A follow-up to our 2015 post with a new look at ways you can reduce your occupancy cost as a means of increasing the profitability of your business.
It may seem counterintuitive to think of the building you pay for each month as a source of profit for your company.
After all, the cost of occupancy, whether you lease or own your building, is probably one of the biggest expenses your business pays for. That’s why it is so important to make informed choices and that starts with your decision to lease or buy.
Let’s take a closer look:
Leasing requires less of an up-front investment, allows you to move when a lease expires no matter what the market conditions are, and landlords may absorb some of the up-front cost of building improvements to suit the unique needs of your business.
In the near term, less capital is diverted to real estate leaving more to invest in growing your business.
However, almost all leases contain substantial annual rent increases, when compounded, drive the cost of leasing up significantly over time. Given today’s market conditions, those increases can run 4% per year or even higher.
Every extra dollar in rent paid is one less dollar of profit realized. And, if changes in your business model require further building improvements during your lease, those are costs that will fall to you.
When the lease expires, the return on that additional investment comes to an abrupt halt, and you may have to spend that money again to properly configure your next leased building. The new tax laws on immediate expensing of capital items may soften that blow, but the potential impact on profitability is clear.
Purchasing a building for your own use presents another set of variables to consider carefully. The down payment is a significant capital outlay that could otherwise be invested in your business. Fortunately, in today’s financing environment, business owners can still pay as little as 10% of the purchase price as a down payment and finance the balance at low fixed rates for up to 25 years. Up to 90% of the cost of capital improvements can also be rolled into the loan, preserving additional working capital.
Currently, interest rates for SBA 504 and 7A loans are approximately 5% on a fully amortized basis. This equates to monthly mortgage payments somewhat higher than the cost of leasing the same space on a pre-tax basis, except for the fact that the mortgage payment is flat for up to 25 years, while the lease rate moves up every year. The potential long-term savings on occupancy cost is astronomical when looked at from a longer term perspective.
Think of the advantage you can gain over competitors who are paying more rent each year for their space while you pay the same each year for yours. Then consider the fact that with each mortgage payment you are building equity in your own property by reducing the principal balance of the loan, rather than doing the same for your landlord for the entire term of your lease. Building equity means a bigger payout for you personally when the property is sold. And, then there is the tax benefits of owning real estate, which include depreciation, mortgage interest write-off and capital gains tax treatment vs. ordinary income tax rates when the property is sold. You can even exchange your property and defer all or a portion of your tax liability at the point of sale.
There are some risks associated with owning that should be taken seriously. In a lease situation, you can walk away without cost when your lease expires. But, if you need to sell your building to find a more functional home for your business, you must do so under the market conditions that exist at the time. Timing market cycles is far from an exact science and the typical range in price from the top to the bottom of a market cycle can be significant. So, it is generally recommended that your need for space be relatively constant over the long term to avoid being forced to sell at a specific point in time.
Cost of occupancy is just one aspect of making your building a source of future profits. The other big one has to do with functionality and physical condition. Not all buildings are the same and no two businesses are exactly alike. Location, building specifications and physical condition all play a role in maximizing profitability.
Location is important to your customers in terms of their ability to find and access your products and services.
Thus, the right building in the wrong location can put you at a disadvantage relative to your competitors. If your business is hard to get to or just too far away, your customers may look to more conveniently located competitors to fulfill their needs.
The same may be the case when comes to your employees. Longer commute times and distances may make it more difficult for you to attract and retain the good people you need to run your business at peak profitability. We often see business owners locate their businesses near their own homes for their own convenience, but that can backfire if it makes it harder for their workers to arrive on time, in a reasonable amount of time, ready to work hard each day. The old real estate mantra of location, location, location didn’t just come out of nowhere.
Functionality is another key ingredient to maximizing profit.
Buying or leasing a building that doesn’t fit your operational needs can have disastrous consequences. Too often we see business owners get target-fixed on the sales price or the lease rate without giving full consideration to the impact the layout is likely to have on the operation itself.
For example, a distributor paying less per square foot for a building with low ceiling height may have to take more space than if he paid a higher price for a smaller, high-clearance building and invested in a new racking system. Likewise, having the right number of loading doors and good truck-turning radius could help you move more product, improving profitability via increased efficiency.
As the most active industrial real estate team in our market, we see the consequences of good and bad real estate decisions every day. Making sure you see the whole picture in terms of functionality is vital to increasing profitability.
Physical condition is also an important aspect of choosing the right building for your business.
If image is important to your brand, then a poorly maintained property that lacks curb appeal will definitely impact your profitability. Conversely, if you don’t deal with your customers face-to-face, an older property in a secondary location that costs less may be just what you need.
A poorly maintained building can also cut into your profits in terms of the time and money required to keep it operational. As a tenant, you have the responsibility to maintain and repair the building as if you own it. HVAC, sprinkler systems, power panels, roof structures and other systems are expensive to fix and even more expensive to replace. It is imperative that you fully inspect the property you lease or buy before you pull the trigger, or you could be sending hard-earned profits to the expense side of the equation.
Given the low supply of available buildings, the aging of the industrial base and the lack of new inventory construction, the issue of building condition is front and center on many of the transactions we complete.
We look at real estate occupancy cost as a zero sum game. Every dollar you save on the cost of your facility is a dollar that goes straight into your pocket, while every unnecessary dollar you spend goes into someone else’s.
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