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Owning vs. Leasing – Commercial Real Estate

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Whether you like it or not, winter is coming.

The most important factor to consider when staring down the barrel of at least 3 months of sub-zero temperatures is preparedness. Here are a few helpful tips that will keep you (and your property) on track and worry free as we move into the holiday season.

 

1. Know your roof’s maximum snow load

When it comes to the weight of snow, the type of snow is as important as the depth of the snow. Fresh powder snow is typically lighter than wet packed snow, and ice is heavier than snow.

There are several contributing factors to the acting load on your roof that include snow drifts from adjacent buildings or mechanical equipment, heavy rain on snow, and melting snow that refreezes.

If you don’t know your roof’s snow load, hire a structural engineer to verify the snow load threshold of the roofing system. This information will be important after an event when determining if there is too much snow on the roof.

 

2. Prevent plumbing from freezing

  • Inspect and seal or repair all cracks, holes, leaks, windows, doors, and other openings on exterior walls with caulk or insulation to prevent cold air from penetrating the wall cavity.
  • Insulate and seal around attic penetrations such as partition walls, vents, plumbing stacks, and electric and mechanical chases.
  • Make sure your pipes in hard-to-reach places like attics, crawl spaces, and along outside walls are insulated. Wrap pipes and faucets in unheated or minimally heated areas of the building.
  • Make sure your existing freeze-protection devices and alarms are in good working order.
  • Test freeze stats (low temperature sensing device) and valves before the weather gets cold.
  • Pipes leading to the exterior should be shut off and drained at the start of winter. If these exterior faucets do not have a shut-off valve inside the building, have one installed by a plumber.
  • Hire a licensed fire protection specialist to conduct routine maintenance on your sprinkler system. Discuss the systems exposure to winter weather and potential mitigation options.

 3. Winterize your landscaping and irrigation

  • Keep all bushes and trees trimmed and away from the building. Trees with branches near or hanging over your building can damage the roof cover, siding, and windows.
  • Pay particular attention to trees within falling distance of overhead power lines leading into the property. Avoiding a power outage can save a day or two of business interruption.
  • Shut off and drain irrigation systems and outdoor hoses.

 4. Maintain your HVAC system

  • Schedule preventative maintenance and make sure the system is operating properly and efficiently.  Be sure to change any air filters and check that exhaust gases are being ventilated properly.
  • Select a heating system repair service before an unexpected outage or maintenance issue arises mid-season. Loss of heat for even a few hours could significantly disrupt your business during a cold snap.
  • Have someone ready to come quickly – including after hours – and negotiate an emergency rate in advance.

5. Service your generator.

The time to maintain a generator is well before a major snowstorm or disaster strikes (when professional assistance may be unavailable, power lines are down, and access roads are blocked). Backup power can help maintain a consistent building temperature and reduce the risk of freezing pipes leading to business disruption and damage.

 Permanent:

  • Permanent generators should have a proper maintenance plan that includes weekly, monthly, and annual checks. See the manufacturer’s specifications for more information.
  • Run the unit weekly on its maintenance plan to ensure it is properly functioning in case of an emergency. Individual units may have a timer that allows a programmed test to be scheduled. Qualified personnel should oversee these scheduled weekly tests.
  • Check the generator enclosure for loose debris or other conditions that could cause the unit to not function properly.

Portable:

  • Store in a dry location.
  • Set up a maintenance schedule to include periodic test runs for the unit

6. Check your roof and gutters

    Water that does not properly drain off a roof has the potential to freeze, adding to snow load and creating ice dams. Ice dams can add significant additional loads to the roof and could cause interior water damage if left unattended. It is important for your team to maintain the roof drains and gutters.

    Low slope (flat) roofs:

    • Inspect roof and repair leaks before winter season.
    • Remove all debris and other items from roof and roof drainage systems that prevent drainage of water from the roof during the melting process.
    • Check that all flashing and seals are flush and secure.

    Steep slope roofs:

    • Inspect your roof and repair leaks before winter season.
    • Secure loose shingles.
    • Check roof-edge waterproofing and seal to prevent potential drafts.
    • Add extra insulation in your attic or surrounding areas.

    Gutters:

    • Inspect gutters and ensure they’re secured to the building. Replace any missing gutter fasteners.
    • Clean gutters and interior downspouts thoroughly, removing all debris and unclogging drains.
    • Run test of gutters and downspouts to be sure water does not back up. This can be done by using a hose.
    • Check downspouts to ensure they divert water away from the foundation.

     7. Create a business continuity plan

    • Have a plan for communicating with employees across multiple channels (text, email, phone).
    • Have an emergency/recovery plan that is communicated to employees, customers, clients, delivery, etc.
    • Create a snow and ice removal plan for all roofs and grounds.
    • Plan for emergency snow removal in event of heavy accumulation. Identify and supply proper equipment and check it in advance of predicted snow.
    • Some businesses rely on on-street parking, so develop a back-up plan for nearby off-street parking if the municipality imposes a parking ban on streets (for plows). This occurs more frequently in the north, even hours before snow is expected, so they can pre-treat the roads.
    • Purchase and be ready to add non-slip water absorption mats to all entrances for both your employees and customers to capture water and snow as they enter your business and to minimize slips and falls.
    • Test/practice the plan.

    8. Check your insurance coverage and inventory valuable equipment

    • Know what your insurance covers and what it doesn’t
    • Keep your insurance agent’s contact in your phone
    • If you have a loss due to a winter-related event, you’ll have to itemize your losses for your insurance company. Take a complete inventory of your home and store it somewhere safely offsite.

