LEASE VS. BUY

PART 1:

Clients who are looking for new spaces are often faced with the choice of leasing a new space or purchasing a new space.  Which is the best option?

My humble belief  is having someone else buy the building and then proceed to donate it to you, because of your yeoman service to the community as the west coast distributor of Whoopee cushions, is the best option for most businesses.  Heaven knows that Los Angeles has plenty of denizens that could use the a little loosing up with humor centered in the  the trouser region.  I must say this would truly be a commendable community service, but I digress.

If after researching this option and becoming reasonably certain that you will not be given a building for free; the answer becomes much less straight forward.   So let’s look at the pros and cons of both options.  By cons I mean negative aspects of a particular course as well as BS that real estate folks may tell you.

This will be a discussion in 3 parts, partly due to the fact that my ADHD will not allow me to sit at the computer long enough to compose it as one post.   Partly because I’m not paid to write this stuff and my wife has informed me that we are low on the $70 a bag dog food my fur factories are fortunate enough to eat.  Which means I need to do some work for a client (not you of course, my other client) that will eventually result in me not getting paid.

PART 1) LEASING:

or as many landlords refer to it “Paying my mortgage and the boat loan on my 40′ power cruiser named ‘It’s Good to Me’ “.

PROS OF LEASING:

• Minimizing the capital tied up in real estate: When entering into a lease typically you only need to have a month or two of security deposit and a month or two of rent.  In most cases this substantially less than the cash needed to purchase a building.  The cash you save can be reinvested into your business or reinvested into a 41′ power cruiser with a name like “Mine’s Bigger than Yours” or some such ego driven slice of nirvana.

• Increased Flexibility: No I’m not talking about touching your toes; though I do have fond memories of that activity.  When signing a lease you have a large amount of discretion to decide how long of a term (length of time) you want.  You can look at your business, look at the growth, look at the risks and make an educated guess about your expected tenure at a location.  When that term has expired you get to decide whether you want to renew, expand, move, etc.  This provides substantial flexibility to keep your business profitable through the various onslaughts of the business cycle.

• Dealing with the unexpected: Though you thoughtfully put a plan together that was detailed down to the number of employees named Edward that you would have, the world went ahead and ruined it.   Your company grew faster than expected.  Your brother in law Edward – the sales savant – was actually only good at selling you on the fact that he wasn’t going to embezzle your cash reserves and retire to a tropical island without extradition treaties on HIS new 41′ boat “Mine’s Bigger Than Yours”.  If these and one or more of the myriad of other common occurrences do strike your business; you have the options.  For example you can negotiate a termination clause, sub-leasing a part or all the space, or even in dire situations dissolving the company and joining your brother in law on his new boat.  Where you can earnestly discuss the piss poor luck of people falling overboard at sea never to be seen again- but only after obtaining his offshore bank account numbers.

• Landlord Paid Tenant Improvements: This is simple; the landlord gives you money to build out the space like you want it.  This is a pro and can be a con.  (For the con see Capital Expenditures below).  Depending on market conditions and the policies of the various landlords this allowance can range from the substantial irksome zero dollar figure to dizzying heights where you are compelled to dance a jig and should feel a strong obligation to give your broker a nice bonus, say an all expense paid trip to a nice ski resort (Did I mention I love to Ski).

CONS OF LEASING:

• You are paying a strangers mortgage for them: You are paying rent, not building equity.  You been in the same building for 20 years and paid the mortgage for the owner 2 times over.  Your company’s name on the Landlord’s invoices to you reads “Cash Cow Incorporated”.  Lets say both you and the Landlord are ready to retire; he owns a building “free and clear” that you paid for, while you have 2 million dollars of whoopee cushions in inventory that are now worth less than a fart in the wind.  Many a business owner has made more money on their property than the sale of their business when they retired.  You aren’t one of them.  On the plus side you can name your 10’ dingy “ Sucks to Be Me”.

