As a banker, a great many of the loans I do are for those looking to purchase real estate – their own office building, warehouse or industrial facility for example. The most common question is whether they can afford it, not whether it makes good financial sense to purchase it.
Why Purchase Real Estate?
One owner may feel a building location is ideal and wants to remain there with no possibility of being evicted.
Having a customer base that is familiar with your location is a big plus.
Other owners want to modify the building to suit their needs, and they don’t want to make those expensive improvements without owning the property.
And of course a building often appreciates in value and allows the owner to build equity.
All of which sounds great – but is it?
Sometimes it Makes Sense, Sometimes it Doesn’t
Well, the short answer is that it depends. If the building is one that is particularly well suited for the company that will occupy it, then it might make sense.
I have a customer now who produces granite countertops for kitchens and baths. They need enough space to store the stone slabs, and an overhead crane to move them, an entry for a forklift, and a showroom. Getting all of that in one space is difficult. Once they have it, they don’t want to lose it, hence the desire to purchase. It helps that the mortgage payments, if they stay in budget, will be significantly less than rent. This is a great reason to buy.
However, even if mortgage payments are less than rent, other expenses related to the building have to be considered. Taxes and maintenance have to be accounted for. And they go up continuously, so the effect of the increase has to be accounted for.
If payments are tight upon loan closing, it may get worse if substantial repairs have to be made, or if ongoing maintenance turns out to be larger than expected.
The Big Reason Not to Buy
The same capital that is used to purchase real estate can often be used to create more profits in the operations of the company.
I once had a customer whose operations produced $300,000 a year in profits. He took the profits and bought $2,000,000 in investment real estate. Unfortunately the real estate produced only $22,000 of profit each year. He could have put the money in a bond and done far better! Had he put the money into a second location, he might have doubled profits.
Let’s Revisit Return on Assets
Return on Assets (discussed here last week) can used to determine whether the purchase makes good financial sense or not.
Normally the building will have to have a large savings over rent for the Return on Assets of the building alone to justify the purchase. But if the owner takes Return on Assets into account along with other factors, such as any rent savings, desirability of the location, and increases in future value, he or she can begin to get a much better handle on the cost versus benefits.
A building that can appreciate at a high rate annually, or is located in an area that will continue to be desirable long into the future, can produce a return upon its sale. Many owners have decided to sell their operations and keep the building, renting to the new owners. This allows them a steady income, and avoids the large tax hit from a sale.
At this point I should mention that is always desirable, when rates are low, to put as little down on the building as possible. The Return on Assets is almost always higher on the operational entity than it is for the building. So it is in the business’s best interest to keep the cash available to invest in operations rather than the building.
The 504 Loan
The 504 Loan product through the Small Business Administration (SBA) allows the purchaser to put as little as 10% down on the building and finance closing costs when they purchase real estate.
The purchaser puts down 10%, the bank lends 50% and gets a first position lien, and a certified development company (NYBDC is one here in NY State) lends the remaining 40% and takes an SBA guarantee to shore up their second position lien. The interest rate is normally fixed for the entire loan on the portion done by the certified development company.
The program is an excellent one and has been used to assist many an owner in purchasing property for their business.
Owning the building your company operates in is not for everyone, but with a little analysis you can determine if it is right for you to purchase real estate.
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