own v. lease: should you buy commercial property
There are several schools of thought when considering whether or not to own or lease commercial real estate. Some – like myself – view real estate as the safest and most reliable method of attaining financial independence and creating wealth. Others see company cashflow as the basis for wealth and consider real estate to simply be a capital asset as a necessary means to achieve said cashflow. In reality, both are correct and justifiable depending on the buyers objective and the business structure and its goals. With that being said, owning commercial real estate has many advantages over leasing which qualify it as an asset rather than a liability:
Property Appreciation
Real estate may fluctuate on a microeconomic scale, but historically, property values have risen very steadily over time. Appreciation generally has a direct correlation to inflation, increased job opportunities within a market, overall community development, ability for a market’s supply to meet the needs of immediate demand, etc. While the inflation rate (which just surpassed 9% this week) affects the operating expenses, which impacts both tenants and property owners, it can also increase the appreciation in the value of the property due to the raised rental income.
Depreciation Schedule
The current tax code allows depreciation write-offs for owners of commercial real estate. Owners may use a valuable tax code to offset income on their property by depreciating the building (not land) over an “economic life” of the building. The IRS code allows an owner to amortize the useful life over a 39.5 year period. Meaning, if a building has a value of $1 million, a qualified owner may write off $25,316 annually against the income on the property. Commercial depreciation acts as a ‘tax shelter’ by offering a reduction in the taxable income and potentially lowering the tax bracket of the investor. Now, the IRS can recapture depreciated value by charging a capital gains tax in the year the property is sold for the difference of its “basis” and sales price. The investor, however, may consider doing a 1031 tax deferred exchange to delay any capital gains tax and diversify their property portfolio.
Leverage
Leverage is a concept that hinges on the idea that an investor/owner user can attain a higher percentage return on their investment by leveraging the transaction with financing. While leverage through debt can greatly increase the potential return, there is also greater potential risk to cash flow if income were to stop. Take, for example, an investor looking to deploy $1 million in capital into a commercial property. If this investor were to invest in an “All Cash” transaction, buying a $1 million property, and that property appreciated by 3% annually for 20 years. This property value would be worth $1,806,000 at the end of said 20 years. However, the same investor could choose to invest his $1 million into a “leveraged” transaction worth $5 million (20% down payment). If this property were to appreciate by 3% annually over the same 20 year period, it would be worth $9,030,000. Though significantly riskier, the investors potential return increases from 80.6% to 371% over 20 years.
Example:
“All Cash” Transaction:
$1.0 million property
$1.8 million value in 20 years
$806,000 gross profit = 80.6% or 4.03% per year for 20 years.
“Leveraged” Transaction
$5.0 million property
$1,000,000 down payment
$4,000,000 Loan
$9.03 million value in 20 years
$4,030,000 gross profit – less debt service (-$316,776 Debt Service*) = $3,713,224 profit.
$3,713,224 profit / $1,000,000 Down Payment= Return 371% or 19% per year for 20 years.
· Note based on 5.0% APR, amortized over 20 years
Another advantage to ownership is principal reduction to the loan balance in the case of using an amortized loan. The ‘Principal Reduction” is a decrease in the amount of the principal amount of the loan though the principal and interest payments being made on the property.
There is an array of different strategies buyers can utilize to mitigate risk, maximize profits, etc. which can be catered to the specific approach and long-term goals the buyer has. It is important to note, that some of these strategies may not suit your investment methods and objectives. As I mentioned, there is no “one-size-fits-all” when it comes to commercial real estate. Please consult with an attorney and financial professional before investing in real estate. I would encourage anybody interested in learning more to reach out to me for a more detailed conversation about how owning v. leasing can benefit you.