Owning Real Estate is not a One-size-Fits All Proposition
In recent posts we have been singing the praises of property ownership for business owners. The owner/user gambit is a time-tested winner, and major fortunes have been made by tens of thousands of area entrepreneurs who found the courage to put their hard-earned cash on the line and take on the risk of debt to become property owners. A significant majority of them have come out big winners and have retired with millions of after-tax cash, while others have held on to enjoy a gusher of rental income from their investments. Either way, it was a winner, and in many instances their properties are worth multiples of the value of their business when they decide to retire.
We have also been touting the many benefits of the One Big Beautiful Bill Act (OBBBA), bonus depreciation combined with cost segregation, in particular. And, now with mortgage rates running in the mid-5% to low 6% range, there are advantages to building ownership that simply cannot be ignored.
That all said, building ownership is not for everyone. In fact, most businesses operate from buildings that are leased from third-party landlords. Ownership is a long-term proposition and should only be considered by business owners who are confident they can efficiently utilize the space they buy for a minimum of 5 years, as there are risks associated with being forced to sell a building that no longer fits given changing market conditions. With a long-term perspective, an owner can ride out market fluctuations and choose the optimum time to sell when property values are at a cyclical peak.
Leasing has its own advantages and should be carefully considered before stroking a check for the down payment on a building. Let’s consider some key elements in the lease versus buy decision.
First and foremost, leasing conserves capital that can be invested into the business at a potentially higher expected rate of return. Some follow the mantra that if the expected internal rate of return on the business is higher than the expected rate of return on the real estate, then the business owner should lease a building and invest the capital in his business to create more wealth.
Secondly, leasing supports flexibility for a business that is growing rapidly and cannot confidently predict its need for space. It is a shorter-term proposition than the ownership scenario. A fast-growing business can sign a short-term lease, perhaps with renewal options, to mitigate the risk of having to operate from a building that becomes too small, too big or is configured in a way that no longer supports revenue growth over time.
Thirdly, it widens the choice of facilities in terms of location, building size and configuration. Generally, most buildings across all size ranges are offered for lease rather than sale. Depending on market conditions, there may be dozens of options offered for lease and only a handful of properties for sale. Most Southern California industrial markets are almost completely built out and what minimal construction there is, tends to be skewed to buildings greater than 50,000 square feet.
Thus, the inventory of 10,000-square-foot buildings is static and will remain so in perpetuity, as the cost to construct them makes their development essentially impossible. That scarcity drives pricing for such facilities up and well beyond the reach of most small business owners. Want a 10,000-square-foot light industrial building in the Irvine Spectrum? Good luck. There are only a few handfuls of them, they were built in the 1970’s, are often functionally obsolete, yet they are prohibitively expensive due to their location. So, for the business owner who needs that size of building in that submarket, leasing is often the only option, as there are more spaces that come available over time.
Configuration and amenities also figure into the mix. Many buildings offered for lease have been improved over time with amenities like heavy power, high-end office space, HVAC systems, etc. that can be utilized by a new tenant without additional capital outlay. Manufacturers, for example, tend to move less frequently because of the high cost of adding power adequate to run their machinery. So, if they find a building that has the power they need, they may choose to sign a longer lease to utilize that power paid for by others.
Bottom line: a thorough analysis of short and long-term needs of the business should be made up front. Capital allocation, functionality, flexibility and locational factors should be carefully considered before any decisions are made. What is right for you will depend on that analysis and we stand ready to assist you in that effort. Just give us a call.