves leasing can be more expensive for your business.
Inflation – Real estate values also increase with greater inflation. There is a current concern among economists that when interest rates inevitably start to increase, inflation will also increase, creating another reason for real estate ownership to hedge against inflation. Leasing likewise will also be subject to more significant rate increases during a time if significant inflation, increasing the costs for businesses that lease space.
Taxes – Leasing and owning each have tax advantages. Leasing provides the advantage of expensing your lease payments as you pay them. With ownership, you depreciate the purchase price of a building over its useful life, typically 39 years. Therefore, your initial down payment will not be deductible in the year made, but will be part of the depreciation spread out over the life of the asset. However, the interest on financing real estate is deductible each year. When you sell a property, you receive reduced tax rates on the depreciation recovery and the capital gains. Another advantage to owning is if you sell a building to buy another building, you can defer any taxes by rolling your basis into the next property.
Risk – Purchasing real estate and committing to a long-term mortgage is riskier and less flexible for your business than signing a 5 year lease agreement with little or no money up front. Ownership provides a certain amount of pride and control of the asset, but also requires time for property management and includes risks of unanticipated repairs, market risks and risks of the property or surrounding area becoming obsolete. While there is less control when leasing, you are generally not subject to these risks.
If you think it may be time to realize your dream of purchasing or constructing a building for your business, contact a real estate professional specializing in your area. He/she can provide you with a detailed analysis with estimates of the financial implications of each option and discuss with you what else to consider in addition to the items above. A good real estate broker will also have a team of experienced advisors, such as commercial lenders, CPA’s attorneys, architects and contractors, to help you navigate the process for a successful and profitable long-term real estate investment. As I can attest from my experience, owning your building can create a better place for your business to operate, help you control your company’s real estate costs and provide for a profitable long-term investment.