To Lease or Own Commercial Real Estate?

The commercial real estate industry has been slow to embrace social media. However, many useful articles appear 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 added comments on whether to lease or own commercial real estate, including observations specific to Luxembourg. We have paraphrased the points here to facilitate reading and commentary. To read them as originally expressed, please visit the original article. Responses from the RealCorp team (RC) are in purple.

To Lease or Own: Advantages of Leasing

These capital buildings are some of the huge number of properties available to lease or own in Luxembourg City.

  • Liquidity & Cash Resources: Leasing often requires less cash than ownership, leaving more capital to invest in core business and expansion. RC: Extra capital could also fund other projects and property investments, yielding returns beyond the firm’s weighted average cost of capital.
  • 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 struggling to get traditional financing might find a commercial landlord to lease to them. RC: For comparison, the cost of ownership must integrate the benefit of loan amortisation 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. These include replacement of mechanical systems, structural repairs, and roof or parking lot replacement. RC: In Luxembourg, capex (capital expenditures) are generally landlord’s costs. Landlords cannot recharge these 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 ownership’s property management distractions. RC: This is related to the capex – it’s not just about cost. The party paying must also manage the issues.
To Lease or Own: Disadvantages of Leasing

Luxembourg's beautiful old buildings, such as this Abbey, give a special settled character to the city. There is a wide range of modern as well as period property available to lease or own.

  • 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: The lease may also contain restrictive use covenants, such as premises to be used as an Office only, or a limit on the the lease term.
  • 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 property appreciation, or for equity accumulation by reducing the property’s underlying financing. RC: One must keep in mind that this reasoning does not hold in declining markets with falling capital values. Then, lease may be a better option until the market rebounds. Deciding “to lease or own?” depends on economic context.
  • 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. Why? a.) Landlords are usually willing to refurbish properties to avoid losing rental income, unless market conditions change substantially.  b.) The tenant may sublet or assign the lease.
  • Loss of Salvage Value: Most leases stipulate that certain improvements by the tenant become the landlord’s property at lease end. 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, the landlord may own it at lease end. Reinstatement and improvements clauses define whether amenities belong to tenant or landlord.
To Lease or Own: 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 tenants often have greater control in single-tenanted buildings, 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, the gains tax is usually 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, often a “share deal” transacts the SPV (Special Purpose Vehicle) holding the property 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.
To Lease or Own: Disadvantages of Owning

Luxembourg medieval buildings

  • Time Frame: Transactional costs of acquisition and disposition can offset or eliminate the benefits of appreciation over a short-term hold. RC: Save for a general property market downturn, transaction costs do not preclude achieving adequate net returns. Careful initial analysis and planning should determine whether to lease or own.
  • Inflexibility: When a business (or a related party) owns a property, relocating for business purposes may be difficult. The property must be relet or sold, which 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 cash is needed immediately, the business could invest in projects such as property acquisitions that yield more than the firm’s weighted average cost of capital.
  • Management: Commercial property management issues are complex and can be distracting and costly. They cover areas such as legal compliance, health and safety, and contractor management. RC: Most landlords appoint asset and property managers to manage buildings, freeing themselves to focus on other business. However, buying time costs money.
  • Financing: Sources and availability of debt may be limited during economic recession or depression. Rising interest rates may make refinancing difficult or impossible. RC: The wave of recent non-performing loans has shown that the higher the leverage, the more vulnerable the property is to market downturns.
  • Debt Covenants & Restrictions: Most commercial property loans require personal or corporate guarantees, with a liquidity requirement. (E.g. a minimum deposit balance with the lender). Alternatively, non-recourse fixed-rate financing may come with other stipulations, such as yield maintenance or a break-up fee, should the loan be retired early. RC: Agreed. Some debt covenants often 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 require property valuations to update market value for lending and accounting purposes. External chartered valuation surveyors undertake these valuations at least once a year.

To contribute your thoughts on whether to lease or own commercial real estate, please Leave a Reply below.

To Lease or Own: How can RealCorp help you?

In conclusion, there are good reasons to consider either Leasing or Owning. 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 Michael Chidiac MRICS, Managing Director, now, to talk through your options:

Sources

Post updated 16 June 2015.

This entry was posted in Acquisition, Asset Management, Financing, Laws and Regulations, Newsletters, Rental and tagged , , , , , . Bookmark the permalink.

Leave a Reply