Most know the essential benefits of owning real estate versus leasing their space, i.e. rent payments that could be building your own equity, control over your space, tax benefits, etc. But the following are five important considerations when deciding whether to own or lease your space.
#1 Do you have the interest and willingness to take on ownership?
Many can afford to own but other circumstances in their lives outweigh the traditional benefits of ownership. Factors such as flexibility, convenience, opportunity cost, etc. can make it more attractive to lease. Tenant’s simply treat rent just like any other “cost of doing business” and invest their capital resources elsewhere. It’s also helpful to consider the “headache factor” when evaluating ownership. Ownership may look good on paper but if it’s a drain on time and energy, maybe leasing is the better option. It’s one thing to be responsible for your own office space, but something altogether different when managing a building and tenants?
#2 Can you afford the down payment associated with ownership?
Most real estate purchases using conventional financing will require a 20% down payment, depending on credit and other terms. As an example, if you were to purchase 2,500 square feet of office condominium shell space at $300 per square foot, the down payment would be $150,000 (2500*300*.20). When you add in soft costs like attorney’s fees and architectural or design costs, plus a little for contingency, it would make sense to set aside $200,000 in cash for the purchase. Of course this doesn’t include interior finish out costs or medical or dental equipment and other FF&E. There are other financing alternatives, like an SBA loan or owner financing, but those options have to be carefully evaluated and considered. When considering a ground up development project and factoring in land costs and the construction budget, the down payment can be more substantial. Most importantly, a down payment shouldn’t deplete your cash position, particularly personal or practice reserves. Preparing a detailed project cost analysis can be a very effective tool for understanding the financial commitment before getting too far down the road.
#3 Can you afford the debt service on a mortgage?
If you own and occupy 100% of the property then comparing a mortgage payment to the prevailing lease rates for similar property in the area would be helpful in determining the effect on cash flow. Remember to consider real estate taxes, insurance, and common area maintenance or operating expenses (aka NNNs) when crunching the numbers. However, if there is space for lease in your project, a cash flow analysis comparing rental income to the debt service should also provide some key insight. Most lenders require a minimum debt service coverage ratio of 1.25, meaning annual net income is 1.25 times the annual debt service. An important consideration is the effect vacancy can have on the income needed to pay debt service. Can you withstand a prolonged vacancy and still meet the debt service obligations? This is often evaluated by analyzing a client’s global income and debt service to determine the client’s capacity to make the mortgage payment in the event rental income is insufficient. Note: it’s not uncommon for commercial space to be vacant for 12-24 months, called “lease up risk,” and it’s important to determine your ability and willingness to manage that risk. It’s a lot easier to make a mortgage payment when everything is going well, but can you make the mortgage payment when things aren’t going as planned? And for how long?
#4 Is ownership part of your retirement plan?
Practice owners eventually turn their attention to exit strategies when they’re ready to transition the practice. A common objective is how to replace income after they sell the practice. Owning real estate can be part of your long term plan for retirement. When it’s time to transition the practice, you have the option to sell the real estate, typically to the buyer of the practice, or, you could continue to own the real estate and lease the space back to the practice buyer. A detailed retirement cash flow and investment analysis would help determine which option may be best for you…selling the real estate (and investing the sale proceeds in another asset to generate income) or leasing the space for rental income.
#5 What are your practice growth plans? Think McDonald’s vs other fast food chains…
Historically, fast food restaurant chains didn’t own the land the restaurants were built on, they leased the land, called a “ground lease”. And for good reason. When a company was expanding their footprint by adding more restaurants or stores, purchasing the land required substantially more of their available capital. This meant less capital dedicated to building new locations. It’s a legitimate strategy, but one very different from McDonald’s. McDonald's is a real estate company. Because McDonald’s is franchised, franchisees own their store and pay McDonalds for the rights to use the name, logo, etc. but they also pay rent. McDonald’s earns more money collecting rent on their approximately 33,000 franchisees world-wide than royalty fees. However, buying real estate could reduce funds available for other growth initiatives, such as opening additional locations or the modernization of practice facilities or equipment, etc. Because capital is a finite or limited resource, determining your long term growth plans is an important factor when considering purchasing real estate for the practice.
These are our Top 5 Pro Series questions for leasing or purchasing real estate for the practice. But of course there are many more. Please seek the advice and counsel of real estate professionals, attorneys, cpa’s, etc. to make sure you’re looking at the decision from every angle. As always, we’re here to help in any way we can.
Wishing you success,
Robert C. Armstrong, CCIM, CIPS, CFP®, LEED AP®
RCA Global Partners