How to Decide Whether You Should Lease or Buy a Business Facility
There are many factors every small business owner needs to consider when getting ready to make the decison whether to buy or rent a business facility.
Once a business owner determines his or her facility needs and searches for and locates the right facility, it's time for another decision regarding the business property: Do you buy or rent the property?
This question is raised in two contexts:
- The owner of the target property would consider either a sale or a rental of the property.
- You are selecting from a group of competing sites, some of which are for sale and others which are for lease.
To help you make this decision, you need to compare the economics of leasing vs. buying as well as the factors that determine whether leasing or buying a facility makes more sense.
Comparing the Economics of Leasing vs. Buying
The main advantage of leasing a business facility is that your initial outlay of cash to gain the use of an asset is generally less for leasing than it is for purchasing. However, perhaps the main advantage of purchasing is that you end up paying out less in the long term than you would have paid if you leased the facility. Moreover, if you purchase, you get the benefit of any appreciation in the value of the property.
How do you reconcile these factors? One way is to do a mathematical analysis of your net cash flows that would result from leasing and from purchasing.
Cash-flow analysis. A cash flow analysis provides an estimate of how much cash you would need to set aside today to cover the after-tax costs of each facility acquisition alternative. To perform the analysis, you need to know or assume certain facts, including:
- purchase and financing terms, including closing costs
- lease terms
- your combined federal and state income tax rate
- the facility's expected useful life to your business, for depreciation purposes
- the asset's estimated value, when you sell it, or at the end of its useful life to your business
- your cost of capital
- any other costs that you would incur if you leased the facility but not if you purchased it, or vice versa (for example, you'd need to account for expected maintenance costs if the landlord was assuming responsibility for those costs)
Long-range effect of the decision. If you are a new business owner considering whether to acquire a facility by purchase or by lease, you may have a tendency to concentrate on the short-term, such as the first year cash flow projections that would result for each of the alternatives. This is natural, and probably altogether necessary: If things don't go well enough in the first couple of years of the business's operation, it may not be around to see how a particular decision would have benefited it 10 years down the road. But having said this, it's still worthwhile to consider how a lease or rental could affect your business in the future. Will it be important for your business to be able to stay at the location for as long as you want? Do you foresee the need to modify the facility in a way that a landlord may not agree to?
Let's say you look at the short-term and long-term implications of the rent-or-buy decision, and conclude that it's in the long-term best interests of your business to buy the property. If your rent-or-buy question is otherwise a close call, this long-term consideration may lead you in one direction. If, however, buying the facility is out of the question, at least you'll know that you should be thinking about how you can accomplish these long-term goals by other means.
Factors to Consider When Making the Lease or Buy Decision
What factors should you consider when deciding whether you should buy or lease a business facility?
The following factors, if relevant to your situation, may lead you to conclude that you should purchase, rather than lease, your business facility:
- You want control of the property. Maybe you intend to make substantial additions or renovations to the property. Or you decide to change your business hours or change something else about the way you are doing business. If you rent your facility, you may have to get your landlord's permission to make these changes. If, however, you own the property, there will be no one looking over your shoulder (expect maybe the zoning board!) to question your moves.
- You can consider the long-term cost. A lease may sometimes beat out a purchase in terms of cash flow, particularly in the early years. But over the long haul, a purchase is usually cheaper because a landlord, in addition to paying all of the costs associated with purchasing and maintaining the property, will attempt to build in a profit for himself. You can avoid paying this profit premium by buying, rather than renting, the property.
- For some businesses, such as certain retail and service businesses, location is all important. If you have established a winning business location, you don't want to lose it because of a rent escalation or because the landlord just wants the property for another use. If you own the facility, you won't have these worries.
- You haven't found a suitable property to lease. You may want to lease, but have found all properties that would be suitable for your needs have been offered only for sale, rather than lease.
- You are in an area of appreciating land values. If you will locate in an area where you think land values will continue to increase, it would be better to own the property (and thereby get the benefit of this appreciation if you ever sell) rather than to rent it. This is would be particularly true if you are able to spot this real estate trend before prices jump up in recognition of it.