• Rents go up: Yes the rental rates go down too, but rest assured that in Southern California the trend is upward.  When you purchase a building you generally have quite a bit more stability in your monthly expenditures for property.   In 5 -10 years you would sell your first born to have the mortgage payment that you were grousing about when you decided to pass on the purchase and lease a new space.   On top of that is the cost of the therapy to handle your self esteem issues; caused by your spouse’s constant reminder of the fact that they told you to buy that property.  That of course is coupled with the shark like smile on your landlords face, as she comes to visit you about your latest lease renewal that falls, like clockwork, 6 months before the market tanks and lease rates drop 20%.  “Oh yeah you are great at timing that market” quips your spouse and you hang up on him/her and return to conversation with your therapist that is only costing you marginally less than your next monthly rental increase.

• Capital Expenditures: When you lease a property it is very rarely ready to go the date you sign the lease (office space is often the exception to this rule).  More likely you will have a TI budget from the Landlord the will be woefully inadequate to renovate the space to condition that is usable for your company.  This leaves you with the wonderful opportunity to create a very nice space in someone else property that they get to keep when you leave.   Remember if it is screwed, glued, nailed, painted, or in any way attached to the building it becomes in technical terms a “fixture”.  Almost all leases say a fixture is the property of the Landlord the moment they are affixed to the building.  $1500 imported Italian door pulls, “you shouldn’t have.”  $10,000 in  modern light fixtures, “You are too kind.”  New fitting rooms and wall mounted display system, “your charity knows no bounds.”    Keep this thought in mind.   You spent $100,000 of your hard earned money to make your space cool, hip and drenched in awesomeness.  In 3 years when your lease is up your landlord is going to charge you 20% more in rent, because your space drenched in awesomeness (that you paid to create) now is worth 20% more in rent on the market.   By the way, if you decide to leave, make sure you don’t take the Italian door pulls the landlord is very attached to them; he would hate to have to sue you to cover the replacement cost.

This is a short list of the pros and cons; of course there are many more that I won’t bore you with.  This is code for “I’m tired of typing” of course, and I need to go practice getting hurt at my Brazilian Jiu Jitsu class.  If you have questions please don’t hesitate to contact me.  My day job is that of a commercial real estate broker.

I will leave you with this thought:

What is your primary business, the goods or services your company provides or a real estate investor?  Where is your cash going to be used most effectively to generate wealth?  (For you socialists where is your cash going to create the most jobs for the working man?)  Look at this honestly, most business will be better served leasing a property and using to capital to grow and strengthen their business.  There have been many businesses that have gone under because the ownership wanted to own a building and the strain on the cash flow was too much.  

Part 2:

This is the second fabulous installment in the lease vs. buy question facing business owners, focusing on scintillating pros and cons of buying a building.  I can feel my heart racing with excitement already, or maybe it is indigestion from lunch.  Regardless, I’m going to go with excitement.

Now in the first installment I said leasing is more beneficial than purchasing for a majority of businesses, but not everyone fits the majority stereotype.  For many businesses purchasing a property is a better strategy than leasing.   While there are many pertinent points on this issue, I have highlighted a few of the major ones.  I would have to change my title from broker to author to attempt to cover them all.

PROS OF PURCHASING:

• Building equity in an appreciable asset: When you purchase a building your company’s monthly “rent” is not being paid to some money grubbing landlord.  It is being paid instead, to a money grubbing banking institution (in most cases).  But, not all of it.  Some of your hard earned cash goes to pay down the principal amount on the loan; so, every month you effectively own a little more of your property free and clear.  If you make your payments long enough you will eventually own your building outright and can brag to all your friends that you are a brilliant real estate baron.  All that money you were paying in rent is now going into your pocket where you can trade it in for a sports car and a trophy spouse. This being the 2000′s this can be a male or female trophy, for those that are accusing me of being misogynistic in my view of business owners…thank you very much.

