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Commercial property: Buy or lease?

Jul 22 2016 19:24
Carin Smith

Cape Town - Current economic conditions have raised the question whether it is better for a business to buy or lease commercial property.

It really depends on each business and there cannot be a generic answer, Leon Breytenbach, national commercial manager at Rawson Properties, told Fin24.

"You always have to make an educated decision as there will be pros and cons for both buying and leasing," he explained.

Among the pros for buying would be that when you take out a bond, your instalments over, for instance a ten year period, could go up or down or stay the same depending on the interest rate movements, while your rental will always go up.

Another advantage of buying commercial property is that you will be paying off your own asset, which will accumulate in value over a period of time. As a tenant, on the other hand, you basically flush cash down the drain, according to Breytenbach.

"If you buy your commercial property you have the advantage of stability in that no one will kick you out. You can then focus on your business going forward. You can make alterations to the property perhaps. So, you have much more freedom and there are some nice tax advantages," said Breytenbach.

"Of course there are benefits to leasing as well. Most commercial tenants sign 3-year leases, which give them some stability, but also, more importantly, flexibility to move if the business grows bigger. Compare this to the problem if you realise you bought the wrong property."

READ: Commercial property adds R50bn to Gauteng GDP

The issue of deposits

Another advantage of leasing is that a deposit on a lease is usually much less than having to provide 30% or 40% of a purchase price.

"That cash flow saving could then be injected into your business. So, from a cash flow point of view leasing could be good," said Breytenbach.

Another pro of leasing is that, while you as the tenant would have to see to maintenance in the inside, the landlord has to worry about things like the gutters and the roof.

"In my view, buying holds a lot more benefit. I am very in favour of buying the right property and if you have to sell at a later stage, your cash flow and your business could sustain it," said Breytenbach.

At the same time tha value of the rental market remains very important, especially in an entrepreneurial environment where cash flow is important.

"Maybe later you could look at buying when the time is right in terms of your cash flow. Your core focus must be your business rather than what the market is doing. After all, in the end it is the money that your business makes that has to pay off the bond," said Breytenbach.

"Make an informed and educated decision, both regarding owning the property and its location in terms of what is needed regarding the running of your business."

READ: Digital disruption and the commercial real estate market

State of commercial property industry

According to Breytenbach, commercial property is doing well at the moment.

"I was concerned at the beginning of the year, but have been pleasantly surprised. Big listed companies are doing great things. Of course there are people concerned about interest rate hikes, doom and gloom and Brexit. Yes, it might impact SA, but I am very bullish about the SA property market at the moment," said Breytenbach.

"We have obstacles to overcome, but the barrier to entry to commercial property - due to, among other things the cash flow needed - brings stability to the industry. Then, in difficult times, there is already stability built in. Not like residential property with its 90% bonds and owners often stretched to the max," said Breytenbach.

READ: Noticeable changes in commercial property sector

Measuring returns on property

Property economist Erwin Rode of Rode & Associates told Fin24 it is important to remember there are two ways of measuring returns on property and the two are complementary.

The first is the income yield, which is the expected first year's net income divided by the purchase price. That tends to be, in most places, a pretty low yield. Then, on top of that, you hope to get capital growth.

"When comparing buying with renting you should look at the combined return of these two - that is the total return," said Rode.

"The big risk is the expected capital return. That is the big unknown and what most research is all about. So, if you are in an area where you expect little capital growth, then it is an indication that maybe leasing could be a good option."

He pointed out that the risk, however, is that you cannot forecast the future. Therefore, there is some risk attached to expectations that are not based on reasonable assumptions regarding capital growth.

"At the moment, given what happened in the world, one would not expect much capital growth from property the next few years (including residential property). That makes the case for renting at the moment," said Rode.

READ: The new Expropriation Bill: Transformative or troubling?

Another factor to consider

He added that there is another factor to consider at the moment though. Currently industrial buildings and office buildings in SA are "quite cheap" in real terms, so the down side potential capital-wise is very low.

"Ignoring the very slight possibility of SA could turn out like Zimbabwe, the chances that capital values will decline over the next few years are very slight. So, the risk is not about owning property, but about the risk that there will not be the capital growth you expected," said Rode.

He explained that there is another argument to consider: You must know what your business' cost of capital is. That means the expected total return. It has very little to do with the cost of loan capital. The total return should also be calculated on a weighted average of the cost of loan capital and the cost of equity.

To make the comparison you have to forecast the future for both options, which is very difficult at the moment. If you were to buy commercial property and hold it for 10 years, eventually you will make a good return, but if your time horizon is three years, for instance, then the argument for renting is stronger.

Rode also points out that renting is more flexible, especially if you are a start-up company.

Another factor to consider is can you buy cash or do you need a mortgage bond? When the company has enough liquidity to buy cash, the argument in favour of buying is strengthened. But when you have to make use of a mortgage bond, the risk (variability of return) is multiplied.

Carol Reynolds, area manager for Durban Coastal at Pam Golding Properties, told Fin24 that, in her view, it is always better to own rather than lease property.

READ: SA property market grows to R5.8trn

'Only negative'

"Perhaps even more so in the commercial space where you can use your own business to essentially pay your rent and, therefore, cover your bond instalments," she explained.

"The only negative with commercial bonds, is that they run over a ten year period, and, therefore, the monthly instalments generally exceed rental returns. However, this then becomes a good vehicle for tax saving, and, therefore, again, the positives outweigh the negatives, and ownership wins every time."

In addition, the cost of relocating a business, renovating and doing shop fittings is high, and, therefore, it makes sense to own and be able to enjoy the capital benefits of the shop fittings and renovations which have been undertaken, in her view.

Guy Friedberg of Seeff Atlantic seaboard, City Bowl and V & A Marina, told Fin24 that, if you have the money, it makes more sense to purchase rather than pay rental. This is because of the escalation of rental.

He said most tenants would prefer to purchase, but they do not always have the money.

"Usually we find people with money rather purchase as you will always pay more if you lease. A lot of peole are looking to purchase commercial property at the moment - both as investments or for own use - but there are not too many sellers," said Friedberg.

"People will only buy property if they can get returns of at least 9% to 10% on the property - it is straight forward. The same goes for businesses of all sizes. Start-ups don't know where the business will go, so they might not want risk buying, while established businesses can project forward and know if buying would be a good investment and they could sell again if they want to."

Like Breytenbach, he too says people are not reluctant to buy commercial property at the moment, despite the economic climate. There are a lot of developments taking place.

* Do own or lease commercial property? Tell us your views or experience and you could get published.

business  |  property  |  entrepreneurs  |  money
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