Buying vs. leasing

The pizza truck honked and Jules Puglisi bolted down four flights of stairs, sprinted across the courtyard and vaulted over a parked car to place his order. He was my childhood friend in the Bronx tenement where I was born. Not knowing what pizza was at age six, I shuffled behind him and gingerly took a bite. Wow! I was hooked for life. 

As an adult, my 30-year commercial mortgage banking and business lending career included financing restaurants. When I financed a pizzeria, my business meetings included triple mozzarella, double sausage and a cold one. But the dream soon turned into a nightmare when the partners ran out of working capital within the first few months and had to close the store. Personal bankruptcies resulted, the owners were no longer on speaking terms and their marriages were faltering.

Why Lease?

Running out of cash is the No. 1 reason that fledgling businesses fail. It is also a reason to consider leasing your building rather than buying it, even though the romance of owning real estate can be compelling. “If the business is a startup or in its infancy, it will need to deploy its capital for business operations, not for a major real estate purchase,” says John Hogan, a volunteer SCORE mentor in Myrtle Beach, South Carolina, who advises clients about entrepreneurship. “The risk of business failure is high in recessionary times,” he adds, “including during economic recovery.” Accordingly, squirreling away extra cash reserves may help you survive through adversity. 

Most lenders consider restaurants among the riskiest of small businesses to start. Even existing restaurants are vulnerable to fickle diners flocking to trendier ones, or patrons never returning after having one bad meal or slow service. Consequently, lenders want to finance owners with deep pockets and are concerned when they deplete their cash reserves by purchasing a building. 

Craig Aberle, a certified commercial investment member of the CCIM Institute and a volunteer with SCORE Manasota in Sarasota, Florida, adds, “Many owners tend to underestimate the true costs of maintenance.” His examples of underestimated maintenance items include “roof repairs, HVAC, insurance, property taxes, school taxes, pest control, garbage disposal, water, upkeep, landscaping, parking lot maintenance and more.”

Even so, business owners can learn how to keep up with the rigors of maintaining and managing a building. But should they? SCORE Manasota’s Joe Palmer, a mergers and acquisitions expert, says, “The business should earn a greater return by investing in operating assets and growth over fixed assets.” Thus, by owning the building, the most distracting fixed asset, owners may take their eyes off their operations.

The Decision to Purchase

The business of owning real estate requires continuously researching the market, and knowing when to sell and when to hold. The timing of the sale of your real estate building should depend solely upon real estate market conditions. But instead, most owners sell based upon the needs of their business and consequently accept less than market value for their building. 

Furthermore, selling a business can be more difficult when the seller also owns the real estate. Some buyers may be interested in the business only and discount the price for the real estate. Others may be real estate investors and not be willing to pay full price for the business. 

However, opportunists are tempted by currently depressed real estate prices. Even though most real estate dynamics are local, Dan Wagner, the commercial real estate research manager of Grubb & Ellis for Georgia, gave me a snapshot of metro Atlanta’s current marketplace. He revealed that small-building sales are currently showing a decline of 65% in prices. By comparison, he says, “If you ask most brokers, they will tell you that effective rents fell by 25% to 30% during the downturn for solid-credit, class A tenants.” “Class-A” tenants refers to large chains with solid corporate balance sheets, which guarantee the lease payments. It does not include family-owned, single-store pizzerias.

Additionally, “effective rents” calculate the value of free extras such as tenant improvements, rather than the landlord reducing contract rents. 

More recently, however, the Financial Accounting Standards Board (FASB) conjured up draconian leasing rules. FASB initiates changes to America’s accounting requirements, and this one takes effect in 2013: All tenants will be required to account for the entire cost of the lease over its full term, plus the estimated additional rent based upon gross revenues above the base amount. The additional rent may be 5% to 8% of gross revenues, or more.

Financing Worries

According to a survey by accounting and advisory firm Deloitte, “more than 40% of respondents believe the new standards would make it more difficult to obtain financing.” In part, this is because tenants used to show their lease obligations as a footnote to their balance sheet. But the new rules put the full impact on the balance sheet and exacerbate the tenant’s financial ratios. That could make lenders more cautious. Deloitte writes, “68% of
respondents said it would have a material impact on their debt-to-equity ratio, and roughly 40% thought that the new lease standard would lead to shorter term leases.” 

The new accounting rules can make leasing less attractive. But some accountants disagree. Dick Fenster, a former CPA with a large Atlanta accounting firm, believes that lenders have always looked at off-balance-sheet obligations. He opines that new accounting rules may be only a temporary impediment until lenders get up to speed. “Clearly, it changes the ratios as presented in a balance sheet, perhaps significantly, depending on the size of a lease,” says Fenster. “I don’t think it will derail many loan applications. I think smart bankers have always considered lease commitments.”

Small-business owners and corporate executives have to focus on producing quality products, attracting customers and managing their cash flow. And even with the latest accounting wrinkle, leasing has fewer distractions than owning. Thus, lessees can concentrate more on making their business great than replacing galvanized plumbing. 

A good business accountant, lawyer and independent insurance agent can help you mitigate unanticipated events if you do decide to buy your building. What if you have to sell quickly because of sudden disability? Can your heirs dispose of the building if you die unexpectedly? Find a buyers agent who specializes in your type of real estate, and always have an exit plan in place.

Jerry Chautin is a former entrepreneur, business owner, commercial mortgage banker and business lender based in Atlanta. He is the 2006 national winner of SBA’s Business Journalist of the Year. Currently, he is a business columnist for several publications and a volunteer SCORE business mentor.