Aside from staffing, the largest investment you’ll make in a new location is buying or leasing the new location. You may be using a whole building or only using part of a building. For simplicity, I’ll be referring to “your building” for both scenarios, regardless of whether you’re buying or leasing it. Here are some things to consider when deciding whether buying or leasing a new location is the right choice for you.
What is your exit strategy?
I teach an Entrepreneurial Finance class to MBA students at a local university. In that class, I tell them that they need to plan their exit strategy whenever they start a company or implement a major strategy. The results of any strategy are uncertain. Each strategy is an experiment with three outcomes:
- The experiment is a success
- We learn something in the experiment, and we decide to make changes to our strategy.
- The experiment results are not what we want, so we discontinue this experiment and try something else.
You need an exit strategy because sometimes the costs to exit (i.e., to discontinue your strategy experiment) are high. Planning at the start can help minimize these costs. When adding a new location, the two most expensive exit costs are staffing and the building. Sometimes abandoned equipment costs can also be very expensive.
When I was in college, there was a church near the college that had a very basic sanctuary made of cinderblock walls. When the church was built, they hoped the church would be successful, but they were uncertain and cautious. They built the church building so it could be sold as warehouse space if they couldn’t continue to afford it. That’s starting with an exit strategy!
By the way, the church used the building for decades until they could no longer afford it in 2021. They sold it to a nonprofit organization.
Modeling Your Scenarios
Why am I spending so much time talking about building exit planning? When you are analyzing scenarios for a new location, you should have projections for a minimum of three scenarios:
- The most likely scenario
- Significantly higher sales or growth than the most likely scenario
- A worst-case scenario
The worst-case scenario should anticipate that you must abandon operations at the new location. Considering that scenario allows you to decide whether to do things now that could minimize exit costs. Conversely, running the best-case scenario also allows you to decide whether to make investments now. These investments could create higher profits if growth turns out to be well above your expectations. Surprisingly, companies get into cash flow issues from both the worst-case scenario and the extreme high-growth scenario.
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Exit planning for staff is very different for each company. There are some common options for exit planning for discontinuing operations for a building. Here are some options you may want to consider:
- Looking for a shorter lease term
- Making sure your lease allows for subleasing
- Leasing with an option to buy clause
- Delaying some tenant improvements or build-out of owned space until you are more certain of the site’s potential
- Buying or leasing a building that has multiple potential uses
- Buying interest rate derivatives. Commercial real estate tends to lose value (or not appreciate as quickly) when interest rates rise, so a derivative may hedge the loss of value.
Modeling your building exit costs in the worst-case scenario helps you decide whether to add costs to mitigate those exit costs.
Where to Get Cost Information
Building costs are big numbers. You don’t have a lot of clarity on costs until you start to look at a specific location or have architectural drawings.
The best place to start for estimates is a commercial real estate broker or your architect. They will help you identify the size and type of building you need. They also know the start rates per square foot for the building you’re looking for.
If you’re in the very early stages of planning, you can get standard rent or construction rates from local journals, internet searches, or working with your local library’s business librarian. The county assessor’s office may provide tax assessments for similar buildings or allow you to search prices on recent sales.
Your analysis will be an iterative process. It will begin with very rough numbers in the analysis of whether to consider adding a location. As you move forward, you will replace early guesses with more accurate numbers. You’ll have fairly accurate numbers by the time you need to buy property or sign a lease.
Leasing vs. Buying
I’ve worked at and been on the boards of companies that preferred to lease buildings and others that preferred to buy buildings. I was on the board of one company whose preference switched from leasing to buying while I was on the board. Let’s look at a few pros and cons of leasing vs. buying.
Sometimes the choice between buying and leasing is made solely based on the cash flow constraints of the company. Leasing takes less cash at the start. Commercial real estate loans often require a down payment of 20-25% of the building’s value.
This is at a time when growth driven by the new location will pressure cash flow. In addition, there will be many other expenses for the new location.
Equity and Control
Leasing requires less cash up-front, but you forego control of the building and any appreciation in the value of the building.
Your strategic plan will determine how long you plan to be at this location. If it’s a long time, buying may be the better option. If leasing, you need to do the research on the building, the landlord, and the building’s management company. You’re entering into a long-term relationship that’s critical to the location’s success and your sanity. I can tell you from experience that some landlords are easier to work with and fairer than others. The others make you fight for all your rights in the lease.
Sometimes the company doesn’t directly buy the building but instead rents it from the company’s owners. This is more common with closely-held companies. This can reduce the cash flow burden on the company while still allowing owners to control the building. The owners may form an LLC with outside investors to own the building. This allows outside investors to provide capital for the building without diluting the ownership of the company. These outside investors receive rental income but not a share of the company’s total income.
Building Management and Maintenance
I’ve been in multiple discussions where the own vs. lease decision comes down to the company’s appetite for managing the buildings. I’ve had facilities staff report to me. Managing buildings is hard work.
