Rent or Buy? The Eternal Question
When executives at Pacific Giant Inc. wanted to expand the company’s seafood importing business and improve customer service, one part of their solution was to buy their own building at a new trade center in downtown Los Angeles.
Pacific Giant had been operating from offices in the Mid-Wilshire district and storing its fish in public freezers, but the company figured it could provide faster service by owning its own facilities. It bought a 16,000-square-foot combination office and warehouse at Alameda Trade Center for about $1.5 million.
Pacific Giant is one of countless small businesses known in real estate parlance as “owner-users”--companies that have asked themselves the question, “To buy or not to buy?” and have decided they would rather own their real estate than rent or lease space.
Whether to buy or to rent is an eternal question for business owners, because the answer depends on ever-changing factors such as how much space the business needs now and in the future; whether the company is owned as a partnership, sole proprietorship or corporation; and, of course, the ups and downs of the real estate market.
Experts say owning your own space has some obvious advantages. You control the space, you don’t have to worry about the landlord raising the rent, you don’t have to suffer through lease negotiations, and you might make a bundle if the building rises in value.
On the other hand, you’re stuck with the space you have and might find it harder to move to a new or larger location. Owning the property could present tax problems, and buying may be more expensive than leasing if real estate values decline.
“There’s no simple rule of thumb on whether it’s better to buy or to lease,” said Duane Waters, a tax real estate partner at Arthur Andersen, the accounting and consulting firm.
“If you’re a doctor or have some other type of business where you know you’re always going to be in the same building, and you want to hedge against increases in rent, owning the real estate can make a lot of sense,” Waters said. “On the other hand, if you open a retail outlet or another business that is more likely to expand, owning the real estate might not be the best strategy.”
Large corporations generally avoid owning lots of real estate, Waters said, because “It throws off their financial ratios and makes the company look like it’s heavily burdened with debt.” Also, overseeing a large real estate portfolio can become a management headache that diverts time and energy that could be better spent on the company’s core business.
By contrast, Waters said, many small businesses that own just a single building find they can manage the property without too much trouble. Often, the real estate turns out to be a good investment that is eventually worth more than the core businesses. This is especially true for businesses that bought buildings at rock-bottom prices during the early 1990s real estate slump.
But Waters also is full of caveats for those who would buy their own buildings. If the business is a corporation, owners can face substantial tax liabilities if they sell their property at a profit. That’s because the profit is taxed twice: first as corporate profit, and then as dividends when the profit is distributed to shareholders.
“You have to be really leery about putting real estate into a corporation because it can be hard to get it out without paying a big tax penalty,” Waters said. Many corporations avoid this problem by putting the real estate in the name of individual shareholders, who then lease the property to the corporation.
“You really have to have a strategy with regard to the real estate and whether you want to keep its ownership outside the business or inside the business,” he said.
Waters said partnerships don’t face double taxation because, unlike corporations, they don’t pay income taxes as a business entity. (Partners pay taxes individually and not as an entity.) But partnerships present other pitfalls.
“In businesses where there are a lot of partners coming into and going out of the business, the partners sometimes get into big battles as to who owns what percentage of the real estate,” he said. “There are a number of businesses that have blown up over this issue.”
Business operators thinking of buying their own buildings also should ask themselves if they’re sure they’re going to occupy the property for several years. “If your business requires you to move out of the building at a time when the real estate market is declining, you might have to sell the property at a loss,” he said.
Despite the possible pitfalls of owning real estate, owner-users are a mainstay of the market for small office and industrial buildings. Developer John Quinton of the Clifford Companies, based in Newport Beach, said owner-users bought half of the space at his nine-building, 75,000-square-foot Plaza Point Office Park in Laguna Hills. He expects owner-users to buy many of the small buildings he is planning to build at office and industrial park projects in Los Angeles, Orange and San Diego counties later this year.
Lowe Enterprises was focusing squarely on owner-users when it planned the 20-acre Alameda Trade Center, said spokesman Doug Hinchliffe. The company has built a nine-building first phase and plans to begin construction in June on an eight-building second phase of what is expected to be a 625,000-square-foot development when completed. In particular, Lowe saw a demand for space from small importers and exporters, so it also obtained designation for the property as a foreign trade zone.
“We designed this project from the start as a place for small entrepreneurial businesses that want to own their own buildings,” said Craig Furniss, a Lowe Enterprises vice president. He added that many business owners want to take advantage of current low interest rates and favorable financing terms available through Small Business Administration loans.
As Brad Knipp of Pacific Giant pointed out, however, the cost of owning versus renting is often only one of many considerations when companies decide to become landowners.
“Our main reason for wanting to buy a building was to give better customer service,” Knipp said, explaining that the cost of owning compared with renting was not a major factor in the decision. “Now that we own our own freezer and cooler, our customers can come to our facility, pick [the seafood] up, and we can have them in and out of here in 10 minutes.”
Pacific Giant could have rented a building and installed a freezer, but Knipp said there is a shortage of clean, new, quality space the company wanted for its operation. And the need for such space was paramount because of a new federal program that requires importers to more closely monitor the quality and cleanliness of fish.
“We wanted a building that was brand-new, state-of-the-art, with no headaches,” he said. ‘It was a lot like buying a new car instead of a used car.”
