Mortgage interest rates are at historic lows, so it should come as little surprise that the usual debate among management teams at small and large business about whether to own or lease their real estate is heating up.
There are three basic questions that any business should ask when considering the alternatives of owning versus leasing.
* What will my business be like six to seven years from now?
* What is my internal cost of capital?
* Is real estate a core component of our business strategy?
Looking into the crystal ball
Predicting the future is a tall order and a challenging task in today’s fast-paced business environment. Knowing where your business will be and having a specific plan to get there includes having a good grasp of the physical plant that will house your employees and products, and the processes that make you a business.
If ownership is desired, be certain that you can envision your company and predict business demands and trends at least five years in the future.
Real estate is, by nature, capital intensive and not a liquid asset. Making a mistake on size, location or product type may take years to recover from financially.
The magic about predicting real estate needs six to seven years down the road has primarily to do with recognizing that appreciation of the real estate will occur, equity is being created with most mortgage structures and stable occupancy costs may swing in favor of owning versus increasing lease rates when compared to typical lease terms of three to five years. Unless you’re in a hyperinflation environment, owning real estate for less than five years becomes a break-even proposition at best.
More important than the time frame may be the impact of predicting sales growth and the support required to meet the growth. Support can mean people or head count, which translates into office space or inventory, which translates into warehouse or manufacturing needs.
Organizations predicting 15 percent to 20 percent annual growth will find it difficult to plan an owned facility. If markets shift frequently, flexibility may be key, and leasing becomes the optimum solution.
Internal capital costs
CFOs know how to keep score in many ways. But the most important way is deploying an organization’s capital. Cash is king in more ways than one, and it is not uncommon for businesses to achieve higher rates of return on cash deployed back into their businesses through product enhancement, product development and employee training.
Real estate is capital intensive and, in most cases, significant dollars may be deployed in real estate as equity or down payments, with returns ranging from 3 percent to 10 percent until such time as the real estate is sold and the capital can be redeployed. Many businesses achieve greater than 20 percent returns on their capital through their core business applications and find it difficult to tie up money in limited liquidity investments like real estate.
The counter point is simple. Real estate is a great place to park money, if it is available to be parked, and over time, it becomes a great asset source for mature businesses and a potential leveraging vehicle for funds in the future. Owning real estate should not be discounted totally by financial measures, but understanding the benchmarks and your internal cost of capital is a critical evaluation.
Strategic decisions
Do you really want to be in the real estate business? Even owner-occupied investments still require a degree of managerial and financial resources to make certain things work right, the lights turn on, the grass gets cut and the snow gets plowed. There are many instances, such as a strategic location for retail trade, a building is highly improved with special features, unique manufacturing processes, historic fundamentals or cultures, where owning the real estate is considered a core component of the business unit.
If you find yourself in this environment, by all means, own. But remember, you make your best investment when you buy by buying right and not when you sell.
Bill Ehret is the president and a founding principal of Summit Realty Group/A member of the Cushman & Wakefield Alliance. He has held the professional designation as an active office member in the Society of Industrial and Office Realtors since 1989, and has been involved in more than 600 commercial real estate transactions since 1982. Reach him at (317) 713-2106 or [email protected]
