To Lease or Own Commercial Real Estate?

The commercial real estate industry has been slow to embrace blogs and social media, but there is an increasing number of useful articles online if you know where to look. One blog post recently discussed at RealCorp is The Pros and Cons of Leasing vs Owning, from LeaseMatrix. Our RICS chartered surveyors made some additional comments on whether to lease or own commercial real estate, including some observations specific to Luxembourg. The points are paraphrased here to facilitate reading and commentary. To read them as originally expressed, please visit To the original article. Responses from the RealCorp team (RC) are in purple.

Advantages of Leasing

Luxembourg capital buildings and forest

  • Liquidity & Cash Resources: Leasing often requires less cash than ownership, leaving more capital to invest in core business and expansion. RC: The extra capital could also be used for alternative projects and property investments, yielding returns in excess of the weighted average cost of capital of the firm.
  • Financing Source: Leasing may be an attractive source of financing, if the cost of leasing falls below that of ownership. Small or low-profit-margin firms who struggle to get traditional financing might find a commercial landlord happy to sign a lease with them. RC: For comparison, the cost of ownership must integrate the benefit of loan amortization and capital allowances.
  • Cost Stability & Predictability: The long-term occupancy costs of leasing are often easier to forecast and budget. While some leases expose tenants to minor capital costs, most commercial leases enable tenants to avoid unforeseen items such as replacement of mechanical systems, structural repairs, and roof or parking lot replacement. RC: In Luxembourg, capex (capital expenditures) are generally landlord’s costs and cannot be recharged to tenants, but specific lease contracts may contain different conditions.
  • Tax Benefits: The occupancy costs of leasing are fully deductible, which can shield the business’s operating income from income taxes, whereas an owner must depreciate the property’s improvement costs. RC: However, owners can also benefit from a tax shield provided by the deduction of mortgage interest expense.
  • Flexibility & Mobility: A lease’s expiration date gives users a specific date by which to plan and re-evaluate real estate needs. This gives greater flexibility to users who need to expand, contract, or relocate. RC: Yes. This is one of the main reasons that companies prefer leasing to owning.
  • Location: Leasing enables users to occupy space at premier or strategic locations which they could not afford to own. RC: Yes, another good reason for leasing.
  • Focus: Leasing enables tenants to concentrate on primary business without the distractions of ownership’s property management issues. RC: This is related to the capex – it’s not just about cost, but that the party paying must also manage the issue.
Disadvantages of Leasing

Abbey in Luxembourg

  • Control: Tenants have little control over the types of other tenants that lease space in the building. These other tenants can adversely impact parking, operating hours, use and compatibility, or building services. RC: There may also be restrictive use covenants in the lease, such as using this premises as an Office only, or that the length of the lease cannot extend more than x years.
  • Cost: For an established business with easy access to capital, leasing could be a more expensive alternative to ownership. RC: It also depends on the strategy. Some major companies have even found that acquisition followed by a sale and lease-back created better value.
  • No Appreciation or Equity Accumulation: Leasing offers no opportunity to profit from the appreciation of the property, or to achieve equity accumulation through the reduction of the property’s underlying financing. RC: One must keep in mind, however, that this reasoning does not hold in declining markets with falling capital values. Lease in this case may be a better option until the market rebounds.
  • Contractual Obligations: If a leased property becomes less desirable or unsuitable, or the tenant’s business becomes unprofitable, the tenant must still pay rent or face penalties for default. RC: In our experience, this is seldom a problem as a.) landlords are usually willing to refurbish properties to avoid losing rental income, unless market conditions change substantially, and b.) the tenant may sublet or assign the lease.
  • Loss of Salvage Value: Most leases stipulate that certain improvements made by the tenant become the property of the landlord at the end of the lease. Alternatively, the landlord may require the tenant to remove improvements made at the tenant’s
 expense. RC: If equipment “touches and concerns” the demised premises, e.g. is a fixture, it may belong to the landlord at the end of the lease. The reinstatement and improvements clauses define whether amenities belong to tenant or landlord.
Advantages of Owning