    NOTE: Check in with tenants regarding any maintenance requests or building concerns they may have. Living or working in your commercial property means they are on constant alert to their surroundings. If they see, hear, or smell something, ask that they say something.

    Imagine you are a mid-level manager at a fast growing small business.  As part of the company’s expansion plans, you have been tasked with finding office space in a new city and deciding whether to lease it or purchase it.  

    Fortunately, there is an objective way to make this decision.  But, it can be a little bit complicated.  In this article, we are going to introduce the key concepts in lease vs. own analysis and apply them with a case study.

    Lease vs. Own – Reasons for Each

    For many, buying a property is automatically assumed to be the best choice.  In many cases it may be.  Property owners benefit from increases in the asset’s value over time and from the tax benefits of depreciation.  In addition, they may benefit from leasing excess space to other tenants, favorable loan interest rates, and the comfort in knowing that their rent isn’t subject to the whims of a landlord.  

    However, buying a commercial property also requires a significant capital investment in the form of a down payment on the property and in the improvements made to the interior.  Depending on the capital needs of the corporation for other projects, it may not always be the best choice.

    On the other hand, leasing commercial real estate requires little to no upfront investment.  In fact, the landlord may even provide a tenant improvement allowance to fund all or some of the interior buildout.  In addition, lease payments are qualified operating expenses so they reduce the company’s taxable income and leasing relieves the company of the burden of property management and does not tie up capital that could be otherwise used to fund growth.

    On the downside, there is no opportunity to earn a profit on a lease and lease rates can be subject to change based on the local market and the property owner’s return requirements.

    The point is this, there are a variety of equally valid reasons to lease or buy a property.  Some of them are based on the company’s specific needs while others are strictly financial.  Lease vs. Own analysis tackles the financial aspect only.  It can provide an objective outcome from a financial perspective only, but there are considerations that go beyond finances that vary from one company to another.

    Lease vs. Own Analysis – Basic  Concepts

    The basic concept behind lease vs. own analysis is that the cash flows for each option need to be evaluated from both pre-tax and after-tax perspective.  There are two ways to do this:

    1. The Net Present Value (NPV) Method:  The NPVapproach considers the present value of all future after-tax cash flows and discounts them back to the present time using the investor’s required rate of return.  A rational actor would choose the option with the highest NPV.
    2. The Internal Rate of Return (IRR) Method:  This method seeks to perform cost/benefit analysis between the cost of buying the property and the benefits that are received from owning it.  The resulting IRRis the rate of return that can be earned from buying rather than leasing the property and it can be compared against other factors like weighted average cost of capital (WACC), required rate of return, and opportunity cost associated with alternative investment options.

    While the concept itself is relatively simple, the actual analysis can be much more complex because it needs to incorporate details specific to the transaction like: lease term, potential lenders, property occupancy, property taxes, loan amortization, capital gains, closing costs, loan debt service, income escalations, the property’s purchase price, tax rate, deductible depreciation, and the monthly payments associated with the lease.

    Lease vs. Own – A Case Study

    To illustrate how business owners can deploy lease vs. own analysis, an example is helpful.  We’ll start by setting it up and then go through the calculations.

    Case Study Setup

    Extending the example from above, assume the small business has found a 10,000 square foot commercial space and they need to evaluate the cost of leasing it versus the cost of purchasing it outright at its current market value.  Let’s start with a review of the lease cash flows.

    Required Lease Inputs & Analysis

    To calculate the Net Present Value (NPV) of the lease payments, the following inputs are required:

    • Marginal Tax Rate:  35%
    • Discount Rate:  7%
    • Improvement Expense:  $15,000
    • Commercial LeaseRental Rate:  $20 Per Square Foot 
    • Rental Increases:  3% Annually
    • Operating Expenses:  $6 Per Square Foot 
    • Operating Expense Increases:  2% Annually

    Using Microsoft Excel or a similar spreadsheet program, these inputs can be transformed into the following analysis (NOTE:  Only the first 5 years of a 20 year lease is shown):

    graph 1

    Let’s go through how each line item in the analysis is derived for Year 1 of the lease period:

    • Base Rent: Base rent is calculated as the total rentable square feet (10,000) multiplied by the per square foot rental rate ($20). Year 1 outflow is $200,000 and it rises 3% annually.
    • Operating Expenses: The tenant is also responsible for operating expenses of $6 PSF, multiplied by 10,000 SF. It rises by 2% annually.
    • Capital Expenditures: The tenant is responsible for $15,000 in CapEx in year 0. This is a direct input. There are no further capital expenditures.
    • Annual Cash Flow: Equal to the sum of total rent payments plus total expenses (including CapEx). In year 1, it is ($260,000) and it rises in each year of the lease.
    • Total Marginal Tax Rate: The company has estimated their own marginal tax rate at 35%. This is a direct input.
    • After Tax Cash Adjustments: Remember, monthly rental payments reduce the company’s tax burden. So, there is some tax benefit from the lease and it is calculated as the total outflow ($260,000) multiplied by the marginal tax rate (35%). The benefit is $91,100, meaning this is the tax savings from the rental expense.
    • After Tax Cash Flow: Equal to the before tax cash flow (-$260,000) plus the after tax cash adjustment ($91,100). This is the key number in the analysis.
    • After Tax Cumulative Cost By Year: This line item is calculated as a running total of the annual after tax cash flows. For example after tax cash flow for year 0 is ($9,750) and ($169,000) for year 1. Together, this is ($178,750). This continues for the analysis period.
    • After Tax NPV By Year: This line item is calculated as the cumulative cash flow discounted at the specified rate (7%) for the relevant number of periods.

    The Excel model makes these calculations for each year in the analysis period and the after tax cash flow is summarized in the table below:

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