Lease or Buy an Industrial Building?

Interest rates and rent comparisons are easy to start with, and they are rarely the deciding factor. The first question is how confident you are that this building, in this size and location, fits your business for a long time. A buyer is betting on that answer more than a tenant is, and buying and selling industrial property has transaction costs and takes time.

• ✓How long do we expect to need a building of about this size, in this location?
• ✓How likely is a change in customers, product mix, automation or labor market that would change our requirements?
• ✓Is the workforce and the freight pattern tied to this area?
• ✓Would the capital do more for us in the business than in a building?
• ✓Does our partner, lender or owner group agree on the time horizon, including any sale of the company?
• ✓Could we manage a building, or would we need to pay someone to do it?

Heavy power, process piping, cranes, pits, reinforced floors, cleanrooms or food-grade finishes change the decision in two opposing ways.

They favor owning, since you control the asset you are investing in, and you are less exposed to a landlord who knows how costly your move would be. A tenant with a costly installation may hold a weaker hand at renewal unless its lease contains clear renewal options and removal terms.

They also raise risk for an owner. Improvements built for your process may mean little to the next buyer, and a lender's appraisal may not give full credit for them. A tenant can sometimes negotiate landlord funding of improvements, and may be able to walk away from a building at the end of a term. Ask your broker and appraiser which of your improvements would matter to a future buyer or tenant. Also, a lease can give you much of the same control if it includes long renewal options, purchase rights and consent to alterations.

Industrial property calls for a harder environmental look than most other property types, and buying is the point where that matters most. EPA explains that under CERCLA, persons may be held strictly liable for cleaning up hazardous substances at properties they own or operate, or owned or operated in the past, and that strict liability means liability may be assigned based solely on ownership.

EPA also describes liability protections for certain landowners and prospective owners who did not cause or contribute to contamination and who meet the statute's requirements, including All Appropriate Inquiries. Timing is specific: EPA says AAI must be conducted or updated within one year before acquisition, and certain components, such as interviews, government records review, site inspection and lien searches, must be conducted or updated within 180 days before acquiring ownership. Protection also carries requirements beyond the report itself. Have an environmental attorney run this process and confirm the current requirements.

A lease is not risk-free either, since CERCLA can reach operators and a lease can assign you cleanup obligations, but a buyer is taking on the site directly. Give the environmental review time, and allow for what happens if it finds a problem: walking away, a price adjustment, or further testing.

Buying generally means a down payment, closing costs and working capital you cannot use elsewhere, plus exposure to property value. Leasing generally keeps that capital in the business but leaves you exposed to rent changes and renewal risk. Have your CPA and lender test both.

Small businesses may look at SBA programs. SBA's 504 page describes long-term, fixed rate financing for major fixed assets, originated through Certified Development Companies in collaboration with a senior lender, with eligibility conditions including being an operating, for-profit business within size guidelines. It says the loans cannot be used for speculation or investment in rental real estate. Occupancy rules also apply: 13 CFR 120.131 says the borrower must permanently occupy and use at least 51 percent of the rentable property for an existing building, and at least 60 percent for new construction, with further rules for new buildings. Program terms change, so confirm them with a Certified Development Company or SBA lender.

On taxes, rent and depreciation work differently, and this is for your CPA. IRS Publication 946 lists 39 years as the recovery period for nonresidential real property under its general depreciation table, and it also describes a special allowance for certain qualified production property, with its own requirements and dates. Land is not depreciated, and manufacturers should specifically ask whether any special rule applies to them. Your CPA can also advise on the financial statement treatment of each option.

A hypothetical, for illustration only: suppose a company compares leasing against buying a building for a 10-year hold. It should total the rent and pass-through costs on the lease side. On the buy side, it should total the down payment, debt service, taxes, insurance, maintenance, capital reserves and management time, and then subtract the expected net sale proceeds. The answer depends heavily on the sale price, which no one knows, so run a low, middle and high case.

1. Write your requirements and time horizon, and agree on them with your owners or board.
2. Ask your CPA and lender what you can realistically afford without hurting operations.
3. Search both ways at once: buildings to buy and buildings to lease, comparing the same criteria.
4. Model each real option over the same period, including exit costs and a downside sale case.
5. For purchases, plan due diligence: environmental, roof, structure, title, survey, zoning and power.
6. Review the final choice with your attorney, CPA and lender before you commit.

If you are leaning toward buying only to avoid a rent increase, also price a long lease with fixed escalations and renewal options. It may solve the same problem with less capital at risk.

Buying is not reserved for companies with long financial histories, though it can be harder. Telling a credible story to the seller and to capital sources may matter as much as finding the building. One TAG client, a new business, describes what that took:

One client's experience does not predict another's result, and any purchase still has to work financially. TAG represents occupiers on both leases and purchases, and because we are not selling a building of our own, we can run both paths side by side and leave the decision with you and your advisors.