Is your business poised for future growth? Are you thinking of moving into a commercial or retail space? If so, are you unsure whether to lease or buy such a space?

You’re not alone. Every day, business owners must decide whether it makes sense to invest their profits back into costs such as more equipment, additional employees, or a new place to set up shop.

It can be a daunting task. But with some smart planning, financial forecasting, and market analysis, it doesn’t have to be, says Larry Margo, a longtime Commercial Associate in our Studio City office. Below, we talk about the pros and cons of leasing vs. owning a commercial space, plus tips for investing in commercial space.

Questions to ask before leasing a commercial space

It all starts with asking yourself the right questions, Larry says:

“Find out what your motivation and goals are, what your accountant says you can afford, and how your taxes are likely to look, especially with the new tax laws in effect. If you’re a startup and you can’t afford to purchase something, you want to try to lease.

“It all depends on what kind of use you have. Is there an industrial area where you can lease, do you need a retail space? One example: The big rage right now is legal marijuana. Are you a grower, a cultivator, a distributor, a retailer? You probably don’t want to buy anything right now if you’re any kind of a startup, because you don’t know what kind of monies you’ll have and how much money you’ll need to put into the operation as opposed to putting into debt service.

Usually, it comes down to affordability and the triple-net costs of property taxes, insurance, and common-area maintenance. Click To Tweet

“If you are a startup or new business, you would want to talk to a commercial broker or our Commercial Division, and they can direct you to the areas you should be in. Usually, it comes down to affordability and the triple-net costs of property taxes, insurance, and common-area maintenance. Those are usually taken care of in a retail setting by the tenant. If you get into an industrial setting or a commercial building, a lot of times those are contained in either modified-gross leases or full-service leases.”

The inventory issue

Like much of the residential market, commercial inventory is tight across Southern California, Larry says, but spaces can be found in certain areas. If you’re looking to lease in Santa Monica, El Segundo, or further south along the coast where many big tech companies are moving to, it’s a tight market for industrial or commercial.

“A lot of industrial spaces have been sold or converted into creative offices spaces,” Larry says. “They’re really trying to go for the Millennial types, younger startup companies, a lot of tech companies. Warner Bros. is moving its entire record division into the Arts District in downtown Los Angeles, so that’s a good area to get into if you want to have a commercial space or an office building, particularly if you’re in that industry.”

Vacancy rates are about 3 or 4 percent in the highly desirable markets. Click To Tweet

Vacancy rates are about 3 or 4 percent in the highly desirable markets, Larry notes. But in less-commercial communities like Reseda in the San Fernando Valley and San Diego’s East County, things are not as tight. In the Gaslamp Quarter in downtown San Diego: “There’s hardly anything there right now. I’m trying to help some people who would like to have a hotel in the Gaslamp area, but there’s nothing available near Petco Park or the Convention Center. So we’re looking further out from downtown.”

What about retail?

If you’ve been considering moving into a retail environment, visit spaces that fit your customer profile, Larry advises: “I’ve had people who are interested in a nice little space in a small shopping center. I tell them to let me drive them around and get to know the area, see who lives here. You need to know your demographic. If you’re out in horse country, give it a country look. Try to draw in the people who you know live in the area.”

Of course, your choices might be limited when it comes to buying vs. leasing a retail space. Unless you can find a standalone building or get into a purchase partnership, you probably will be looking at a retail lease.

They’re going toward more entertainment and huge food courts because people want to have an experience when they go to a mall. Click To Tweet

As for getting into a shopping mall, proceed carefully, Larry says. Again, you most likely will be getting into a lease. But larger shopping malls across the country are going through somewhat of a catharsis.

“A lot of malls have never revitalized and made themselves more of a draw for people,” Larry says. “They’re going to have to make themselves more exciting because they’re being affected by online purchasing. So they’re going toward more entertainment and huge food courts because people want to have an experience when they go to a mall.

“I believe shopping is a social activity, and while people will never stop shopping, the malls are going to have to rethink their situation. You need to know a given mall’s future plans before getting on board.”

Pros and cons of leasing vs. buying a commercial property

Before you even decide on a location and whether to lease or buy there, it helps to know the advantages and disadvantages of each situation.

Below is a summary from LeaseMatrix of some of the pros and cons to consider when analyzing whether to lease or buy. And remember, Larry says, to always consult your CPA or tax attorney before signing a lease contract.

Advantages of owning:

• Appreciation – As an owner, you are able to realize any asset value appreciation, whereas as a tenant, you would not.
• Income – If you lease out a portion of the property to tenants, the rental stream can be used to help pay the mortgage, reinvest, or distribute funds.
• Tax Advantages – Ownership provides the benefit of interest and depreciation deductions in order to shelter income from taxes. In addition, upon the sale of the property, gains are usually taxed at a lower marginal tax rate than ordinary income.

Ownership provides the benefit of interest and depreciation deductions in order to shelter income from taxes. Click To Tweet

Disadvantages of owning:

• Capital requirements – In most cases, commercial property requires a down payment of least 20 to 30 percent. This uses capital that could otherwise be invested in your underlying business. However, you might qualify for an SBA (Small Business Administration) loan of about 10 to 20 percent if you have at least three years of experience in your business, and occupy at least 51 percent of your tenant space.
• Financing – The sources and availability of debt might be limited during an economic recession or depression, and rising interest rates could make refinancing difficult or impossible.
• Management – Commercial property-management issues are complex and include areas such as legal compliance, health and safety issues, and contractor management, which can be distracting and costly.
• Downside risks – The many risks related to ownership include the value of the property declining because of the economy or market, financing uncertainties, and unexpected expenses for repairs and maintenance.

Advantages of leasing:

• Location – Leasing can allow you to occupy space at a premier or strategic location you probably couldn’t afford to own directly.
• Focus – Leasing lets you concentrate on your primary business without the distractions of the many property-management issues that come with ownership.
• Liquidity and cash resources – Leasing usually requires less cash out of pocket than ownership, leaving more capital to invest in the core operating business and other expansion opportunities.
• Tax Benefits – Unlike owning outright, the occupancy costs of leasing are fully tax-deductible. An owner is required to depreciate the property’s improvement costs, and cannot depreciate the value of the land itself. This benefit might help shield your business’s operating income from federal, state, and local income taxes. However, in some instances tenants do receive the tax bill and are asked to pay it, depending on the terms of the contract.

Disadvantages of leasing:

• No appreciation or equity accumulation – With leasing, there is no opportunity to realize profits from the appreciation of the property occupied. In addition, you won’t realize any accumulation of equity through the reduction of the property’s underlying financing.
• Control – Tenants tend to have little or no control over the other types of tenants that lease space in the building. Sometimes, these other tenants can have a negative impact on parking, hours of operation, use and compatibility, or building services. Be aware of non-compete clauses that might, for example, not allow you as a tenant to start selling clothing if a clothing store is already established in the property.
• Loss of salvage value – Most leases stipulate that certain improvements made by the tenant become the property of the landlord at the end of the lease. Alternatively, the landlord might require that you remove certain improvements made to the premises at your expense.

A purchase vs. lease model can help

If you’re on the fence about leasing or buying a commercial space, creating a purchase vs. lease model is a good idea. The Commercial Investment Member Institute will gladly tell you how to do it.

About our Commercial Division

With commercial agents throughout Berkshire Hathaway HomeServices California Properties’ close to 60 locations, our Commercial Division provides a comprehensive real estate solution for clients throughout Southern California and the Central Coast. To find a commercial agent near you, visit www.bhhscalifornia.com/commercial or call 877-778-8811.