- A purchase may bring you tax savings. Although, unlike rent, the money you use to purchase your facility is not deductible, you are allowed to recover this outlay over time by yearly depreciation deductions. If you financed your purchase, interest-paid deductions are also available. Depending on several factors, such as how long your have been in business, how profitable your business has been, and what portion of the purchase price or rent relates to the land itself — rather than to buildings — a purchase may actually cut your tax bill when compared with a lease.
On the other hand, the following factors, if relevant to your situation, may lead you to conclude that you should lease, rather than purchase, your business facility:
- Your current cash flow is of vital importance. Particularly in the early years, a lease may be better than a purchase from a cash flow perspective. This is because up-front outlays associated with a lease are usually less than those required with a property purchase. With a lease, your main initial cash expense may well be limited to your security deposit, plus first rent payment. With a purchase, you have to have the lump-sum purchase price, or at least a down payment on a mortgage.
- You don't want maintenance duties. Many leases place the duty of maintaining the property on the landlord. Examples of such maintenance can include the things that are necessary to ensure the continued structural soundness of the building (such as roof repairs and periodic maintenance and maintenance of heating and cooling, electric, and plumbing equipment), and those that go to the facility's ease of use and appearance (such as snow shoveling of walkways and parking lots and cleaning of windows and common hallways).
- You want to retain your mobility. Maybe you're not sure that the facility that you will select now will serve your needs several years in the future. You may need more or less space, your target market may have moved elsewhere, or better-suited properties may later be built.
- Your company's credit rating may not support a mortgage. If your business is rather new, or has experienced some financial difficulties, lenders may not be willing to extend it sufficient credit for a mortgage on the facility. With the same financial situation, however, a property owner may well be willing to rent a property to your business.
- You haven't found a suitable property to buy. You may want to buy, but have found that all properties that would be suitable for your needs have been offered only on a lease basis.
- The facility may be in an area of declining real estate values. You may find a facility that meets your needs, but you are concerned that the real estate values in the area are stagnate, or may actually drop in value. In this case, leasing makes sense: let the landlord suffer the effect of the declining values, not you!
Familiarizing Yourself With Standard Commercial Lease Provisions
If you are leasing your business facility, you should be familiar with the following terms and provisions which are commonly found in commercial leases:
- Gross lease. This is the most traditional type of lease: the tenant pays rent; the landlord pays taxes, insurance, and maintenance expenses relating to the property. Increasingly, gross leases contain escalation clauses, which provide that the amount of rent is to be adjusted (usually each year) to offset increased expenses.
- Net lease. A net lease transfers some or all of the expenses that the landlord is traditionally responsible for to the tenant. With a single net lease, the tenant pays rent plus taxes relating to the tenant's portion of the property. Under a double net lease, the tenant also pays its proportional part of insurance premiums. Finally, with a triple net lease (which is often favored by larger businesses), the tenant pays all charges payable under a double net lease, plus maintenance expenses.
- Fixed lease. A fixed lease provides for a fixed amount of rent over a fixed rental period (term). These types of leases usually seem the least threatening for the small business owner tenant, since you don't obligate yourself today for rent increases in the future. But, there is a downside to a fixed lease: if you want to renew the lease when it expires, the landlord may choose to raise rent sharply, particularly if your business appears to be doing well, and would suffer from relocating elsewhere. If your initial lease term was short, you might end up wishing that you had opted for a longer term lease with fixed or determinable rent increases.
- Step lease. A step lease provides for set rent increases to take effect at stated times. This will provide you with the peace of mind of knowing what your rental amounts will be for a longer time period, while giving the landlord some protection against rising costs. If you are considering renting a facility under a step lease, carefully consider whether each of the scheduled rent increases is reasonable. Are the increases out of line with historic consumer price indexes or local rental increases?
- Percentage lease. With a percentage lease, your landlord shares in your good (or bad) fortune. The lease provides for a fixed amount of rent, plus an additional amount that is set as a percentage of your gross receipts or sales.
- Lease term. Identifies how long the lease will be in effect. If you suspect that you will want to stay at this same business location beyond the initial term, try negotiating the inclusion in the agreement of a renewal option that entitles you to renew the lease for a specified period and a specified rent.
