When an organization decides that it's time to find new space, the tax implications of leasing versus buying, and how those will affect your investment, are a significant element in the discussion that drives decision making.
Real estate investment goals will differ based upon the investor and their overall asset strategy. The definition of a "realistic" return will also differ among investors, but is mainly determined by one's analysis of the market - demand, financing conditions and the overall economy. However, most investors who are comparing both leasing and buying space share two goals: equity build-up and cash return.
Initial built-up equity: Equity is established when the value of the property minus the debt and the capital leave a positive value, or equity. Generally this occurs upon stabilization, when the property reaches an occupancy level of 90-95 percent. For example, if the property value is $10 million, its debt is $6.5 million, and its capital is $3 million, the equity or value of the project is $500,000.
Cash return: Is there positive cash flow after paying expenses, debt and reserves to provide a cash return in addition to equity? A healthy cash flow ranges from 10 percent to 15 percent.
Once these initial criteria are considered, investors can determine whether or not it makes sense to carry real estate debt from a tax perspective. Generally, if it is better for a company to have fewer debts on its balance sheet, then it might consider leasing instead of buying. In bigger corporations, property is depreciated on the balance sheet. In addition, there is a middle ground that real estate development companies can provide for their clients.
For example, we constructed a building for a company that will be the sole occupant and responsible for its operation. However, the company did not want to own the building, and therefore entered into a 10-year lease with us to retain ownership. The firm didn't want the depreciation - which translates into a taxable loss or less taxable income.
Depreciation is a tax advantage for a company that would like to offset income from other business segments by non-cash losses. However, it is also possible for tax losses to be avoided by a public company that cannot afford to publish diminished earnings-per-share. In that case, the company may seek an alternative occupancy cost, such as leasing, or partner with an entity that seeks tax losses. The partner would then bear all of the building's profits and losses.
Building costs depreciate over 39 years, while the market value of the building has the potential to increase. Yet there are ways for companies who don't want to wait 39 years for full depreciation to get tax advantages during this time period. Other components of the building can be depreciated over five, seven or 15 years. Among these elements are the building's HVAC system, parking lot, roof, landscaping, signage, and subterranean improvements.
If your company does not need an entire building and is not interested in entering the real estate business, leasing may be a better alternative for you. Again, there are tax and other financial considerations that may help you make the decision whether to lease or buy.
Finally - whether leasing or buying space - the vagaries of property ownership demand that clients know the reputation of a building's management company. A good management company will operate a building cost-effectively for the owners while maintaining a proper level of service to the tenants. Good service is the key to charging a higher lease rate and keeping occupants satisfied.
Dave Pavlik is treasurer for The Gustine Compa
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