Should You Buy or Lease?

Should you own or lease the next home for your business? The answer depends on the dynamics of your business model, your tolerance for risk, your access to capital and your long term wealth strategy.

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Before we get to the answer to that question, a bit of history.

Orange County has long been a hotbed of owner/user sale activity. The county’s industrial base was largely built around the concept originally championed by Dunn Properties, back in the 1970’s. The merchant developer, owned by Pacific Lighting at the time, built projects of small buildings for sale throughout the state by offering functional, freestanding units with pre-arranged financing and low down payments. Interestingly, the move to individual building sales was in response to a slump in leasing activity in some of its projects, which had been pre-sold in bulk to investors with rent guarantees.

As the old saying goes: “necessity is the mother of invention”.

To say that the concept took off like a shot is an understatement. In short order Dunn had hundreds of buildings underway in projects up and down the state. Demand from local business owners easily outstripped demand and Dunn soon had dozens of competitors chasing down industrial land sites to join the party. If not for the success of the owner/user concept, Orange County’s industrial landscape would be dominated by large business parks, owned by institutions only willing to lease their space to area businesses. Instead, there are literally thousands of small to medium-sized buildings scattered around the county that are owned by individuals who have chosen to be their own landlord and pay down their own mortgage rather than writing rent checks to strangers every month. The owner/user equation was and remains a winner to this day.

So, now to the question: should you own or lease the next home for your business? The answer depends on the dynamics of your business model, your tolerance for risk, your access to capital and your long term wealth strategy.

First, the dynamics of your business. Generally, to be a good candidate for a purchase you should be confident that the building you buy will serve the operational needs of your company over the long term, at least 5 years, but the longer the better. Owning a facility you can’t use efficiently might force you to sell under unfavorable market conditions in the future. Selling in a down-cycle can be painful, so being able to operate out of your building even when the economy is struggling, reduces the risk of a poorly-timed sale. That also means you should not stretch too far at the point of acquisition by buying too much building or depleting your cash reserves to the point that you are unable to invest in other opportunities to grow your business.

While it’s true that long term owner/users have struck gold through building ownership, you may be better off investing what would be a down payment on a building in equipment, inventory and people that will help you boost the return on your business. In today’s market, you will need at least 10% of the purchase price for the down payment plus closing costs, and you can expect to obtain a loan or loans for the balance.

Your tolerance for risk should also be taken into account. There are no guarantees when it comes to buying industrial real estate. While it’s true that Orange County’s industrial building owners have made huge gains in the last ten years, no one can say with certainty how long the current trend line will continue, what will precipitate the next correction, or what combination of events will cause it to happen.

While it is impossible to time a peak or bottom of any market cycle, we do know that those who choose to sell today will turn a handsome profit. Demand for quality buildings has never been higher, supply has never been tighter and mortgage interest rates have never been lower. That combination has taken us into uncharted territory in what is now the longest real estate up-cycle in Southern California’s history.

So, as a buyer entering the market at this price point, you are taking on a significant risk. Acquiring a building that will suit your needs for the long term at today’s low interest rates would serve to mitigate that risk. That said, it is also important to maintain a cushion of working capital, as accessing your equity in real estate may become difficult or impossible during a downturn.

Back in the early 2000’s, owner/users borrowed against their home equity to raise capital for a down payment on a building, only to lose both when the market corrected sharply in 2008. At the same time, business owners who were leasing at that time gained an upper hand on their landlords, which allowed them to substantially lower occupancy cost and divert precious capital to battle a deep recession.

The low cost of capital in this recovery cycle has had a profound effect on property values. Last month, mortgage interest rates returned to an all-time low. The SBA is now funding 25-year fully-amortized loans at a rate under 3.5%. In the late stages of the last up-cycle rates were close to double that amount. Low rates absorb the impact of higher prices because they lower the cost of servicing each dollar of debt. This is the main reason buyers continue to pay record prices for buildings, and the logic of that strategy remains sound because lease rates have skyrocketed along with sales prices due to a supply shortage. Either way, the cost of occupancy is expensive. It really comes down to your unique circumstances and preferences. Your tolerance for risk should figure heavily in your decision.

Your long term wealth strategy should also figure heavily into the decision to buy or lease. You may remember our series on the Wealth Cycle (found here), which breaks down an investor’s lifetime into three stages; Wealth Creation, Wealth Preservation and Wealth Distribution.

Acquiring a building for your own use may be one of the biggest investment decisions of your life, so it is important that a real estate acquisition be made in support of a carefully crafted long term plan. Becoming an owner/user diversifies your investment portfolio, provides a time-tested hedge against inflation and offers significant tax benefits, both during the hold period and at the point of disposition or transfer to your eventual heirs.

It is so important for you to consult with your professional financial advisors before acquiring commercial real estate to make sure that it fits with your long term strategy. Owning the building you occupy might not be the right move. You might be better off mitigating your risk by owning multiple types of real estate like retail, office or multi-family. It may even be in your interests to own property in other markets that are driven by economic factors different than those in Southern California.

The bottom line: buying or leasing is a big decision that will require significant time, energy and resources to ensure that whatever decision you make is fully informed and in service to your long term interests. We welcome the opportunity to be one of those critical resources. Just give us a call. We are here to help.