Buying or leasing is a topic where people generally have very strong opinions. Earlier this week we had a client say something to the effect of “I refuse to lease and watch all that money disappear“.
After all, people often boast about how wise they were to purchase real estate (and presumably how rich they are as a result).
Purchase real estate + pay down the mortgage + participate in property appreciation = get rich.
We would not necessarily dispute the merits of that formula, however there are elements to leasing that often get overlooked when a person (or company) becomes fixated on purchasing.
First, lease payments are typically fully tax deductible, whereas only the interest portion of the mortgage is deductible. While each scenario will be different, the accounting impact of leasing will generally result in a larger taxable expense.
Second, leasing does not have downside risk at the end of the term. There could be a recession (which coincidentally we’re facing right now in Alberta), and as a tenant you can hand the keys back at the end of the lease or stand in a position to negotiate more favorable terms on a renewal. If you own property during a downturn, your options are to sell at a loss or wait until the market recovers. Neither are good options if your company’s needs have changed and the property is no longer suitable.
Third (and in our minds this is the biggest), the money that would be ear-marked for a down payment on a purchase has a substantial opportunity cost attached to it. Instead of applying that money towards a property, the company could use it to fund internal growth. A study from a couple years ago showed that the top 10 industries had ROE’s (Return on Equity) ranging from 62% to 112%. Even if one of those companies was extremely bullish and thought they could make an Internal Rate of Return1 of 20% by purchasing a property, they would do so by trading off the potential to make a much higher return within the company. A company should make higher returns within the business than they would by purchasing real estate. Otherwise what is the point of being in business?
It may sound like we are taking a pro-leasing stance here, but that is not our intent. In fact, purchasing comes with it’s own set of rewards, such as controlling the asset, hedging against inflation and potential returns down the road. There are also some banks2 that offer higher loan-to-value mortgages which reduces the amount of the down payment. As we mentioned, there isn’t a quick answer on whether a company should buy or lease.
What we often recommend is that companies simply keep their options open. Looking at any market, there will be a number of properties available for sale and for lease. If a company looks strictly at properties for sale, they are omitting all the properties for lease that otherwise might have been a good (or potentially even better) option. It could potentially be reckless for a company to fixate on purchasing as it would narrow down the pool of available properties. Even if you feel strongly about purchasing, we think it is prudent to also look at the options available for lease and make the best decision for your business.
Since our headline was a bastardized reference to the great Bard, we’ll end with perhaps a more appropriate excerpt from the same soliloquy:
1: Overly simplified, the Internal Rate of Return is the annualized compounded return. In our opinion, a 20% IRR would be a strong return for a 10 year hold on real estate.
2: BDC and Roynat are good examples in Canada.
3: We bet you weren’t expecting to see a Shakespeare quote in an article about buying or leasing!