Must I buy or rent commercial property? How to decide:

Lease or Buy?

A question we get asked a lot at Baker Street Properties: is it better for my company to invest in office space, or should I keep renting? In reality, this is a multi-faceted question which is best answered through a personal consultation given your company’s current business phase and financial position. Our property investment specialist, Andre Theron, has summarized the main advantages and disadvantages of each option for owner-occupiers of commercial property to consider:

Advantages: Buying office space

  • If you are financing your commercial property through a bond, your fixed costs are more predictable. The expected rise in interest rates of roughly 1% over the next 12 months is still better than the average 8% annual rental escalations.
  • If one purchases in a good area and the property is well maintained it should lead to wealth creation as the property appreciates in value. As market rentals increase, so the value of your property increases.
  • Interest on your mortgage loan is also tax deductible whilst the capital portion of your loan repayment goes towards reducing debt.
  • At the end of a 10 year loan period, you will have a fully paid commercial property which can serve well as a boost to your balance sheet.
  • Businesses have the flexibility to make changes and additions as and when needed without having to obtain permission from a landlord.
  • If you outgrow your premises you can rent out the property and achieve a good potential source of additional revenue or sell the property and put the proceeds towards your next property or have the capital for expanding your business.
  • If you urgently need cash for your business, you can always Gear Up (increase the mortgage) or enter into a Sale and Leaseback agreement with an investor who will pay you out the net value of your property against a lease from your business.

Disadvantages: Buying office space

  • Commercial property ownership brings with it significant upfront capital investment as well as maintenance costs associated with property ownership. In a growing business, it would be wiser to invest this capital back into the business.
  • Limited flexibility in terms of business growth: if your business outgrows the commercial property too quickly, a forced sale would typically result in a bad investment decision.
  • If interest rates increase more rapidly than expected and you have a mortgage loan, you could find yourself running into cashflow difficulties.
  • If your business goes into decline due to adverse market conditions, you could be forced to sell a vacant property which is not going to achieve book value. This could result in substantial losses.
  • Commercial property maintenance, upkeep and management takes time away from your main business. This is especially true if you plan on renting out your property investment.
  • It is imperative that a business invests in an area with good future growth. Some examples of areas with potential are Woodstock, Salt River and parts of the Cape Town CBD which we expect to see significant future growth in property values over time.

Advantages: Leasing office space

  • Businesses often benefit from the ability to rent premium or prime office space, as buying in a prime location is often more expensive. This is especially true for Cape Town.
  • If your company is growing rapidly, it would typically be better to keep renting with fewer constraints on the business.
  • Generally speaking, an entire rental can be listed as a tax deductible expense, whereas the capital portion of a bond repayment is not tax deductible.
  • You benefit from freeing up your working capital to further invest into your business.

Disadvantages: Leasing office space

  • Sometimes the fit out costs associated with setting up a new office space is so significant that the money could have been better invested. Keep in mind that tenant installation costs typically equates to 2/3 months gross rental and that this cost can never be recovered – in effect you are investing into upgrading the landlord’s asset.
  • Therefore, leasing does not provide any sort of equity or investment value, and the business is effectively funding the landlord’s retirement.
  • A business is subject to annual rent escalations and other variable cost implications that may result in a more expensive rental overtime. With flat office rentals in Cape Town since 2008, there is a slow upward trend in annual escalations over the current 8%.

Illustration of Buying versus Renting (with gearing effect):

BUY RENT
Buy for say R1,000,000; Borrow 70% = R700,000; Cash 30% = R300,000 Equivalent rental say R110,000pa
Bond instalment at 9% = R106,408pa Starting rental @R110,000pa
Increase in interest of 1% = R111,007pa Escalated rental of 8%  R118,800pa
Interest  of R70,000pa is tax deductible Full rental of R118,800 is tax deductible
Balance reduces debt

Because of the gearing effect on investment the following is evident:

Your investment growth is on the full R1,000,000 purchase price. If the property value only grows by say 6% per annum, that equals R60,000 (year 1). Therefore, your cash investment of R300,000 has effectively grown by 20% per annum.

Need our advice on how to get commercial property finance? CLICK HERE

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