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Leasing or buying commercial property

Once your business has outgrown its home or serviced office, the choice to lease or buy a commercial property will be crucial. Rebecca Spicer weighs the options, taking into account financial and practical considerations.

Whether you’re starting out or looking to relocate, the decision to buy or lease commercial property in the area you’ve chosen will be crucial to the stability of your business. It’s an important decision and one which needs to be well understood by business, says Simon Fonteyn, managing director of leaseinfo.com.au. "If you get it wrong, it’s going to cost you a lot of money," he warns.

"When you’re assessing, from a business point of view, the lease versus buy decision, you’ve got to really understand your business," adds Fonteyn, explaining both sides incur significant costs, so working out which is the most cost-effective for your business is important.

Garry Addison, senior tax adviser with CPA Australia, suggests that traditionally business owners went into owning property because it was one of the few investment vehicles available. He says it’s still very important these days, but there are lots of other avenues for investment, such as the stock market, managed funds, and so on.

"So you’d probably have to question why a business would want to own its property. Most businesses, particularly small businesses, are usually strapped for cash and to buy a property is an expensive matter. So you’d think, normally, they’d be better off using whatever they either have or can borrow to finance their business, and simply lease a property."

But there can be some advantages to owning a property, mainly because of the way in which the tax and superannuation rules work out. "If you have a building which you use to run your business from, then you can transfer that into your superannuation fund, either initially or at some stage in the future," explains Addison. "And if you hold it outside your superannuation fund, you can normally transfer it into the fund, not tax free, but you can get significant capital gains concessions that apply to small business."

Fonteyn agrees but warns you still need to have enough equity in your super fund to purchase the property outright because the fund can’t borrow extra funds. If you don’t purchase the property using your super fund, the decision to buy will hugely depend on how much capital (if any) is available to make the purchase. Will you take capital out of the business to buy the property outright, or will you need to take out a loan?

Both Addison and Fonteyn believe buying commercial property would be more effective for mature businesses, considering the superannuation and long-term investment incentives, and owning a property also means the business should be worth more if you’re planning to sell.

In the case of young or growing businesses, however, excess capital is less likely to be available and a loan will be needed to purchase. In this case business owners will need to consider ongoing costs such as mortgage repayments and the effects of changing interest rates. Property owners will also incur the expense of repairing and maintaining their own property, as well as stamp duty on the property when purchased, annual land tax and any other council rates applicable, as well as capital gains tax.

Fonteyn says there’s more to consider than just cost when weighing the options. "For example, what is your actual return on equity in terms of your business? If your business has a growth rate, or return on equity, of 7-plus percent per annum, it would be better to put your capital—all things being equal—back into your business, and lease, because you get a tax deduction for your rental, and you should get a better return putting your money into your own business.

"The other thing is, if you’re in the growth phase of your business it’s probably not a good idea to tie up your capital in a property," adds Fonteyn. "It’s more advantageous to lease because you get a tax deduction, it’s flexible, and you can hand back the lease after a short period of time if you outgrow your circumstances."

The question is, though, can you get a long-term lease? Addison says a short-term lease is risky because you don’t want to have to change locations regularly. "Location is important to many businesses. If they’re in a prime location and have to move, then it could diminish the value of the business."

Fonteyn agrees, saying if the success of a business is reliant on its location, then it may be beneficial to purchase. He uses the example of a drive-through dry cleaner. "This case could present good reason to purchase the asset, because of the strategic importance of the location to the business." This option allows the business owner to control the asset long-term, and even after the business ceases to exist the owner can still lease back the premises and continue earning an income from it.

Overall, Addison advises that business owners need to clarify exactly why they would need to own a property. "Is it for long-term investment purposes, is it for security of tenure, is it to take advantage of the superannuation concessions? They just need to clarify what their objective is in terms of owning the property, and then compare that against the alternative, of continuing to lease and investing in other assets."

Bear in mind that many commercial leases will be offered for longer than five years, with an option to renew. Explore possible leasing terms and factor this into your decision.

When going down the leasing path, Fonteyn singles out retailers as having more specific concerns. In retail environments—particularly the big shopping centres—competition is rife and there’s a waiting list to get into the big centres, which means it’s a landlord’s market—a scenario which isn’t always very kind to the shop owner.

"The retailer has a number of issues to consider including the fitout, goodwill attached to their business, and most leases in shopping centres don’t exceed five years and have no options," warns Fonteyn. "Usually when the lease expires there’s a substantial increase in rent, with the average rental increase per annum in major centres is somewhere between 4 and 6 percent." Then there are other outgoings these retailers will have to pay, such as promotion levies and other possible fees, depending on the centre.

Given that the decision to buy or lease is so important, it’s worth consulting a number of experts to help advise on your options, and what might work best for you and your business. Fonteyn offers the following checklist:

Accountant. Find out from them what your capital requirements are in the short term (next three to five years); what are your growth prospects; and try and work out what sort of returns on equity you’re likely to generate from your business.

Independent valuer (not an agent). Ask them what they consider to be the likely growth rates in rents for a particular area, and what are the supply and demand issues in the area.

Financial adviser or (again) accountant. Work out with them the after-tax returns of buying versus leasing, which is a relatively simple analysis to do. Prepare that analysis to see which is the better option over a period of time. Then, write down some of the qualitative issues, rather than just quantitative. For example, how important is the location to my business; will this premises suit me in three to five years; is there an option available within this lease or do I just have a three-year lease; and if I was to renew the lease, how much of a rent increase will there be? And finally, prepare a business plan on the outcomes of that analysis.

 

Options at a Glance

Pros and cons of purchasing:

Advantages

Disadvantages

Property is an asset of the business

Higher initial starting costs

Capital appreciation of freehold premises (in good economic times)

Capital depreciation of freehold premises (in poor economic times)

Security of tenure

Selling premises may be difficult

Do not have to deal with a landlord—more certainty & control

Can’t share or offload costs to the landlord

Can borrow against equity in the premises to grow the business, buy new equipment or open another store or office

Can’t vary bank loan repayments as easily as you may by seeking a re-negotiation of the rent

Asset value grows as the business grows

Increased risk if the business fails

Can sublet parts of the premises, or change use from retail to residential:

Additional costs of entry and exit fees of retail premises: stamp duties, bank fees, legal fees when entering, agent and legal costs when exiting

Can claim depreciation of building, fixtures and fittings for taxation purposes

Subject to increasing cost of borrowing

 

Depending on how much is borrowed, you may be locked into loan repayments for 20-30 years 

Pros and cons of leasing:

Advantages

Disadvantages

Flexibility of moving to other premises at end of lease

•1 Open to uncertainty and subject to directions of landlord

Usually cheaper set-up costs than buying

Money spent on rent is money not contributing towards attaining an asset

•1 Share the costs of certain aspects of the premises with the landlord

You can still be liable for lease responsibilities even after assigning the lease to someone else

Money otherwise spent on purchase of premises can be used for other uses

Can be subject to restrictive clauses in a lease

More flexibility with moving or relocating

Can’t relocate or close the business unless lease is assigned

Can claim lease payments as a business expense

Can’t claim depreciation for tax purposes

Source: Business Victoria (www.business.vic.gov.au)

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