Controlling Occupancy Cost in a Rising Market

If your business is like most others, the cost of your facilities is one of your largest expense line items. So, it is important to make sure that you do everything possible to control that cost whether you own or lease your space because the impact on your bottom line is outsized in comparison to most of your other expenses. 

It’s no secret that the cost to lease or own industrial real estate has risen sharply over the last 10 years. After a huge price correction from 2009 to 2011 as a result of the so-called Great Recession, lease rates and sales prices have risen sharply and steadily, even through the darkest days of the pandemic. At first, it was sales prices that took off, mainly due to low mortgage interest rates offered through the SBA. Rates fell to historic lows and remain there to this day. Demand has been on the rise since 2011 and sales prices have more than doubled and even tripled in some cases since then. A typical 10,000-square-foot building in central Orange County has now reached $350 per square foot or more depending on quality, configuration and location. Frankly, we would never have been bold enough ten years ago to predict such a meteoric price point. But, here we are and it’s up to us to help you figure out a way to control your occupancy cost under the circumstances.

In the early years of the recovery, lease rates rose more modestly than sales prices. There was plenty of inventory then and a disproportionate number of business owners were more interested in taking full advantage of long-term, fixed-rate financing and down payments as low as 10% of the purchase price. With demand directed to the sale side, lease rate growth lagged behind sale price growth. Buildings offered for lease only sat on the market for months while anything offered for sale was gobbled up in a matter of days or weeks. It got to the point that owning was substantially more costly on a pre-tax monthly basis and we expected sales prices to level off in response. They didn’t. In fact, sales prices have risen even faster in the past few years because we ran out of inventory to sell. Scarcity of product in combination with cheap mortgage rates essentially turbocharged the price spike.

While it is true that lease rates were moving higher as vacancy fell, it was a more moderate and predictable trajectory. Not so anymore. The vacancy rate is now under 2% and not a single square foot of new space is in the construction queue. That has made space for lease just as hard to find, and that means the rate rise curve has turned sharply upward. Potential tenants are bidding up prices above asking rates just to secure space, and many buildings are offered without an asking price to encourage bidding wars. Free rent is virtually non-existent and landlords are loathe to offer much in the way of tenant improvements to secure a tenant. It’s “take it or leave it” time much to the chagrin of those in need of space as the post-pandemic economy picks up steam. 

So, what should you do to control your occupancy cost? First off, if you own your building and have low rate, long-term debt, you probably should stay put as long as your space still works for you. If you are a tenant, you may be well advised to purchase a facility now while mortgage rates are still low. You’ll pay a premium price, but you would also fix your occupancy cost for up to 25 years with either an SBA or conventional loan at an interest rate in the low 3% range. We think it is safe to say that mortgage rates will not go any lower, but lease rates will continue to rise due to low vacancy and lack of new development. The narrowing of the gap between the cost to own and cost to lease makes the purchase route more favorable. And, if you own your building, every mortgage payment you make pays down principal on your own loan, not your landlord’s. 

Let’s look at a hypothetical. Say you are looking at a 10,000-square-foot building in Anaheim with a price of $350 per square foot. After a 10% down payment, you’d be borrowing $3,150,000 at approximately $3.25%, fully amortized over 25 years. Your monthly payment would be $15,350, or the equivalent of $1.53 per square foot. That payment is fixed for 25 years. 

If you leased the same building from a landlord, you’d pay approximately $13,500 or $1.35 per square foot, or $22,200 less than the mortgage costs in year 1. Then you would have fixed annual rent increases of 3% to 4% each year thereafter. 

If you purchased the building, you would reduce the principal of your loan by over $83,000 in the same period. That gap would widen as your rent goes up and your principal pay-down accelerates as the loan amortizes.

In most owner-user scenarios, the owner of the business buys the property and leases it back to his business at a rate that covers the mortgage payments. The owner then takes the tax benefits associated with depreciation and interest expense, while his business writes off the rent in full. Thus, rent to the business is fixed for 25 years along with the mortgage payment, fixing long-term costs for both the owner and his business. As the building value appreciates, the owner builds additional equity as his loan balance decreases. Good for the business and good for the owner.

Now, we realize this example does not take into account fluctuations in market conditions, but if the strategy is to hold for the long term and assure fixed occupancy cost, then those short-term fluctuations become less important. 

The performance history of industrial owner-user properties over time makes a compelling argument. Our theoretical 10,000 square foot building in 1978 would have sold for approximately $28 per square foot, $180 in 1988 and $250 in 2018. Not too shabby to say the least. 

We don’t know what it will be worth in 2028, but we do know that it is unlikely that a building in that size range will ever be built again in Orange County. So, even modest business growth over the next decade points to a continuation of the supply/demand balance that drove prices up to where they are today, even if mortgage rates move substantially higher.

So, buying a building, even at today’s high price point, could be your best bet in terms of controlling one of your biggest expenses. If you’d like to learn more about whether the foregoing makes sense for you, just give us a call. We are here to help.