• Rent stability and long term rent reduction: In most cases (in SoCal) when a property is initially purchased, the mortgage and other property expenses are higher than renting a comparable space.  But, typically your property expenses stay pretty flat while rents in Southern California have an annoying habit of going up.  Eventually your property expenses will be so far below market, you have a competitive advantage on all the those who still rent; whom you now refer to as idiots.  Additionally, you are not at the mercy of what a landlord decides is fair rent for your leased space.  When leases expire landlords have a despicable habit of raising the rent to market value.  This may mean a considerable jump in rental expense, and subsequent reduction in disposable income.  You as a property owner don’t have to worry about these issues.  This can be a great stress reliever and help you keep more cash in your pocket so that your trophy spouse can spend it as per your marriage agreement.

• Retirement Income: Eventually, as a business owner you may decide that you want to retire and let your progeny run your business into the ground or sell it to some stranger so they can run it into the ground.  Regardless you now have a building that you own that can generate substantial income for you with minimal effort on your part.  I know what you’re thinking, this would have been so much easier if my parents bought the building and gave it to me 30 years ago.  I have the same feeling.  I can’t help you there.  After you retire you can rent your building out to the new owners of your company at a market rate, or even above market if said owners happen to be family.  Alternatively, if that isn’t a viable option, you can hire a broker to lease the property and create a nice monthly income.  Let me take this opportune time for me to mention that the author of this article is a talented capable broker who is waiting for your phone call with baited breath.

CONS OF PURCHASING:

• Lack of flexibility: Flexibility does not only apply to yoga studios.  When you purchase a building for your company, you are effectively stuck with that building until you can lease or sell it profitably.  Depending on where the real estate cycle was when you purchased the building this typically falls in the range of 1 to 10 years from your date of purchase; with 5 years being a good rule of thumb number.  Pricing on owner/user buildings in Southern California makes even the breakeven leasing of the property difficult if not impossible for years after purchase.  The cost of selling a property, with commission, closing costs, loan prepayment penalties, etc. make selling the property a similar proposition.  If you need out of a property the cash flow issues this may create are not typically beneficial to the stability of your trophy relationship.

• Initial cash flow issues: Some business owners (certainly not you of course because you are assumed to be brilliant due to fact that you are reading this blog) purchase a building and create a difficult cash flow issue for themselves.   The initial down payment for the purchase drains a substantial portion of their cash reserves or borrowable equity, and the higher property expenses (at least for the first few years of ownership) on the business affects your cash flow. This coupled with slow payment from clients; a drop in business; the inability to rent the extra space in your new building; the blackmail payments for your progeny’s indiscretion; etc. can all create a negative effect on your cash flow.  More than one owner has ruined a perfectly good company by overextending their resources in an ego driven need to own their own building.  Spend time understanding the impact a purchase will have on your business prior to jumping into a purchase.

• Cost of Ownership: This may surprise you, but it costs money to own and maintain a building.  You’re thinking to yourself “Well no S*@t Sherlock”; but let me tell you, it will cost more money than you think it will.  There are many maintenance costs that you will incur on a property eventually.  These may include remodeling, new HVAC units, structural retrofitting, parking and yard repair and maintenance, painting, etc.  While it is true that many leases have maintenance costs allocated to the tenant, there are still costs the owner pays for, even in a NNN lease.  As a property owner you get to pay for ALL of these costs.  It is imperative that you have cash available through your own considerable assets or through a maintenance reserve fund you create and pay into.  Nothing will piss a trophy spouse off more than having to drive their 3 year old German sports car, when all their friends have brand new ones, because you needed to repave the parking lot.

So, now that you have read the pros and cons of leasing and buying; how does it apply to your business and your specific criteria?  Great question you’re thinking, I gave myself a big gold star for that one.   So let’s look at situations that lend an argument to leasing or buying for a company…In the next post.  Cruel I know, but hey I live in L.A. so I am partial to the cliff hanger cliché.  So tune in next week for another exciting installment of……..

PART 3:

So you read about the pros and cons of both leasing and selling and enjoyed the humorous delivery of the subject matter (okay, okay, maybe not that humorous) but now your thinking to yourself how in the name of all that is useful does this apply to my business and situation.  The reality is all of the verbiage in the previous posts is nothing more than a great exercise in creative writing if you the (smart, attractive and savvy) business owner can’t apply it to your situation.