If you have a small number of locations, it may be easier to lease and have someone else manage the properties. For a small management group, it’s tough to manage your core operations and manage buildings.
As you grow, controlling building maintenance makes more economic sense. It’s also easier to control the quality and timeliness of the work of your facilities employees than those of a management company.
Some see leasing as providing the most flexibility. You may be able to sign a short lease to test a market for a few years. You could sign a longer lease but make sure you have the ability to sublease the space if you’re not absolutely certain you’ll use it for the full term. You may rent for a while, knowing that you intend to grow into a larger building down the road or a better location.
Buying a building also comes with some flexibility. You can build or buy a larger building than you need. You then lease out the parts you don’t need now to help cover the cost of the building. Over time, you can then expand into the leased spaces.
Buying vs. Building
You have two choices if you decide to own your building:
- Buy an existing building
- Build a new building
Managing the construction of a building is more complex than buying an existing building. It also comes with additional financial considerations.
Building involves two to three loans. The first purchase is the land. In a hot market, you may decide to use an existing line of credit or cash to quickly close on a land sale. Another option is to finance the land with the construction loan you’ll also use for the building.
The second loan will be for the building construction. This will be a floating-rate loan during the construction period. You’ll make periodic, usually monthly, draws that increase the loan balance. You’ll likely be required to make monthly interest-only payments during the construction period.
The final loan is the “takeout” permanent financing for the building and the land. This will be a fixed-rate loan or one with periodic repricing.
The construction period is often longer than planned. This lengthens the time from when you invest in the building to when the new location’s operations begin producing cash. You’ll need more cash to fund this compared to buying or leasing.
Finally, the new construction will consume more management time over a longer period than buying or leasing. This reduces resources and lengthens timelines for other projects. The budgets for your existing operations will need to reflect this.
If leasing, you’ll need to read the lease carefully to see which costs are paid by the landlord and which costs you are responsible for. At one extreme are gross leases (a.k.a. full-service leases), where the landlord pays the property’s operating expenses. At the other extreme is a triple-net lease, where the tenant pays taxes, insurance, and maintenance. Any costs above the rent amount for which you’re responsible need to be included in your projection for the new location.
Another important part of the lease deals with tenant improvements. The owner usually will create an allowance for these. They are paying for them because they add value to the building they own. You will pay for any amount the tenant improvements exceed the allowance. In construction, there are often cost overruns, so you’ll want to budget for the chance of that.
The right to sublease the space may become very important to you in the future. There are many reasons why you may decide to vacate a new location. Some reasons are:
- The new location proves so unprofitable that you must close it.
- A nearby but much better location becomes available, and you decide to move there.
- You quickly outgrow the space.
- You decide to buy another location rather than continue renting.
If you want to quit using the new location, you have a couple of lease options:
- You can break the lease and pay any associated fees
- You can sublease your space until the end of the lease to offset your lease payments.
If there is any chance you will not want to stay in the location for the term of the lease, you need some option to cancel the lease or to sublease the space.
In the worst-case scenario that you model, you’ll want to estimate these costs, how long it will take to sublease the space, and what rent you may receive. Remember, the worst-case scenario may be a recession, in which case the sublease income may be well below your lease payments.
You’ll want to talk to your tax accountant to see whether a cost segregation study makes sense for the new location. This is especially true if you’re buying or constructing a new location.
A cost segregation study identifies costs that qualify for shorter time periods than the standard building depreciation term. For example, items can be reduced from a 39-year term to 5, 7, or 15 years. Some items may be eligible for immediate deduction. This reduces your taxes to improve your cash flow and profits.
A cost segregation study can range from $5K to $25K, so the tax savings will have to exceed the cost of the study. Your tax accountant can estimate the saving in their proposal to help you decide if the study will save you money.
Picking Amortization Lives
Picking amortization lives for financial accounting is usually not seen as a critical decision. I worked for a company where these lives greatly influenced later decisions.
You may be tempted to pick long lives to reduce expenses in the short term. I worked for a company that had aging locations. Remodeling them would trigger write-offs of building expenses from years ago. Those costs were slowly being amortized due to long accounting lives. In this scenario, the write-offs would reduce capital ratios for the company, which might limit the company’s growth.
Some companies would be very reluctant to trigger material losses for the remodel or sale of a building. They are hostage to sunk costs and poor accounting policies.
Your lease or loan agreements should be reviewed by an attorney if they’re significant to the size of your company. They can outline important clauses that you will need to model.
They can also warn you of clauses that are particularly disadvantageous to you. I was at a bank where we were leasing land on which we would build a branch that would be leased. Our attorney was able to point out some areas in the lease where we needed to negotiate for a fairer agreement.
Is Buying or Leasing a Building the Right Choice for You?
There is no right choice for everyone. Your strategic plan and cash flow determine the best choice for you. I’ve also listed other considerations in this article. If you don’t have a cash flow projection or a strategic plan, I have simple templates for both.
I wish you the right building ownership for your needs. I wish you well.
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