- Rental rate. Tells how much the rent is and when it must be paid. Most leases also include late payment provisions that impose additional charges if you fail to pay the rent when it's due or within a specified grace period. If your business experiences seasonal or irregular sales activity, try negotiating a flexible rental rate that corresponds to the changes in your cash flow.
- Escalation clause. This clause provides for increases in rent over a specified time period. The escalations can be fixed, or determined with reference to an outside factor, such as increases in the landlord's operating costs, increases in a cost index (such as the consumer price index), or increases in the tenant's gross receipts or sales.
- Maintenance. Specifies who is required to maintain which portions of the building and land. If you are responsible for doing so, the lease should say whether you can contract with anyone of your choosing to provide these services, or whether the service providers have to be approved by the landlord.
- Competition. In the case of a lease of retail space, such as a store in a shopping mall, there may be restrictions placed on the landlord's right to lease nearby space to businesses similar to your business. (If there are not, you should consider pushing for such a provision.)
- Subletting. Spells out whether, and under what conditions, you are entitled to sublease the premises to another. Remember, if you sublet the property, you normally will still be liable for paying the rent if the subletting tenant does not pay.
- Improvements and modifications. Identifies whether you have the right to make improvements or modifications to the facility so that it better suits your needs.
- Taxes. Specifies who is responsible for the real property taxes.
- Insurance and liability. Fixes who is responsible for casualty and liability insurance and how much coverage must be carried. Also may contain language that says under what circumstances, if any, the parties to the contract (the landlord and you) will excuse each other for liability for injury to persons, or to the property.
Although you may be willing to reimburse the landlord for losses caused by your actions, watch out for language that would legally excuse the landlord from damages that the landlord caused to the leased premises or to persons or property on the premises.
- Renewal option. Specifies whether the tenant has the option to renew the lease when it expires and, if so, specifies the amount of rent to be paid (or how the rental amount is to be determined) for the renewal lease term. A renewal option can give your business protection against your landlord's wanting to hit you with an unreasonably large rent increase when your first lease term expires.
- Purchase option. Tells whether you'll have the right or obligation to purchase the facility at the end of the lease term. This provision should specify an option price or range and how and when the option may be exercised.
- Destruction or condemnation. States whether the landlord is required to rebuild if the property is destroyed. Specifies whether rent will be abated, and whether you can terminate your lease obligations if the facility is totally or partially destroyed. This provision will specify what rights you and your landlord enjoy if the facility is taken by eminent domain (that is, acquired by a local government body for a public purpose).
Most leases include a provision for termination of the lease following destruction of the facility, based on either the time it will take to repair or the costs involved. You should insist that there be an absolute cutoff time beyond which you may treat the lease as terminated. This will protect you against a landlord who drags his feet making repairs while you continue to lose business.
- Landlord's solvency. A useful provision from your point of view, which spells out your rights as a tenant if your landlord's mortgage company forecloses on the leased premises.
If you have any doubt about the landlord's solvency, before you enter the lease, consider requiring the landlord to obtain a nondisturbance agreement from any mortgage holder. The agreement would obligate the mortgage holder to adhere to the terms of the lease in the event of foreclosure.
- Zoning and land use restrictions. Specifies what zoning or other restrictions apply to the building.
If your intended use would violate a zoning rule or private land use agreement, insist on a provision that lets you back out of the deal unless you are able to obtain a zoning variance or judicial relief from a private land use agreement within a specified time. Because of the importance of this transaction to your business and the legal technicalities that are often present with commercial lease transactions, we suggest that you obtain competent legal advice about the content of such a contingency provision.
- Tenant "going dark" rights. A fear of many small tenants in a shopping center is that a major tenant will go out of business or not renew its lease, known as "going dark". In the present economic climate, in which major department stores are filing for bankruptcy and closing stores, this is a real problem. One approach to this problem would be for you to negotiate a clause that gives you the right to close your store or get a large rent reduction if a major tenant or several other tenants go dark. Defining "major tenant" is usually a simple matter; defining "other tenants" may be done in terms of a percentage of the total square feet occupied by all other tenants.
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