Unless you’re running a home-based business, you’ll need some type of business space to conduct operations, store inventory or manufacture your products. You have two main options to consider: leasing commercial property or buying it outright.
At Addition Financial, our business members often consult with us about major expenses and financing and that includes the option of buying vs. leasing commercial real estate. Each option has its advantages and disadvantages. We’ve created this guide to help you understand leasing and buying, including the pros and cons of each and some tips to help you choose the right option for your business.
When Should You Buy or Lease Commercial Property?
The first thing to ask is when it is appropriate or necessary to buy or lease commercial property. Here are some of the reasons you might wish to do so:
- You’ve been operating a home-based business that you want to expand.
- You need warehouse space to store raw materials or inventory.
- You plan to open a retail location or expand existing retail operations to new locations.
- You need to hire additional staff and don’t have room for them to work.
- You want the security of having a fixed location for your business and fixed monthly expenses.
Both buying and leasing have their advantages and disadvantages. You may not be able to use residential property for commercial purposes, and in that case, it makes sense to either lease or buy commercial property for your business.
What Are the Pros and Cons of Leasing Commercial Real Estate?
Leasing commercial real estate has some significant advantages as well as a few disadvantages, all of which you should consider before deciding to lease.
Pros of Leasing Commercial Real Estate
Here are four important advantages of leasing commercial real estate instead of buying it:
- Liquidity. When you lease commercial real estate, there’s no need to save for a down payment. That means you’ll keep more cash on hand than you would if you purchased property for commercial use.
- Maintenance. With a lease, you won’t be the one responsible for routine maintenance or repairs on the property. Instead, you’ll be able to call your landlord.
- Flexibility. The qualifications for a commercial lease are often less stringent than those for a commercial real estate loan. It’s also possible that you can afford to lease a location that might be too expensive for you to buy because you won’t need to worry about a down payment.
- Tax advantages. When you lease commercial property, you may be able to deduct your lease payments, property insurance, utilities and maintenance. In most cases, you’ll be able to deduct your entire lease payment instead of just the interest, as would be the case with a mortgage.
Cons of Leasing Commercial Real Estate
Here are some of the potential pitfalls of choosing to lease commercial real estate instead of buying it:
- High rent. The rent on commercial properties can be high and in some cases, may be higher than what your mortgage payment would be.
- No appreciation or equity. Rent payments don’t accrue toward anything unless you negotiate a lease-to-own contract that puts a portion of your lease payments toward your eventual purchase of the property in question. When you pay your rent, you won’t be accumulating equity.
- Lack of stability. While your lease contract will protect you to some extent, you won’t have the same ability to control property that you rent that you would if you bought it. Your landlord may increase the rent when your lease expires. They may choose to sell the property and, if your business doesn’t succeed, you may still be stuck making rent payments out of your personal finances.
- No rental income. As a lessee, you won’t have the option to rent out space that you’re not using as you might be able to do if you owned a property.
In some cases, the tax advantages of leasing may outweigh the high cost of leasing and offset some of the other disadvantages we’ve listed here.
What Are the Pros and Cons of Buying Commercial Real Estate?
As is the case with leasing, there are advantages and disadvantages of buying commercial real estate with a commercial loan.
Pros of Buying Commercial Real Estate
Here are some of the advantages of purchasing commercial real estate instead of leasing it:
- Equity. Since commercial real estate loans require a minimum down payment of 20%, you’ll have instant equity in the property you buy and will continue to build equity as you make loan payments. Building equity makes it easier to refinance your loan, borrow against your property or make a profit if you decide to sell.
- Capital gains. Since real estate is an appreciating asset, you may be able to turn a profit and realize capital gains when you sell the property.
- Tax advantages. While you can’t deduct your entire mortgage payment, you can still take advantage of interest deductions, property tax deductions and depreciation to reduce your tax burden.
- Rental income. You must occupy at least 51% of any commercial property you buy, but that leaves you free to rent up to 49% of it to generate income and offset your loan payments.
- Autonomy. As the owner of commercial property, you have the right to control it. You can make any renovations or upgrades you choose. You also won’t have to worry about rent increases the way you would with a lease.
Cons of Buying Commercial Real Estate
Here are some of the potential disadvantages of buying commercial real estate:
- Financing. You’ll need to prove to any potential lender that the property you’re buying will generate enough income to pay off the loan. That includes having a debt-service coverage ratio of 1.25.
- Initial expenses. The initial expenses associated with buying commercial real estate are significant. In addition to coming up with a down payment of 20% or more, you will also be responsible for loan-related expenses, including closing costs, appraisal fees, property insurance and loan origination fees.
- Personal guarantee. In some cases, you may be required to sign a personal guarantee that puts you on the hook for payments on the commercial loan in the event your business fails.
- Liability. When you own property, you’re responsible for what happens if someone is injured on your property. That means you’ll need to buy liability insurance and, if you rent some of the property, additional insurance to cover you as a property manager.
- Prepayment penalties. It’s common for commercial real estate loans to have prepayment fees and penalties, so be sure to read the fine print of your loan agreement.
- Lack of liquidity. Considering the high upfront costs of buying commercial real estate, you should expect to experience a loss of liquidity that may impact your ability to pursue opportunities. You’ll also need to consider the possibility that your property might lose value over time.
It’s important to consider all possible ramifications of buying vs leasing commercial real estate before you decide which option is best for you.
Reasons to Buy or Lease
Let’s review the reasons to buy or lease commercial property, starting with signs that you might be better off with a lease.
You may want to choose leasing instead of buying if any of the following things apply to you and your business:
- You don’t have enough cash on hand for a 20% down payment.
- You’ve just started a company and you need only minimal space as you grow your business.
- You want the flexibility to move into a new/bigger space after a few years.
- You need office or warehouse space quickly and can’t wait for the loan application and approval process.
- The only option that will keep you close to your customer base is a lease.
- You find a killer deal on a lease that will fit in your budget and allow you to save for a later purchase.
- You don’t have the wherewithal to deal with property maintenance and repairs.
Here are some reasons that you should consider buying commercial real estate instead of leasing it:
- You want to build equity as you make monthly payments. With enough equity, you’ll have the option to refinance your loan at a more advantageous rate or to borrow against to obtain funding to pursue your business goals.
- You want to have full control of your business premises including the option to renovate or remodel without worrying about your landlord’s permission.
- You want the option to rent part of your property to other businesses to supplement your income and offset the cost of your commercial loan.
- You want to take advantage of tax deductions for mortgage interest and property tax payments.
- You’ll have your ownership in the property to fall back on in the event your business runs into problems or fails.
We suggest reviewing your finances, business goals and specific circumstances before you decide on buying vs. leasing commercial real estate.
The decision to buy or lease commercial property is not one that should be undertaken lightly. The information and guidance we have provided here can help you review your options and make the right decision for your business and its goals.
Do you need assistance with small business financing? Addition Financial is here to help! Click here to learn about our business loans.