Every few years, the real estate market suffers through a crash or a correction and underscores a perpetual dilemma for small and mid-sized businesses: Is it better to rent or own commercial property?
Buying commercial real estate is a complex undertaking that is difficult even for experts to time right to maximize their investment value, let alone entrepreneurs or business executives whose areas of expertise are in different industries. It's also a venture rife with risk, as buyers, sellers, agents, and renters alike can suffer the consequences of a dip or spike in demand. At the same time, for a business, on the upside the potential rewards can be substantial.
Why should a business buy? "To get a greater control over the cost of the real estate component of overhead, as opposed to leasing, where you can be victimized by the market if the lease rolls over when the market is tight and, as a result, you have higher rental costs," says William Martin, chair of the real estate group in the Denver office at Kutak Rock LLP, a law firm with 400 attorneys and offices around the country. "The other benefit would be investment benefits, including depreciation of the property for tax purposes and, over the longer term, asset appreciation."
There is no one-size-fits-all strategy for purchasing commercial real estate. That decision must be weighed by each business. The following guide will help a small business assemble a real estate search team, choose a location, and purchase property.
Purchasing Commercial Real Estate: Deciding to Buy Versus Lease
When deciding whether to buy commercial real estate, it's important to understand the potential risks. The last thing you want is to buy property and realize a year or two later that you would have been better off renting. Here are some of the potential risks a business faces when buying:
- Location may backfire. Today's "hot" neighborhood can become tomorrow's "not" neighborhood. Locations are trendy. Gentrification may stall. The market may go bust. The area you choose one day may become undesirable the next. Of course, the reverse can be true, as well.
- Loss of liquidity. Businesses may tie up much of their liquidity buying real estate. It's not always easy to sell real estate, particularly in a slump. At the same time, businesses that own real estate at least have something to sell if they need a cash influx to revive a lagging business.
- Tenuous cash flow. Tenants sometimes stop paying their rent. Other times, buildings are in need of unexpected -- and expensive -- repairs. Your cash flow can become compromised, especially if you are forced to simultaneously pay repairs and attorney fees to handle a tenant situation.
In order to be aware of risks, do your homework. Undertake extensive due diligence before signing any contract. You also need to be hands-on with your commercial property by overseeing every level of operation and making frequent on-site visits -- otherwise, you may learn about problems after it's too late to do anything to fix them.
The decision ultimately comes down to the economics. You may want to have a real estate expert help you undertake a rent versus own analysis, taking into account growth forecasts for your business and real estate market trends. "It's really beneficial to sit down with an expert that can lay out options for you and discuss scenarios, such as in three years this is where business will be in terms of revenue, size, or people. This is how many locations we will have. This is what our space needs will be," says Hessam Nadji, managing director of Marcus & Millichap, a national brokerage focused on real estate investment. A real estate expert can also help you figure out the costs of renting versus buying, factoring tax benefits such as depreciation.
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Purchasing Commercial Real Estate: Assembling a Team of Experts
As a small business owner, you're most likely not a commercial real estate expert. That's why it's important to surround yourself with the right team of experts. They can help you determine the right time to buy or sell, the right locations to consider, and the nuts and bolts of closing the deal. Here are some of the experts you may consider contacting:
- Accountant. An accountant can help you figure out what your business can afford and analyze the tax and operating budget benefits.
- Lawyer. A lawyer can help you complete the transaction, negotiating with the seller and lender on your behalf.
- Commercial broker. A real estate broker can help you identify potential properties and what you can afford.
- Mortgage broker. A lender or mortgage broker will help you sort through financing options, from bank loans to those guaranteed by the U.S. Small Business Administration, such as the Certified Development Company (CDC) 504 Program, used to finance primarily real estate or equipment.
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Purchasing Commercial Real Estate: Identify the Right Property
There are a number of factors to consider when looking for suitable commercial real estate to purchase. The old adage "location, location, location" is true for commercial properties just as much as it is for residential. But there are other issues at play, as well. Here are some things to consider:
- Location. This is still the No. 1 issue. You want to be close to your customers, your workers, and your vendors or suppliers. "You want to be convenient to customers to the extent that you have a business where the customer comes to you," Martin says. "But depending on the type of business, access to rail and highway and shipping lanes may be important, too."
