When is the Right Time to Buy Your Office Space Instead of Leasing?
This is a question I have heard many times from clients over my career, typically when lease rates are at historical highs or property values drop and begin to look attractive. I think without question that recent economic and real estate market conditions have created opportunities for corporate users to acquire properties for their operational use with attractive financial terms.
The idea of owning your business real estate for companies who never have seems like a great idea. For major corporate users with multiple locations who typically both lease and own key facilities there is less emotional appeal, and it is strictly a financial decision as they understand the implications of owning real estate and whether it’s a viable operational choice for a particular space requirement.
Most companies are in the real estate business by default as it serves as an operational need to produce products or provide services. The decision to buy versus lease corporate real estate is not a consideration that should be based solely on financial considerations but should include the evaluation of a more comprehensive set of decision drivers. Corporate real estate decisions are not only about the financial implications but also managing the risk associated with that decision.
Many internal and external factors affect such decisions and their eventual outcomes. These factors have to be carefully evaluated in order to make the decision that best complements the overall business objectives of your organization.
Why Today Might be the Right Time to Own
These items address the financial implications of the decision:
Lower Real Estate Values
Office buildings and industrial property prices have dropped across the board and very significantly in many markets. While we are beginning to see a fairly strong rebound in values in some markets, this trend has been confined to trophy properties in key markets. According to the Moody’s/REAL Commercial Property Price Index (CPPI), prices have fallen to the levels of 2003/2004 and for some markets and asset classes, the value deterioration may not be over for another 12 to 18 months.
Low Borrowing Costs
The cost of debt to acquire real estate is at historical lows, particularly for the owner-occupant. Access to cheap funds available to financially sound corporate users is going to make ownership look very enticing and the delta between their cost to borrow compared to real-estate investors’ cost to borrow is significant.
Cash Surpluses
Corporate earnings have been solid and many companies survived the recession sitting on significant cash reserves. U.S. companies are holding a record nearly $2 trillion in cash according to the Federal Reserve Bank and have been hesitant to hire again, but once they start they have the surplus capital necessary to invest in real estate without impacting other capital investment objectives.
Lease Accounting
The proposed lease accounting changes will place all leases onto the balance sheet, taking away one of the benefits of leasing (at least for those companies who have been sensitive to how many assets are on their balance sheet).
Weighing the Benefits and the Risks
However, as I have alluded to, an attractive financial transaction does not always translate into the best real estate decision. The benefits and risks of each option must be weighed carefully.
Leasing Benefits
- Lower upfront capital requirements
- The availability of various lease term choices (length) that best fit your company’s projected operational requirements
- More flexibility for growth and contraction both short and long term
- Ease of disposition at the end of the lease term
Leasing Risks
- Exposure to fluctuations in market rents and landlord-provided concession packages and incentives
- Potential for missed option and notice dates
- Disposition prior to end-of-term can be challenging, depending on market conditions and other factors
- Typically, dependent on third-party property management and service providers for quality of life and service issues
- Building ownership can change hands
Ownership Benefits
- Property Value Appreciation
- At some point with continued occupancy, ownership becomes less expensive each year on an actual cash basis
- Realization of residual value of tenant improvement costs
- Depreciation for some entities
- Tax Benefits (Income and Property if municipality offers incentives)
- Control of quality of life and property management vendors
Ownership Risks
- Ownership of real estate is a separate non-core business that requires time, real estate expertise, and resources
- Less flexibility than leasing particularly in growth and contraction
- Potential loss in asset value
- Economic and Interest rate risk
- The risk associated with a change in demographics, transportation issues, and perceived neighborhood quality
Decision Drivers
- Required capital outlay (including retrofit costs)
- The required return on investment
- Internal competition for capital
- Short vs. long-term plans impacted by other large capital investment initiatives
- Projection of required employee headcount based on revenue, product, or service demand (static or rapid changes)
- Projected market conditions
- Demographic and labor force shifts
- Neighborhood stability
- Capital appreciation
- Income tax implications
- Financial reporting
- Perception of stability as a result of ownership
- Exit strategy
The buy versus lease decision has a myriad of financial and operational factors that extend beyond the real estate asset and its projected occupancy cost. There should be equally as much consideration given to business needs and expectations. The recent depreciation of property values as a result of the recession also is evident in lease rates. Today’s market creates the opportunity for the commercial space user to take advantage and either purchase or locks into long-term leases at bargain terms compared to peak market levels prior to the recession. Lease rates will change as the economy recovers, concession packages will get leaner and market rents will eventually escalate. You can effectively achieve long-term control of a facility with a 7-15 years lease commitment and build flexibility into a long-term lease with expansion, contraction, and renewal options, but there will likely be some scheduled rent increases or exposure to the appreciation of market rents.
Owning is Typically More Advantageous as a Long-Term Decision, Keep the End in Mind
Purchasing a facility can certainly be a prudent long-term occupancy decision with significant financial rewards and operational advantages. The real question in my mind assuming the economics are attractive is how much or how likely will your business or space requirement change, and will ownership of a building create significant challenges in managing those changes? Owning versus buying is not only a financial decision but equally as much a risk and operational decision.
You have to consider not only how attractive ownership might be going in, but also what will be different if you own and how you will meet unexpected changing space needs. Can the building or site be expanded or is leasing additional space at nearby buildings viable? Is excess space marketable to third-party tenants if staff reductions are necessary, and what is the exit strategy and projected value of the asset if required?
During my career, I have helped users lease, purchase, build, sale/leaseback, sublet, and dispose of office and industrial space. I am ready to help you make and execute a prudent decision.