Luxembourg Architecture

  • Appreciation: Owners can benefit from asset value appreciation, whereas tenants cannot. RC: Keep in mind that property can depreciate as well.
  • Debt Reduction: Under an amortizing loan, an owner accumulates equity in the property as mortgage principal is paid down. RC: Correct unless property values fall.
  • Control: Property ownership enables direct decision-making and control, whereas leasing does not. RC: Yes, in theory. But, in single-tenanted buildings, a great degree of control is often granted to the tenant, especially regarding building management and appointing service contractors.
  • Income: If a portion of the property is leased, the rental stream from tenants can help pay the mortgage, or be reinvested or distributed. RC: It might be strategic to “save” a part of the revenue to set up a sinking fund for capital expenditures or debt repayment.
  • Tax Advantages: Ownership enjoys interest and depreciation deductions that shelter income from taxes. Also, on sale of the property, gains are usually taxed at a lower marginal tax rate than ordinary income. For example, in the USA, the capital gains tax rate is currently 20% and depreciation recapture is 25%. RC: Another example: In Luxembourg, the buyer pays registration duties at either 7% or 10% of the property purchase price. However, one frequently sees “share deals” where the SPV (Special Purpose Vehicle) holding the property is transacted via the sale of its shares. This sale of shares does not attract registration duties as an “asset deal” would. This tax saving is beneficial to both seller and buyer.
Disadvantages of Owning

Luxembourg medieval buildings

  • Time Frame: Transactional costs associated with acquisition and disposition of property can offset or even eliminate the benefits of appreciation over a short-term hold. RC: Save for a general downturn in the property market, transaction costs do not preclude being able to achieve adequate net returns. It is all about carefully planning and analysing the acquisition at the outset.
  • Inflexibility: When a business (or a related party) owns a property, a decision to relocate for business purposes may be difficult, as that property must be relet or sold. This can take months or years. RC: This is why any acquisition must be thought through, considering exit scenarios such as letting the property or outright disposal.
  • Capital Requirements: Commercial property usually requires a down payment of 20 to 30%. This consumes capital which could otherwise be invested in a user’s business. RC: Unless there is an immediate need for cash in the business, investments could be made into projects such as property acquisitions that yield in excess of the weighted average cost of capital of the firm.
  • Management: Commercial property management issues are complex and cover areas such as legal compliance, health and safety, and contractor management, which can be distracting and costly. RC: For this reason, most landlords appoint asset and property managers to manage buildings, to free themselves to focus on other business. This gives them time, but also costs money.
  • Financing: Sources and availability of debt may be limited during economic recession or depression, and rising interest rates may make refinancing difficult or impossible. RC: As we have seen with the wave of recent non-performing loans, the higher the leverage, the more vulnerable the property is to market downturns.
  • Debt Covenants & Restrictions: Most commercial real estate loans require personal or corporate guarantees, along with a liquidity requirement (e.g minimum deposit balance with the lender). Alternatively, non-recourse fixed-rate financing may come with other stipulations. One of the most common examples is paying yield maintenance or a break up fee, should the loan be retired early. RC: Agreed. Some debt covenants frequently found in loan agreements are the Interests Cover Ratio and the Loan to Value Ratio.
  • Downside Risks: As with every investment, ownership carries numerous risks. These include decline in property value due to the economy or market, financing risks, and unanticipated repair and maintenance expenditures. RC: Banks and shareholders often require valuations of the property to update market value for lending and accounting purposes. This is undertaken at least once a year by external chartered valuation surveyors.

To contribute to the points above, or to add any thoughts on whether to lease or own commercial real estate, please Leave a Reply on this post.

How can RealCorp help you?

In conclusion, there are good reasons to consider either Leasing or Owning, but your specific circumstances will likely point clearly in one direction or the other, if you’ve done your analysis homework! However, this type of analysis is complex and may be time-consuming. RealCorp has the expertise to help.
Contact us now to talk through your options:

Sources:
The Pros and Cons of Leasing vs Owning, by LeaseMatrix, 06 April 2014: https://lease.io/blog/leasing-vs-owning-real-estate/

RealCorp MRICS (Members of the Royal Institute of Chartered Surveyors)

Post updated 16 June 2015

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