By Stephen A. Cross, CCIM
Generally speaking, leasing provides flexibility. However, as lease rates escalate regularly, the ability to relocate and/or quickly right-size comes with an ever increasing price tag. Owning the building that houses your business helps ensure long-range stability. In addition to having pride of ownership, benefits of owning include: 1) The ability to control the costs of occupancy; 2) The drastic reduction in occupancy costs when the mortgage is retired; 3) Real estate is an asset that can be sold or leased to others; 4) The buildup of equity can be used to generate cash through refinancing.
With that said, there are several critical decisions and factors that warrant careful consideration before proceeding with a purchase of commercial property:
Decision #1: Have you saved enough cash for a down payment? Most lenders will finance 80 to 90 percent of the purchase price for commercial real estate. In some circumstances, even the down payment can be borrowed, and certain professionals, most notably those in the healthcare occupations, can obtain loans for the full purchase price plus funds to complete needed improvements.
Decision #2: What is the likelihood that your business or practice may need the down payment amount as future working capital? Many business owners and corporate decision-makers choose to lease space because they reason the money tied up in an illiquid investment (such as real property) can be better utilized to grow their businesses.
Decision #3: What type of image do you wish to project? Most businesses and medical practices do not require prime locations and typically need less than 10,000 square feet of space. Thanks to the availability of business condos, small–to-medium sized office users, medical practitioners and those requiring warehouse or showroom space can now readily locate suitable properties to purchase.
If prime locations, large floor plates and upper-story views of the city are important to you, leasing space will probably be the best alternative.
Decision #4: Should you buy a building adequate for your current needs or invest in a multi-tenant property? If your business is likely to grow, consider acquiring a building larger than required and leasing the unneeded portion to others for either short terms or stager expiration dates to ensure space is available when needed. If you elect to purchase a multi-tenant building, always include a relocation clause in each lease, giving you the right to move a tenant to another space in the building.
(Seldom Discussed) Factors that Affect Price
Financial institutions generally require a formal appraisal of the property, typically from one of their approved appraisers. The appraisal will confirm whether the purchase price is reasonable when compared to recent sales of similar properties. Purchase contracts should contain a contingency provision specifying an appraisal “satisfactory to your lender” is a material element of purchase. In the event the appraised value comes in lower than the purchase price, request a reduction in price from the seller; otherwise, you will likely need to contribute additional cash to complete the purchase.
Be mindful that property owners hire listing agents to market their properties for the maximum amount possible. These agents have a fiduciary duty to protect the interests of their client (the property owner) and generally answer only those questions a prospective buyer thinks to ask. Even then, many times their answers are vague. Tip: Ignore so-called “upside” potential, “market” rates or “comparable” sales. Fully investigate all representations made by the listing agent(s) and property owner, as well as factors that directly affect the price.
The selling price of existing buildings has been greatly affected by investors seeking to complete a “1031 exchange.” Section 1031 of the IRS code provides for the deferment of taxes on the appreciated value of a property when exchanged for a like-kind, more expensive property. To avoid current taxation, and because of time limitations in completing the exchange transaction, many property buyers have been willing to pay top dollar for commercial property, thus inflating the “comps.” Prices paid in 1031 exchanges are many times not true comparables.
Some sellers increase the perceived value of their multi-tenant investment properties by deferring capital improvement expenses and providing significant up-front concessions to tenants (free rent, tenant improvement allowance, etc.) in order to induce them to sign leases with high-contract rent rates. Taken together, these tactics serve to increase the NOI, or Net Operating Income. All too often, unsuspecting buyers pay prices based on the capitalized value of understated expenses and artificially inflated rental schedules, only to find the roof needs to be replaced and tenants are requesting deep concessions at lease renewal time. Hire experienced building inspectors and read all leases and amendments carefully. I suggest interviewing each tenant during the due diligence period to confirm whether they have received any inducements, their feelings and opinions about the building, as well as their intentions and expectations.
In order to make fully informed decisions, savvy tenants and buyers obtain objective information about properties and guidance from an unbiased, experienced commercial real estate advisor and refrain from representing themselves in any commercial real estate transaction. An objective tenant or buyer advisor does not list properties and therefore avoids the inevitable and unavoidable conflicts of interest that arise when one agent, or multiple agents from the same company, attempts to represent both tenant and landlord, or buyer and seller in the same transaction.
All things considered, it makes good economic sense to invest in commercial property as soon as practical and economically feasible. In the long run, commercial real estate should be viewed as a source of wealth creation for you and your family or, if you continue to lease space, for your landlord’s family.