Why lease when you can buy?

Because it can be cheaper to lease than to buy.

By: Mitch Wright

As a real estate professional I am always asked: "How much does it cost to buy a building?" My answer is: "That depends on the size of the building, where it is located, what the zoning is and what you can do with it."

 

The questions people should be asking me are: "Can I afford to buy" and "Should I buy?" and "Does it make sense for me to buy?" Now those are real estate questions!

 

While there are many different reasons to buy, the reasons depend on the nature of the purchase and the costs associated with it. It is not enought to simply say: "I want to stop paying rent to my landlord and own my own real estate."

 

In this artilcle I will attempt to discuss three relevant questions people should be asking before buying and a discussion related to each of the questions.

 

Question 1. "Should I buy?"

My standard answer is: "Maybe." Lets start with a property that is logical for your business. A logical purchase for a business owner is when the annual cost of ownership is equal to or (hopefully) less than the anual cost the business owner would pay in rent, assuming a modest (say less than 20%) down payment. And remember, the annual cost of ownership must include all relevant costs including: property taxes, property insurance and property maintenance (the so called triple net or "NNN" fees in a single tenant lease), bond fees, association fees and sate and local taxes. In a perfect world, the buyers goal should be to acquire "fee simple ownership" (ie. a separate land parcel with no association membership).

However, that dream can be relatively expensive when compared to leasing the same building. Let's see why:

a) Sometimes a tenant can lease property and negoatiate for the landlord to pay a portion (or all) of the NNN fees. But, when you buy something, you will pay all the fees;

b) A tenant is only obligated to occupy a property for the durration of the Lease. But, when you buy it you own it until it is sold;

c) Sometimes a tenant can transfer or assign a lease to someone else [landlord permission required] to someone with less than perfect credit. But, when you buy it you have to find a qualified buyer to either assume the loan or get a new one.

In a gross lease, a building owner pays all NNN fees, plus the unknown (ie fire, flood, earthquake, vandalism). And, remember, tenants are quick to vacate a property and leave the landlord to fix the problems whenever there is an expensive problem to be solved.

 

Questions 2 and 3. "Should I buy" and "Does it make sense to buy?"

Again, my standard answer is: "Maybe." So, let's start making some assumptions.

First, assume it is summer of 2009, and you want to move your printing business, the 10,000 square foot building you are renting costs $6,500 per month. The NNN fees are $825 per month ($125 for landscape maintenance, $450 for property taxes, $250 for property insurance and no management fee). The landlord (who bought the building in 1979 for $400,000) wants a five year lease.

Second, assume similar buildings in the immediate area can be purchased for about $1,500,000.

Third, the property tax rate in area is 1.25% .

Fourth, assume you can qualify with a lender willing to loan you 85% of the purchase price for 25 years at 6.5% interest fixed for five years and charge 2 percent (2 points) for making the loan.

Fifth, assume all escrow related fees (appraisal, environmental, title, insurance, recording, etc.) will cost $6,000. And, assume no prorated property taxes or insurance has to be reimbursed to the seller in escrow.

Sixth, assume the cost to relocate the business is $100,000.

Now we're talking real estate!

 

So, the annual rent is $78,000 and the annual NNN fees are another $9,900 [Wow. $87,900 a year sounds like a lot of rent money going to the landlord!] But, remember, in California, the NNN fees are subsidized with below market property taxes thanks to Proposition 13.

 

Now the cost to purchase in this example will be $225,000 for a down payment, $6,000 in escrow fees and $100,000 in relocation expenses, which total $331,000. (That equals 3.77 years of rent and NNN fees.)

The $1,275,00 mortgage amortized at 6.5% interest over 25 years equals $8,608.89 per month. [According to my handy dandy HP12C calculator.]

The new property tax rate (which increased based upon the fair market value of the property at time of sale) is $15,937.50 or $1,328.13 per month.

Assuming the monthly landscape and and insurance stay the same, the monthly cost to own a building would be $10,312.02, or $123,744.24. [Hey wait a minute, that's $35,844.24 more than rent each year! That equals $179,221.20 over five years! Ouch!]

 

The opportunity cost of purchasing must include the down payment, escrow fees, moving costs and additional monies paid over the base expenses of rent for five years. As shown above the opportunity costs total $510,221.20 or 5.8 years of rent and expenses. A renter saved $70,721.20 ($510,221.20 - $439,500) by not purchasing the building. [Wow, how can it be that expensive?]

 

New Question: "What would the purchase price be to justify buying the building as a leased investment?"

In real estate finance the math is simple: Take the annual income, less vacancy and reserve expenses (about 5%) and divide it by a capitalization rate (in this case the cost of capital or the 6.5% interest rate). The $78,000 annual rent, less five percent for vacancy and reserve expenses, equals $74,100 in net annual income. Now divide the $74,100 net annual income by the 6.5% cap rate and the building value to an investor equals $1,140,000. [Wow, that is $360,000 less than the market value of the building!]

 

The moral to this story is do your homework before buying. All great investors do!

And, while rent may seem expensive, it may be cheaper to Lease it than Buy it.