A Guide to Buying Business Property
If your business is going strong — perhaps on pace to outgrow its current space — you might wonder whether it makes sense to buy your building rather than leasing it.
While the answer depends on the details surrounding your company, plans, location and personal preferences, the potential advantages of buying make the decision worth exploring for most business owners.
Investing in a property to house your business can bring financial and operational benefits now and significant wealth and retirement income later.
“If you're paying rent, you might as well pay a mortgage and own it," said David Cameron, City National Bank's executive vice president of Personal & Business Banking. “Oftentimes the real estate is worth as much as the business in high-density markets. It's a secondary way to accumulate wealth."
6 Benefits of Owning Your Business Property Rather than Leasing
Use as an Investment to Support Retirement
This strategy may not work well for those planning to sell their companies in a few years, but entrepreneurs with longer time frames are more likely to be able to pay off their commercial mortgages, keep the property and collect substantial income from future tenants in retirement. Meanwhile, long-term real estate trends should work in their favor.
Economic cycles typically last about seven to 10 years, so businesses looking to hold onto a property in a high-density area for two or three decades are likely to see the facility appreciate in value over the company's life cycle, according to Cameron.
Even an owner with only 15 years until retirement could benefit from investing in a property in a desirable commercial market, Cameron said, noting that during the Great Recession and recovery, from roughly 2008 through 2012, commercial real estate values "performed very well."
Generate Rental Income Now
Owners, who often form LLCs to buy their property, may not need to wait decades to derive some income from the building.
Depending on the type of business, the building and their real estate loan restrictions, entrepreneurs may be able to rent out parts of their industrial facilities or office buildings to tenants, thereby subsidizing their monthly mortgage expenses or perhaps breaking even on the property.
Commercial real estate development trade group NAIOP reported strong industrial space demand in U.S. markets in early 2019, with an historically low 7% national vacancy rate - decreasing the chances of a downturn in the industrial market. Meanwhile, record high asking rents across the country indicate that market supply continues to tighten steadily.
"Overall, the U.S. industrial real estate markets appear to be healthy and stable. It is the asset class that is potentially in the best position to weather any macroeconomic downturn that may come in the next several years," the report said.
Of course, there's no guarantee that every retiring business owner will instantly reap financial rewards from his or her real estate investment, but the property itself can provide some protection nonetheless.
Lower Costs with Fixed Mortgage Payments
By fixing your monthly mortgage payments for a decade or longer, you can hold down costs by protecting your business against rising lease rates, which a landlord could increase annually. While you'll have to make a down payment up front, you may well enjoy lower monthly mortgage payments as a building owner than you would with lease payments as a tenant.
Those making monthly lease payments, meanwhile, are missing the opportunity to build equity and own something, Cameron noted.
In addition, business owners who've invested in their commercial real estate may be able to borrow against the property to extract cash flow for their company.
Customize the Facility to Suit your Business Needs
Business owners who lease rather than buy also may find themselves facing greater environmental, zoning or landlord-imposed limits on what they may do with the property. For example, manufacturers in particular need significant latitude to customize their facilities.
It's important for business owners looking to buy a particular property to explore the surroundings and the regulations and covenants affecting the real estate.
Buyers can walk around the area, talk to neighbors, check with the local government and use a knowledgeable broker. Early due diligence can prevent legal difficulties after the site is bought.
Leverage Tax Advantages such as Depreciation and Interest Deductions
While businesses leasing their space can deduct rent payments from their income taxes, ownership also brings significant tax advantages, including potential depreciation on the property, which lowers taxable income, and a mortgage interest deduction. Consult a tax expert to help you analyze the numbers to see if they work in your favor compared with renting.
Factors to Evaluate Before Purchasing Your Commercial Property
The first question a business owner must answer before looking at the financial analysis is whether he or she wants to own commercial real estate, said Cameron. Many entrepreneurs simply want to focus on running their business and therefore aren't good candidates for real estate ownership.
But for those interested in adding real estate to their portfolio, it can be a worthwhile investment.
Cash Flow, Debt and Expenses
If businesses are growing and profitable, enjoy strong cash flow and don't carry excessive debt, their owners are generally very good candidates to buy a building, noted Cameron.
Cash flow is critical, he said.
“As an entrepreneur and potential real estate owner, I want to be confident that my business is sound and can support the debt on the building because it's really the cash flow of business that has to service the loan," Cameron said.
For entrepreneurs whose firms have a strong cash flow and little debt, commercial property can improve their financial foothold.
“It's advantageous in almost any case for a business owner to own their building," Cameron said, noting the significant expense associated with property rental. "It's about controlling costs."
A business owner who can keep building costs consistent even as other expenses escalate will make more money in the future, Cameron explained. “You're controlling your largest fixed expense when you own your own building. You're also able to customize the building to maximize operating efficiencies."
Building ownership isn't a one-size-fits-all prospect, and owners need to closely evaluate their particular needs and circumstances beyond the balance sheet.
Your Property Circumstances
There are many circumstances entrepreneurs need to understand about their operations, leased property and business location that weigh on a decision to purchase. The different business objectives that owners have and the limitations of the building they are currently in, play a major role in the decision to buy.
