Lease or Purchase Real Estate
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Considerations for Renting vs. Purchasing Real Estate
The decision to rent or purchase a location to conduct business depends on numerous factors. These factors generally regard the adequacy and availability of suitable properties. When a business has the option to rent or purchase an adequate property, it is important to understand the advantages associated with each decision.
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Advantages of Purchase
- Flexibility in use of property;
- Property appreciation;
- Long-term, cost savings;
- Secured asset for future borrowing;
- Tax deduction for interest expenses; and
- Tax deduction of property tax costs.
Advantages of Renting
- Increased mobility;
- Lesser maintenance responsibility for property;
- No exposure to property value fluctuation;
- Generally no property taxes,
- Tax deductions for rent payments; and
- Lower upfront capital costs.
Math of the Rent vs. Purchase Decision
When determining whether to rent or purchase a property, there is often a better financial option depending on the cash flow needs of the business. There are several things you need to know when doing a comparative calculation.
1: What is the required rental down payment vs. Down payment, closing & finance costs? Your business may not have the available cash on hand to meet one of these amounts. On commercial spaces, most purchasers must put down between 10-30% of the purchase price. A commercial lease, on the other hand, generally requires a first and last month rental down payment.
2. How much is the monthly payment amount on a lease vs. Mortgage? Leases payments are generally certain. Mortgages, however, include additional maintenance costs, property taxes, etc. Remember, this is just a preliminary number and does not accurately demonstrate the effect of leasing or purchasing on the bottom line.
3. What is my real cost of capital associated with each rent or mortgage payment? A mortgage payment is not deductible against income tax liability. Only the interest paid (or points at closing) on the mortgage payment can be deducted. You will calculate the tax effect on the business (or individuals in a pass-through taxation entity). Depending on the applicable tax rate of the organization or individual(s), the effect of deducting the interest payment will vary. In a lease, on the other hand, the entire amount of rent is deductible. If an organization (or individual owners in a pass-through tax entity) has a high tax rate, then deducting the lease payments will have a larger effect.
4. What is the projections for capital appreciation of the property? This information will tell you what you can expect to recover on a mortgage. You will need to compare the lost income from employing the down payment in other investments. You will then compare this to the amount expected to be recovered on the property. You will do a time value of money calculation to determine the commensurate values:
Example: You will purchase the land for $100K, with $20K down payment and $80K payments. The payments on the $80K are $500 per month ($50 of which is interest). The rental payments on the same property is $650 per month. You will first determine the tax benefits of expensing the $650 of rent vs $50 in interest. This will put the amounts closer together. Then you will calculate the the expected future sale price of the business. You will deduct the taxes on any gains. Now, you will reduce this amount by the future value of the $20K that you put down up front. Calculate this as follows $20K (1 + Interest Rate)^N
The Interest Rate equals the rate of return on a relatively secure investment, such as the S&P. (Ex. 7%)
N equals the number of years until you expect to sell the property.
This will give you the true value of what you expect as a return for holding the property that amount of time.
The above example is an overly simplified example of how you will calculate the value of purchasing vs renting. The real numbers or costs associated with each can get quite complicated. As a general rule, purchasing is generally a better long-term decision. If, however, there is a need to immediately preserve cash, then purchasing may not be an option.