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Advantages & Disadvantages of Leasing & Owning Commercial Property

Should you lease or purchase commercial property?

When looking for a commercial property, you may wonder whether to purchase or lease a space. To help you decide, we will outline the advantages and disadvantages of both.

Advantages of Leasing

Location – In certain markets, more properties are available to lease than to purchase, which provides a business with more options. Leasing may also enable users to occupy a space in a location where they couldn’t afford to purchase.

Flexibility – Leasing can provide greater flexibility to a user who may need to contract, expand or relocate in the future.

Availability of cash – Leasing typically requires less cash out of pocket than purchasing. Therefore, businesses have more available capital to invest in the company’s products/services or to establish additional locations.

Source of financing – Leasing can be viewed as a source of financing, which can benefit many small or marginally profitable firms that may find traditional financing difficult to obtain.

Stability of costs – The long-term occupancy costs of leasing are typically simple to estimate. Tenants are generally insulated from unforeseen capital costs such as the replacement of mechanical systems, structural repairs or roof/parking lot replacement.

Tax Benefits – Unlike ownership, the occupancy costs of leasing are fully deductible, including that portion of rent attributable to the value of the land.

Focus – Leasing space enables the user to concentrate on its primary business without the distractions of property management.

Disadvantages of Leasing

Cost – For a firm with a strong earnings record, ready to access to capital, and the ability to take advantage of tax benefits from ownership, leasing is often the more expensive alternative.

Loss of appreciation – Leasing means the tenant does not benefit from property appreciation.

Contractual penalties- If leased property becomes obsolete or the business occupying the space becomes unprofitable, the tenant must continue paying rent or face penalties for default.

Loss of salvage value – Many leases state that any improvements made by the tenant become property of the landlord at the end of the lease term or must be removed at the tenant’s expense.

Control – When leasing, users have little to no control over the other tenants in the building, rent increases and other factors that may adversely impact business.

Should you lease or purchase commercial property?

Advantages of Owning

Appreciation – An owner enjoys the benefit of capital appreciation over time.

Debt reduction & equity build-up– Assuming conventional financing, an owner enjoys debt reduction and equity build-up through amortization of the original loan amount, since both interest and principal are included in every mortgage payment.

Control – Within certain legal limits, a user who owns a building enjoys the opportunity to operate the building as they see fit.

Income – If a portion of the property is rented, income from other tenants can be used to pay the mortgage on the property or fund other business objectives.

Tax advantages – An owner enjoys the benefit of interest and cost recovery deductions that reduce the annual tax liability from real estate operations. Accumulated cost recovery deductions and capital gains from appreciation are typically taxes less than the user’s ordinary income tax rate. The user enjoys the benefit of those unused tax dollars until the property is sold.

Disadvantages of Owning

Time frame – The decision to purchase should be made with a holding period of at least five years in mind. Although commercially properties historically appreciate in values, the costs of acquisition and disposition may offset or eliminate the benefits of appreciation over a short-term holding period.

Inflexibility – Owned facilities often do not lend themselves to the expansion or contraction of building improvements.

Initial Capital Outlay – Most commercial lenders require equity at closing of 20 to 30 percent of the cost of the property acquired. This equity requirement ties up capital that could otherwise be deployed to grow the user’s business.

Management – The management of commercial property can absorb manpower and require an owner to focus on building management issues such as legal compliance, health and safety, contractor management and other issues not related to the user’s primary business.

Financing – The sources and availability of debt may be limited in times of economic recession or depression, and rising interest rates may make refinancing difficult or impossible.

Financial Liability – Although equity financing and investment capital may be readily available, a commitment to long-term debt financing often involves a 20 to 30 year amortization and possible loan provisions that mandate pre-payment penalties if a loan is paid off prematurely.

Risks – There are numerous risks to ownership, including internal and external obsolescence, market risks, financing risks and unforeseen capital requirements for repairs and maintenance.

Contact one of Menlo Group’s expert advisors to learn more about if leasing or purchasing is right for your and your business.

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