There are two approaches to applying it to your specific situation.  The first and most effective method for analyzing your specific situation is to call a good broker, whom you trust to be honest and not steer you towards purchasing a building for the main reason that purchases have larger commission checks at the end of the rainbow, that rat bastard.  A good broker (or agent) will be able to use their Jedi mind tricks to help you identify the key issues affecting your business as they relate to leasing or buy and steer you in the right direction.  If I may humbly make a plug for the writer of this article, yours truly, as an experienced, honest, dedicated, hardworking and downright good broker if you need one to fit the above criteria (not the rat bastard part, the other good part).  The second method, and the one used here, is talk about general conditions affecting a business that dictate that a company would be better off leasing or buying a property.

Cash Reserves:

Every company should have cash reserves to handle emergencies such as; college friends coming into town and requiring a debacle of carnage trip to Las Vegas; the slightly more mundane seasonal inventory purchases; or the spa week with friends because you NEEDED to get away.  Regardless having cash reserves is important.  It is generally not a great idea to purchase a building if the purchase is going to substantially deplete your cash reserves.

Growth:

It is important to understand the growth and anticipated future growth of your company when evaluating the purchase of a property.  If your company is growing faster than the national debt, purchasing a building would create a physical constraint on your growth; it like a reptile that can’t shed its skin and is packing more and more inside a rapidly tightening space.   I’m not saying your company has reptilian tendencies, now stick your forked tongue back in your mouth!  It can typically take 2- 3 years for a building in our market to appreciate to the point where it can be sold profitable in a rising market.  In today’s market the building you bought 2 years ago will break even on a sale when we have genetically engineered pigs to fly; 5 – 7 years!  So, if you think you may out grow or out shrink your building in the next 3 – 5 years it is typically better to lease a building.

The Real Estate Cycle:

As much as a shock as it was to Wall Street and the brilliant folks that packaged mortgage backed securities and insured them, real estate values can go down, shocking I know!  The typically cycle involves credit loosing up over time, the economy flourishing and more and more people being able to qualify for loans.  Sale prices increase substantially, while rents tic up slowly and the classic real estate bubble is formed and eventually something causes the bubble to pop and you have a recession and a reduction in rents and property values.  A property that was bought 2 years ago could be bought in today’s market at 30% – 40% price reduction.  No one can definitively time a market, but understanding when the market conditions create situations where a bubble is occurring can help owners make smart decisions regarding purchasing or leasing a property.

Business and Retirement Goals:

What are the goals for your business as well as the planning for retirement?  I myself want to have a “Dr. Evil-esque” private island where I can threaten to launch snarky verbal attacks unless I get paid a ransom of $1 miiillion dollars, whaaaa haaa haaaa haaa, but I digress.  If your business is stable and generating great cash flow, and your progeny hasn’t discovered embezzlement as a form of employment, buying a building can be a very smart investment for retirement and investment for your cash.    If on the other hand your business is growing faster than a commuter on the 405 freeway with no traffic, you may want to consider leasing to free up more cash and flexibility to assist in facilitating the growth.

Dealing with Business Cycles:

I have talked to multiple business owners who said in essence if it wasn’t for the fact that they owned their buildings and pay very little (if anything) in mortgage, they wouldn’t have made through this recession.  The investment in a building and paying down the mortgage, or buy a building all cash when times are good creates benefits when times are bad.  The important issue is not to be caught with a mortgage that is 50% higher than market rents when times are bad, this has put many companies out of business.

I’m sure you found these articles helpful; I know this because if you didn’t you would have stopped reading this long ago.  I encourage you to contact me if you have other question on leasing or buying a property.  I enthusiastically encourage you to contact me if you are going to lease or purchase a new property in the near future.

Best wishes,

Chris

Chris@chrisla.com

Chris Barbieri is a commercial real estate broker specializing in the office, industrial and retail markets in Southern California.