To lease or to buy? That is the question
One of the more common questions we hear from businesses is whether they should lease or buy the space they need. The answer? It depends. There are many subjective and financial considerations that go into the analysis.• Use of capital: Leasing frees up money for other uses, such as investing in a company’s core business or other attractive opportunities. However, a tenant cannot realize the appreciation potential of owned real estate (although properties can depreciate in value, too).• Flexibility and control: Leasing allows a business to make short-term commitments and affords greater flexibility in expanding or contracting, but could force it to find a new home at the end of the lease term. It also allows a business to take advantage of current market concessions like free rent or substantial tenant improvement allowances. Owning gives a business control over its space, pride of ownership and marketing opportunities via signage that a tenant may not have. But owning also exposes the business to functional obsolescence.• Occupancy costs: Leasing requires virtually no down payment, and monthly expenses are fairly predictable. However, at the end of the term, these expenses may increase significantly during strong markets. Owning brings with it the potential for unexpected large capital expenses for damages, repairs, replacements, etc., creating uneven expenses.• Tax and financial matters: Lease payments are generally fully deductible and bookkeeping is fairly simple.Owning may require more sophisticated bookkeeping practices, but it affords tax deductions for interest expenses and tax deferral from depreciation, or cost recovery, resulting in lower overall occupancy cost, as well as appreciation in value.• Financing: For businesses that lease, the equivalent of 100 percent financing is available to them. For some, leasing is the only alternative because of their financial picture. Businesses that are growing over time may prefer leasing than negotiating loan terms and being forced to find the down payment required to get a loan. Stronger businesses can qualify for financing and thereby leverage their investment of capital by buying real estate. But loan agreements can be very restrictive, exposing the business to risks that are not of concern to tenants.Apart from the considerations mentioned above, there are two methods of financial analysis that can quantify the comparison between leasing and buying.One is the present value method, which compares the present values of the after-tax cash flows of the two alternatives. It allows a business to look at the expense of leasing against the expense of owning, taking into account the business’s after-tax opportunity cost of capital.The other is the internal rate of return method, which computes the internal rate of return on the difference between the two after-tax cash flows. Under this method, if the internal rate of return on the differential is less than the after-tax opportunity cost of funds, the business should lease rather than buy; if the return is higher, the business should buy.Making a lease or buy decision is more than a bottom-line matter, and experienced advisers should be consulted for a full analysis.Dan Scanlon, JD, CCIM, is an adviser with Grubb & Ellis|Coldstream Real Estate Advisors Inc., Bedford. He can be reached at 603-206-9605 or firstname.lastname@example.org.