- Physical condition. After identifying the general location, consider how the property was used, the wear-and-tear, whether there are any environmental issues or potential liability issues, such as asbestos or lead paint.
- Allowable uses. If your business is an accounting firm, you likely need commercial office space. If you are a manufacturer, you need an industrial space. Either way, you need to make sure the zoning allows you to do what you need to do on the property.
- Limitations on exterior and interior. Whether due to zoning laws or building codes or covenants, there may be limits to changes or alterations you can make to the property. A good example is a building that is in an historic area and subject to restrictions on changes that can be made to the façade.
- Adequacy of access and parking. You need to make sure your customers can park and take into consideration whether access is compliant with laws such as the Americans With Disabilities Act.
- Opportunity for expansion or leasing. Entrepreneurs often have a rosy outlook about growth and so the potential to expand is a consideration as is the flipside – if you don't grow as much as planned, can you lease out extra space?
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Purchasing Commercial Real Estate: Do Due Diligence and Evaluate the Property
After you locate the right property, you go to contract and commence a one- or two-month period during which you need to do your homework. Now is the time to revisit your objectives, and ask yourself if the property you have identified helps you meet or further your stated objectives.
Beyond that, this is where your team of trusted advisors plays an important role. A broker will often help bring in third parties -- engineers, appraisers, environmental analysts -- to help verify the condition of the property, its prior use, and any potential liability issues, whether structural soundness or necessary upgrades of electrical wiring. You should also be involved to make sure that there isn't any potential for changes in adjacent properties that could negatively impact your business or property value, such as development, road or infrastructure construction, etc. A title company can also make sure there are no prior or existing litigation and/or insurance claims affecting the property.
If you find any problems, you may have the opportunity to renegotiate with the seller or sometimes to walk away from the deal.
Purchasing Commercial Real Estate: Taking the Plunge and Making the Purchase
Once you've found the right property and worked with the owner on the right price, the next big step is to secure financing and come up with the right mix of how much cash you're putting down and how much you need to finance, Nadji says.
During good economic times, there are a host of attractive financing options available to small and mid-sized businesses. After the global economic meltdown, starting in 2008, banks tightened up credit and limited many of these options. In order to get a loan during a tough economy, it's doubly important to make sure your business has sufficient cash reserves, has a good credit rating, and is profitable.
Your attorney and accountant play key roles here to ensure contracts are sufficiently detailed, and structured to your maximum advantage. You need to envision every possible contingency, and make sure it is covered -- clearly and unambiguously -- in the contract. Everything from air rights and other zoning laws to the nuances of existing tenant leases and tax requirements must be understood here. You also need to verify -- and re-verify -- the financial terms associated with this purchase, to confirm you are ready to pull the trigger.
At this step, you should also update or add to your original business plan, to cover the specifics of this acquisition; this is when your plan comes to life. Once the purchase takes place, it is imperative that you implement and execute on the plan without procrastination. The cliché "time is money" is never truer than when you are building or renovating a commercial real estate property.
Before buying commercial real estate, it's important to make sure that buying is right for your business for the long-term. "The most important thing is to think carefully about what could happen in the first 12 to 24 months after buying a building that would make you look back and say, 'I made a mistake,'" says Nadji. "If you're very aggressive with revenue growth projections or overshoot how much space you need to occupy or buy and then the business doesn't grow fast enough into that, you may have a problem."
Dig Deeper: How to Pick a Site for Your Business
Purchasing Commercial Real Estate: Additional Resources
Pick a Location for Your Business
The U.S. Small Business Administration's small business planning guide offers advice on locating your business.
Buy Vs. Lease
US Bank's Small Business Center has a run down on what you need to consider in determining whether you should buy or lease a commercial property.
Costar Group, Inc.
Information on commercial real estate in the U.S. and U.K.
Online commercial real estate listing service.
Research Reports on Commercial Real Estate Market
Registration required for access to no-cost commercial real estate market reports.