The leasing vs. owning decision in today’s market

Jeremy Reeves
Vice president, Colliers International

For office tenants that have had to stomach increasing lease rates, which are up a staggering 38% in metro Denver since they bottomed out in 2010, the idea of owning their own building or condo is intriguing. Couple that with low interest rates becoming a recurring topic in the news and tenants may want to investigate purchase options to some degree before signing up for a long-term renewal.

What they will find is owner-user buildings and office condos in metro Denver also have hit an all-time high average sale price. What are the dynamics of buying in the current market and how should that decision-making process be navigated?

Tenants must start with asking themselves if the makeup of their organization lends itself to jumping into a commercial real estate investment. A good candidate is an organization that is profitable, maintains strong cash flow and doesn’t already have excessive debt.

The growth trajectory of the organization’s number of office employees needs to be minimal or the targeted building must have a path for growth. The business owner or executives must be able to carve out time for the real estate beyond the operation of their business.

The purchase of real estate as an owner-user provides numerous benefits. In a market where tenants are suffering from sticker shock with every new lease or renewal negotiation, control over the cost of the real estate component of overhead provides major upside.

The financial benefit also includes the building of equity as debt is paid down and the asset appreciates as well as depreciation of the property for tax purposes. Many business owners see it as a secondary avenue to create and accumulate wealth for the business or for retirement. In a lease situation, landlords build certain rights into the lease, which encumber the tenant, while ownership gives an organization control and decision-making authority for the building, such as determining the scope of improvements to be made to the building and when to make them.

On the other end of the spectrum, one of the major challenges to purchasing a building is the loss of liquidity as the up-front capital required is typically 10% to 25% of the purchase price plus due diligence and closing costs. Cash flow can be tenuous with repair and capital improvement costs as well as re-tenanting costs if there are other tenants in the building.

Looking back at the history of owner-user and condo sales, the price fluctuations are great depending on the economy and market conditions. For instance, in 2012 the average sale price was $73 per square foot, while in 2018 the average sale price hit $182 per sf. Not being able to plan the timing of the exit from the property to line up with the top of the real estate cycle could result in a significant loss.

Lastly, a well-negotiated lease in a multitenant office building provides for flexibility for an organization’s occupancy and common area amenities, such as a café, training room or workout facility, which might be hard to come by in a user building or condo.

Once the decision in made to pursue an owner-user building or condo, the first step is forming a team, which typically includes an accountant, lender, real estate broker and an attorney to review title, the survey, and the purchase and sale contract.

A popular lending option is the SBA 504 loan program, which provides for long-term fixed rate financing. Fifty percent of the project costs are provided through a private-sector lender. Forty percent of the project costs are financed with a fixed-rate debenture secured with a junior lien from an SBA Certified Development Company. The debenture is backed by a 100% SBA guaranty. The buyer will need to bring 10% down payment to the table.

There are some specific requirements for this loan program, including an owner occupying 51% of an existing building and falling within a certain net worth. Fees, longer timing and generally more hoops to jump through weigh into the decision to pursue an SBA versus a conventional loan, which often requires a minimum 25% down payment.

Although there is variability depending on the situation, at the time of writing the interest rates on recent acquisitions have been in the low 4% range.

Sales prices will vary dramatically based on location, age and condition of the building, as well as various other factors, including whether the building is portrayed as an investment or user building. Investment properties will have an associated cap rate and likely limited vacancy. User buildings are delivered vacant at closing or have enough vacancy to appeal to buyers that will occupy the building and lease the remaining space.

Users have a different set of parameters than investors, so often they will pay more than an investor. The intrinsic value of operating their business in the building, along with a simple lease versus purchase analysis typically allows a user to justify a higher price.

There is a wide delta in this market between what a user building and investment property with similar attributes will sell for. Recent building comps tell this story. While it would be a stretch to say that the market for owner-user buildings and condos is robust, it is as steady as it has ever been, with sales volume for user buildings two to three times higher in recent years than during the Great Recession and average time on market less then half of what it was.

Buying a building now may be a little riskier than it was a few years ago because the economic cycle appears to be around the peak. However, low interest rates help offset high market prices and can make it very affordable to secure a real estate loan.

If history dictates, over the long-term, real estate prices will appreciate and a stable organization that plans to occupy a building for at least seven to 10 years with a well-thought-out exit strategy should be primed for success in this market.

Data analytics source: CoStar

Featured in CREJ’s September 2019 Office Properties Quarterly

Edited by the Colorado Real Estate Journal staff.