Revisiting the 'buy' vs 'lease' debate:

Posted On Thursday, 03 February 2011 02:00 Published by eProp Commercial Property News
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Alchemy Corporate Property Advisors outlines some of the pro's and con's of buying premises, rather than following the traditional route of leasing them

Michael SchirnigThere are at least three things to look at:
1) Get advice from an independent 3rd party (i.e. not the guy that's selling to you) as to the investment returns achieved in that area - you're an investor now, so put your money into a decent office node that is likely to provide a substantial exit price in 10-15 years time. Supply and demand trends are the most basic items to analyze, but there are many more - get a good guide (i.e spend time/money on having thorough research).
2) Get a buy-side advisor to analyze the "standard" offer to purchase and highlight areas that may unfairly favour the seller - this is a large and long term investment for most companies, so it's worth doing right up-front. The old adage refers: "an ounce of prevention is worth a pound of cure".
3) Ask a bank for a bond over the property, even if you don't need the money: banks typically process many deals of this nature (Vs the limited number of deals you may do in a 10 year period) so will provide a useful sounding board. If they ask for your firm to put in >35% equity, or turn down the deal altogether, take that as a significant warning sign regarding the investment status of the building and/or node...
4) And as a matter of course you have to do the other 8 or 9 things you'd do if you were simply leasing the space - staff growth projections, space planning etc.

Buying your premises: the advantages

+ Certainty via fixed costs and automatic renewals: Locking in your bond long-term can give your business clear, fixed costs and in addition, your “landlord” is unlikely to kick you out upon lease expiry!
+ "Zero" occupancy costs: Bond repayment amounts generally become cheaper than (annually escalating rentals) between Year 7 & 8 of occupancy and over the longer term, typically by year 12 of ownership, occupancy costs for the business can approach zero given that the initial bond would’ve been paid off. 
+ Tax Deductions: The costs of owning and running a commercial property can provide expense deductions in the form of bond interest, property taxes and other items.

± Additional income, additional headaches: Owning your premises means you’re in the property “game”. On the upside is the opportunity of renting out extra space to 3rd party tenants adding another source of income. However, being a reluctant landlord has it’s own costs – the hassle of managing leases, collecting the rent, replacing tenancies etc, fairly straightforward tasks when handled by a dedicated property management firm, but tricky to extract maximum value from when its not your core business. Also, until you have a substantial portfolio in place, its relatively cost inefficient to appoint expert property management staff to your payroll.

± Retirement fund: The prospect of owning commercial space and having the property appreciate over time, though almost certainly not at the extraordinary rates seen in the last few years, allows the owners of many smaller firms to sell out and fund their retirement. In the short term, any equity that has built up is an asset which can be used as collateral. However, corporate governance issues rear their heads when the property is owned in a separate entity by one or more directors of a public firm. Is the firm paying a fair market related rental to the director(s)? Or is the branch in now-innapropriate premises due to the building being owned by a director? These questions have to be transparently answered to prevent management time from being wasted in review meeting after review meeting to justify leasing premises from a director.

The disadvantages of buying:

- Lack of Flexibility: A new or growing business may experience unexpected needs in the future. If your business continues growing, your owned premises may become inadequate forcing a sale of the property, which can be tricky, in particular if you’ve customised it in a way that narrows its appeal to the general market.

- Upfront Costs: Buying commercial property will initially cost far more upfront. There are the building, transfer, appraisal and on-going maintenance costs along with a typically substantial down payment (25-35% of the value of the building, in the current mood) and possible property improvement costs.

- Not a realistic option: occupiers needing high profile premises in specific locations, e.g. a regional shopping centre, generally aren’t in a position to own their trading environments. With the exception of perhaps the Shoprite group, retailers in SA don’t have significant property holdings, as many American and British retailers do. So it would seem that pragmatism and culture combine in SA to make leasing the favoured option, for retailers at least.

- Working capital: money not tied up in property can be used to respond quickly to opportunities in the market. In addition, your ability to borrow funds will not be as limited as with buying your space.

- Lack of focus: Lastly, and in my mind most critically, is the question of focusing on one’s core business. A ‘widget’ company should by rights generate significantly higher ROI from manufacturing and marketing widgets, than it does from property investment (notwithstanding the previous bull market in property, which made accidental property millionaires out of many). So applying resources (capital + time) to managing property investments can be a costly distraction. And if the firm does in fact become world-class at property investment, it should sell out of the original widget business and re-focus on property – it’s practically impossible to ride two horses at once.   
Worth considering is the "core-satellite" approach, whereby one owns core properties - strategically important premises where one can take a 10+ year view - and leases satellite properties that can be chopped and changed as market conditions demand. 

In a UK study done by Cass Business School in London, it found that listed companies which leased 60-80% of their premises achieved a 71% better return over 14 years than their peers. Their conclusion was that where companies lease their premises, they seem to manage it more effectively than when they own it, and this efficiency is rewarded by the markets.

This is confirmed by the Gerald Eve/RICS study showing that UK firms used 17.6sqm of office space per person in their owned buildings and only 15.5sqm per person in leased premises, a significant difference of 13.5%.

In summary: stick to your knitting and focus on your core business. Do not get distracted by property ownership and, as a rough guide, lease from 60-80% of the portfolio you occupy.

Last modified on Wednesday, 21 May 2014 17:34

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