Manufacturers typically have a much greater need to customize than retailers or businesses occupying a standard office building, and many even build facilities to their own specifications. Customizing a facility can be more challenging when leasing the property.
Even so, some owners find that leasing makes the most sense in their particular circumstances.
When You Plan to Exit the Company
An entrepreneur's exit strategy often plays a big role in the decision about purchasing a facility, as many owners view real estate as a major part of their retirement plan.
"It's a big retirement asset," Cameron said, noting that retired business owners who purchased buildings decades earlier are likely to consider the move one of their best decisions.
"You get to use somebody else's money — the bank — to buy an appreciating asset — the building. Eventually you own 100% of the building and keep 100% of the cash it generates, he noted. “That's very powerful when you look out 15 or more years and further into retirement."
Not only will real estate potentially appreciate over the long term and bring immediate tax advantages, but owners can hold onto the property when they sell the company and — assuming they've paid off the mortgage and own the building free and clear — generate significant income by renting to their company's next owner or third-party tenant.
For that reason, owners interested in real estate ownership often make the commitment relatively early in their business life cycle, although those with shorter retirement horizons sometimes invest as well.
Location and the Economy
Generally, Cameron said, owning a building makes sense unless the business is in a highly variable industry, or geographic location makes the real estate less attractive.
Owning the only building in a rural area might not present great advantages, but buying a facility in a high-density, low-inventory market could help a business control their fixed expenses, he said.
Entrepreneurs considering building ownership should take the economy into account, but less-than-ideal conditions shouldn't necessarily preclude the investment.
3 Financing Options for Purchasing Your Business's Real Estate
You've made the financial projections, explored the options and decided to buy a building for your growing business. Now it's time to determine the best way to finance that purchase.
A healthy business may choose from a variety of options to help acquire this important asset, which not only will house your company for years but may eventually become an income-generating pillar of your retirement plan.
“You want to work with a banker who has experience in financing real estate through SBA and conventional loans," said Cameron.
An experienced banker can help customize your financing options to maximize loan terms, minimize down payments and ensure your business has sufficient capital to customize or retrofit the property to suit its needs, he added.
1. 504 Loan
A U.S. Small Business Administration 504 loan, designed specifically for owner-occupied commercial real estate and related fixed assets, offers appealing features. These long-term loans, provided by the SBA and participating lenders, generally allow businesses to borrow up to 90% of building costs at a fixed rate.
The borrower, who typically provides a 10% down payment for a loan with a 10- to 25-year maturity, may use the funds not only for the building and land purchase but also for renovations, parcel improvements, major equipment, furniture and certain other costs. An entrepreneur meeting the requirements could borrow several million dollars under the 504 program.
SBA 504 loan application turnaround takes a month or two, with the bank providing the initial review, followed by the nonprofit Certified Development Company that handles these loans for the SBA in a given region, and then the SBA itself.
2. SBA 7(a) Loan
Another option, the SBA 7(a) loan, designed for general business purposes, allows businesses to borrow up to $5 million for terms ranging to 25 years at variable rates, also with a relatively low down payment. (Fixed-rate options may be possible.)
Small businesses can use SBA 7(a) expansion loans for real estate but usually don't go that route, according to Cameron.
With their relatively low down-payment requirements, SBA loans can make borrowing easier than conventional commercial real estate loans, which often involve a 25% down payment. On the other hand, SBA loans typically impose higher fees.
3. Alternate Loan Options
Conventional options generally allow companies to borrow up to 75% of the property's appraised value and choose from a variety of terms, with fixed or variable rates and different maturity and rate-reset options.
In recent years, many businesses with sufficient cash flow have locked in low interest rates by securing 15-year loans that are fully paid off at maturity, according to Cameron. These terms often allow borrowers to put just 20% down, he said.
Typically, though, business borrowers opt for lower monthly payments by taking out 10-year loans amortized over 25 years and refinancing when the debt matures, Cameron said.
Cameron noted that City National often combines different types of debt to help a business purchase and retrofit a building, rolling a secondary loan into a real estate loan. A business that wants to purchase a building for $3 million and spend $500,000 on customization and improvements, for example, would need to put up $300,000 as an SBA 504 loan down payment for the purchase and could secure additional financing for the remodeling.
“Banks can provide financing for retrofitting and customization," Cameron said.
Borrowers should check with their banker to thoroughly examine the details of each option, including any prepayment penalties for fixed-rate loans.
Starting the Process
Many entrepreneurs who own their buildings are happy about it, and many derive income by leasing out portions of the facilities, in some cases renting space to vendors to secure better deals or minimize certain costs.
“The majority of business owners that I've met over the years think that it's a very good investment to own the real estate that houses their business," Cameron noted.
With any major purchase, it's critical to evaluate your situation and determine if it makes financial sense for your business.
This article is for general information and education only. It is provided as a courtesy to the clients and friends of City National Bank (City National). City National does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors or persons quoted as of the date of the article with no obligation to update or notify of inaccuracy or change. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.
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