Buy or Lease?

3 Real Buildings Shed Light

by Robin Holleran

Whether you own your business or operate it for others, you’ll face the decision of when to own and when to lease facilities. Arriving at the right answer is often not all that straightforward. At times, the prices paid and motivations behind these acts seem to be more influenced by the pull of the moon than logic.

“The commercial market is a function of economic conditions, interest rates, and supply and demand,” says Steve Fleming, a senior vice president at The Staubach Company, an organization devoted exclusively to user representation in the office, industrial and retail markets. “We have some clients who’ve been able to sell their buildings at a considerable profit after 10 years, while others only expect to recover their initial investment after the same time period.”

Prior to committing to any real estate investment, the following questions should be considered, according to Fleming:

• What amount of flexibility is required in a company’s long-term business plan? (Flexibility applies to both finance and space requirements.)
  
• Where is the highest return on capital generated—in the core business or in a real estate investment?
  
• What are current and projected market values for both leased and owned real estate? How do the projected economics compare for both scenarios over a 10- or 15-year time frame?
•  Are the assumptions used in the buy-versus-lease projections realistic? Assumptions can be manipulated to make any scenario attractive, and it’s easy to fall into the trap of being overly optimistic.
•  What impact does a purchase/lease decision have on the balance sheet?
•  Are there any specialized aspects of the property or business operations (such as machinery or equipment) that need to be considered?

Because each situation is so different, the ultimate drivers of a deal can be any number of qualitative and quantitative factors unique to the company and/or individual(s) involved, although in Fleming’s experience, the decision to buy is often based purely on personal philosophy.

Rick Coyne, a CPA with the Princeton office of Withum-Smith+Brown, recently advised a Monmouth County client on a $10 million building acquisition. The first, and simplest, financial test was determining how the monthly payments on a commercial real estate loan compared with the company’s current lease payments.

In doing this, he ran several different scenarios using a 20 percent cash deposit and either an 8 percent rate for a 20-year term or a 7½ percent rate for a 25-year term (we’ll skip the adjustable rate options). In addition, Coyne recommends a 6 percent opportunity cost be calculated on the deposit monies being committed to long-term real estate rather than being reinvested in the core business operations.

“Anything more than 6 percent would be a high-risk investment anyway; anything less and you might as well put the money in the bank or other safe investment vehicle,” Coyne observes. “I also generally don’t factor in capital gains, especially if this is a dedicated client that expects to stay in the building for some time, because depreciation is subject to recapture at the time of sale anyway. Besides, capital gains rates are difficult to reasonably project because they’re likely to be raised.

Coyne also tends to lean toward a conservative analysis of a real estate investment, especially in these less-than-certain economic times, and not consider any potential appreciation on the future sale of the building. If a proforma is still economically feasible with a sale 10 to 12 years down the road at the same price for which it was purchased, then the deal is a slam dunk.

This brings in the whole issue of assumptions and market values. Projections are only as good as the numbers used—and nobody, despite claims of any prophetic abilities, can accurately foresee future values.

Otteau Appraisal Group, a leading real estate consulting and appraisal firm in East Brunswick, tracks a multitude of variables throughout the residential and commercial markets. According to Niels Guldbjerg, vice president of the firm, there are four very distinct sectors of the office market, each experiencing different conditions. The top-quality, often very large, Class A headquarters buildings are currently experiencing the largest vacancy rates, while Class B is faring slightly better, and Class C is still holding strong. Flex buildings, a combination of storage or manufacturing spaces with a smaller component of low- to moderate-quality office space, are also holding their value.

Flex space works well for many businesses because the rental rate is significantly lower than that of regular office space, and as the name suggests, it provides for great flexibility for a tenant or an owner. “If an owner needs additional office space, he can often convert some of the warehouse space into office or vice versa,” Guldbjerg observes.

Each submarket in New Jersey also contains its own set of variables, making it all the more important to fully investigate each area prior to making a decision to purchase or lease. Many investors also buy buildings that are slightly larger than what’s required for their current needs. This way, they can lease the excess space, preferably on a short-term basis, and use the income to cover some of the building’s carrying costs yet still retain the option of retaking the space as their business grows.

In addition to financial considerations, Coyne points out that not everyone is well suited to handle the day-to-day headaches that accompany property ownership. It’s one thing to call the landlord when the air conditioning isn’t working; but it’s quite another to deal with the issue yourself and with potentially angry tenants.

Also, moving costs can vary considerably from one use to another. It doesn’t take much for an office to unplug a few computers and pack-up a few file cabinets, but a manufacturing business with 17-ton equipment bolted to the ground with an underground water system is an entirely different situation. In those circumstances, a business wants to move once and stay put for a long time.

Despite the words of warning contained in the news, Coyne believes the time may be ripe for investing in commercial real estate as many “old school” property owners are starting to divest of their holdings. This suggestion, of course, comes with the caveat that the company has sufficient cash flow to endure a recession should one come.

“The last thing anyone wants is to be put in the same dilemma as many homeowners now trying to carry variable rate mortgages on homes with values less than the mortgage,” concludes Coyne.