I regularly get asked from business owners whether they should buy their business premises instead of rent, and my advice is always the same. You need to look at this through two different lens’;
First look at it through your business lens and ask yourself the following;
- Is the property right for your business?
- Is it in the right location?
- Does it align with your brand image?
- Will it suit your current and medium to long term needs? Can the business afford the rent?
It really comes down to;
is this the best place for our business to operate?
Would our business rent this from a 3rd party on the same terms?
If all this makes sense from the business perspective give it a big tick and then look at it through your investor lens
As an investor consider these;
- Is this the type and quality of an asset that you want to hold long term?
- Do we plan to run this business for the medium to long term?
- If our business is sold would we be happy to be the landlord to the new owner? Or find a new tenant?
- If our business wasn’t going to rent this thing – would we still buy this asset?
- Do we have the capital to fund the deposit and on-costs?
- Can we fund the loan repayments and other costs of ownership like land tax, rates, repairs and maintenance, body corporate etc etc?
- Does the financial return fit our investor profile?
- Is this the best use of our capital?
This last one is where it gets interesting, so hold that thought as we take a quick look at some numbers.
Owning or leasing commercial property is a different beast to residential. Unlike residential, it’s not always easy to find a tenant for a vacant store/workshop. Just take a look as you’re driving around the number of vacancy signs in windows – and how long they stay vacant for.
If the commercial premises is specialized for a limited number of uses or is particularly large – or small, the pool of potential tenants is going to be smaller, which means it can be a lot longer that the place is empty.
As your business is going to be the tenant that may not be such of an issue right now, but it could mean you have a harder time to sell the place when you want to sail off into the sunset.
Specialized assets are also more difficult to get financing for. Though not at all impossible, it just reduces the number lenders who are interested, and increases the amount of capital you need for a deposit.
Usually, commercial property will require a larger deposit than residential. This is because lenders know they can be vacant for longer and or take longer to sell.
Commercial property valuations can also move down more quickly than residential as the values are linked to the rental return. So the lenders want to protect their downside risk by getting you to stump up more.
So how much are we talking?
Between 10% - 40% (or more) plus the on-costs like transfer duty, valuation fees etc. And if the property is not being sold as a going concern then there is likely to be GST on top of that. Which although you can claim back on the next BAS, means you need a bigger pile upfront.
Now these deposits vary wildly between lenders, types of commercial property and the value. In general if the property is less than $1mil, a smaller deposit is the norm.
Once you get over $1mil, the LVR drops dramatically and can easily require a 35%- 40% deposit.
In addition to this the loan term can also vary wildly. Some owner occupier deals can be 30 year mortgages. Others can be 10 – 15 years, and that obviously makes a huge difference in cash flow for the investor.
But for the sake of simplicity, let’s assume you need a 20% deposit for your office valued at less than $1mil and the loan will be secured up the ying yang by all and sundry, so you get a 30 year loan term.
That’s $200k, plus transfer duty and other costs. So let’s call it $300k you need to stump up (or have as equity in another property – but bye bye asset protection) so you have some cash in the kitty come settlement time.
Now going back to the investor question I left hanging.
Is stumping up $300k for an office, the best use of your funds as an investor?
Of all the possible investments you could make – is this the best one?
Think about it you could;
- Buy a commercial property and rent it to someone else
- Buy a residential investment property
- Buy shares, managed funds or ETF’s in some of the biggest and best businesses in the world.
- Invest $300k to buy a competitor, or go 10x on your marketing to grow your business. Your business is (hopefully) producing good EBIT and your return on assets should be 15%+ (and way more if you’re a small business).
In a simplified example, you can buy your competitor for $1mil. You don’t need any other assets as they can all just “tuck in” into your business.
So you’ve spent $1mil on your buying the asset (goodwill), that competitor makes 30% EBIT. That’s a 30% return on assets (ROA) (EBIT/Cost of Asset). Compare that to buying the office space and leasing it to the business.
Rental yields are razor thin at the moment so you’d be looking at 4.5% to 6% (if you’re lucky). That means there needs to be significant upside in capital appreciation for this to come close to the ROA of expanding your business.
So why would anyone buy the premises when investing in business has a higher return?
Risk & Diversification
Business is risky, we all know that. It’s not fait accompli that the acquisition of your competitor is going to produce 30% EBIT year in, year out without a few hiccups.
Acquisitions and business growth are tricky things. So borrowing against your house to tip in more on your business isn’t for the faint hearted – and it might just be down right stupid.
If your business isn’t doing great to start with but you think that new marketing agency can get you 10x sales in 10 days just like they said and geometrically change your business. I’d be urging caution about mortgaging your children’s future.
Business risk is real, that’s why businesses need to make higher returns to compensate for the very real possibility that something goes wrong (and it does every day. 45% of new business starting today won’t exist in 3 years).
So for a lot of business owners they’d like to build some assets outside of their business. And property is something they can feel and touch as opposed to the ethereal goodwill. And if they are already paying rent to someone else – paying rent “to yourself” to pay off an asset can make a lot of sense in diversifying your investments.
Of course, it’s not all about numbers. Buying your own place gives you certainty of tenancy. It means you don’t need to worry so much about landlord’s being d**ks, or them wanting to sell or that make good or fitout clause you didn’t see and WOW having to re-do the fitout every 5 years really doesn’t make your business any more money does it?
So having a place for your business to call home is an admirable aspiration.
But there are also other things that may not cost you cash right now but could spell trouble if things go pear shaped.
Like personal guarantees to the bank for the loan.
Like using your house as security to get the deposit.
These things void any fancy asset protection structures you’ve got going and have paid good money for, so enter them with a lot of caution.
Buying your business premises can make a lot of sense to both the business and the investor – but not always, you need to find the right place at the right value, AND be willing to stump up a fairly significant pile of cash or equity.
Financing in commercial property land is as you might expect different to residential. In commercial land its best to have a good broker or business banker in your corner, because these things are all about the “deal” and how it can be structured to make it work.
We regularly workshop scenarios with commercial lenders as part of our broking service to see if there is a deal, and if there isn’t a deal just yet, we can find out what needs to be in place so it works in the future.