To Own or to Lease....That is the Question

The question of whether to lease or own a facility from which to operate your business and the decision's impact on the business operations and future value of the business remains the single most confusing topic among educational business owners.  Rarely is this question asked when a school is in the initial planning phase, as most start-up business owners lease their facilities as a means to preserve capital.  The question is much more common as a company grows, builds some capital for growth, and wants to make smart decisions regarding preservation of capital for business growth and long term value of the business and real estate.   In our opinion, there is no correct answer.  Each individual should consider his or her capital needs and future business strategy, and even for individuals, these considerations change as the business develops and grows.  Regardless of each individual's decision, however, the impact on the value of the business and development of future personal wealth is tremendous and worth the considerable time spent on advance analysis and planning.

Real Estate Leasing

Except for staffing costs, real estate costs are the next largest item for an educational company's budget.  A poorly developed lease, with terms that don't match the ability of the underlying company to support them, can bankrupt a company.

Case Study:  Martha is new to the education industry and wants to open an afterschool center.  She is seeking a lease for a small facility to get started conservatively and wants flexible terms that will allow her to move to another site if she has more demand for enrollment that the initial site will allow.  She has personal savings for the purchase of the start-up equipment and supplies and for initial operating costs, but does not have the capital necessary to purchase a building.  She finds a landlord willing to lease her a building, calculates the appropriate amount of rent based on the revenue her business can generate, and enters into a five year lease with two five-year options to renew.  She also has the ability to assign the lease to another tenant, with landlord approval, within the lease term in the event she grows quickly and needs to move.

As we can see in the case of Martha and many other business owners, a lease gives her the ability to open a new business without having a large amount of capital and gives her the ability to move as her business grows and she needs more space.  Also in Martha's case as an inexperienced operator, it was easier for her to qualify for a lease than to seek financing for a mortgage.

Case Study:   Elliott owns his business and intends to grow it to other sites within the next 3-5 years.  By leasing his real estate, he is able to use the cash that might be invested as a down payment for real estate for the purchase of businesses or for operating cash and purchase of additional equipment and materials as he grows.  He intends to sell his business in 10 years and does not want the hassle of selling his real estate and is not comfortable with holding the real estate long-term for his successor operator to lease.  He has secured favorable terms that set a lease amount that is equal to or less than 14% of the gross revenue that his business can generate when it is 70% occupied.   With 10% increases in rent every five years during the initial term of 20 years with 2 five year options to renew, Elliot can easily budget his expected facility costs for the future.

Elliott also finds a lease advantageous at the point in his growth so that more cash is preserved for business development.  He is interested in selling his business and wants to secure long-term leases that will be attractive to a buyer of the business.  Elliott understands that it is critical in developing lease terms to understand that based on the licensed capacity of the building and the tuition rates that can be charged in his area, there is a limit to how much rent he can pay and remain financially healthy.  A good rule of thumb is to project what gross revenues a business can produce when it is 70% occupied, and plan to pay around 14% of that in rent.  This amount might be slightly higher at 15% if the building is new and maintenance will be limited.  It might also be as low as 10-12% if the building is older and will require more expensive upkeep.

Case Study:  Gabrielle is opening her second childcare center in a new market and also owns a real estate company.  She wants to lease the new building to give her the flexibility of exiting the business in the event that the new market does not perform well, and will enter into a three year initial lease with year-to-year options to renew.    Gabrielle's real estate company seeks financing frequently and it important to her that she not have the additional debt on her childcare center in the event that it damages her ability to seek lending, and she also like the full deduction of rent expense for tax purposes.   In exchange for a shorter term lease, she has agreed to be responsible for the HVAC system and the parking lot maintenance and repair.

In Gabrielle's case, it is important that she mitigate the risk of opening in a new market with a shorter lease.  Since most landlords prefer longer leases than Gabrielle is willing to commit to, she has agreed to accept the responsibility for certain maintenance items related to the building.  In a typical absolute net lease format, the tenant is responsible for all of the costs relating to the building, including real estate taxes, property insurance, and repairs and maintenance.  When the tenant is responsible for the management and cost of these three items in addition to the rent, the lease is referred to as triple net.

Real Estate Ownership

Real estate investing in general has proven to be very profitable over time, even with recent challenges in the market.  However using a significant amount of capital for a real estate investment means that there is less money to invest in the business, which typically has a greater potential for return.   In addition, real estate markets are unpredictable at best, although the US is once again experiencing modest increases in value for owner-occupied properties.  Despite these challenges, there are many advantages to real estate ownership.  Now is an opportune time to consider purchasing real estate since values are down and interest rates are low.  Real estate prices in many markets have dropped  and we are starting to see a strong rebound in values in some markets.   In addition, the cost of financing is at historical lows particularly for business owners who operate the business in their own real estate.  All of these factors make this a very interesting time to invest in real estate.

Case Study:  Contessa owns her multi-site childcare business and the real estate it occupies.  She enjoys the flexibility to make changes to her building without having to obtain landlord consent and she saves cash because her mortgage and related expenses on the building are less than she would spend if she leased from someone else.  In addition, with each month's mortgage payment she builds equity in her property and pays down the principal balance. 

Contessa enjoys the flexibility she has in owning her real estate by being able to make decisions about its use and possible changes without gaining the approval of a landlord.  In addition, she received favorable mortgage terms and is saving money by making mortgage payments instead of paying rent to a landlord.  She is confident in the real estate value being equal to or greater than what she paid for it when starting her business.

Case Study:  Alex owns a large Montessori school and afterschool center.  He initially leased his real estate with an option to purchase at his discretion.   As his business grew and became more profitable, Alex chose to invest the excess cash into purchasing his real estate.  His long-term plan is to continue to operate his single site and focus on developing enrollment as high as possible, without sacrificing quality programming, selling the business at its most profitable point to secure maximum value.  He wants to sell the business to a large, financially-sound competitor that will enter into a lease with Alex as the landlord, and then use the revenue stream from the lease as a retirement asset.

In Alex's situation, real estate was a good investment for his additional cash since it was not his intention to grow his business by expanding or developing additional sites.  By purchasing his real estate, he gained control over the property while he continues to operate the business and secured a long-term asset that he expects to appreciate over time.  Also Alex will enjoy a future revenue stream when he sells the business and becomes the new operator's landlord by receiving rent income.

Case Study:  Beth has operated her private school for 20 years in an area where the real estate value has increased substantially since a new hospital system was built five years ago.  An analysis of her real estate indicates that it might be of greater value to her if she sells the real estate for another use.  Beth intends to investigate moving her business to another facility within the same general area to preserve her enrollment, and to seek a sale of her real estate.

Beth has operated her school in an area that has grown quickly in recent years.  She works with a real estate broker that is familiar with the education industry and finds out that she has a real estate asset that is more valuable if she sells it for another use other than her educational business.  This is a scenario that is not unusual for business owners who have operated their companies over long periods of time in growing markets.

The Bottom Line

When considering whether to lease or to purchase real estate, it is critical to have a complete understanding of all the current and future implications for your company and to have a general idea of where you want to end personally.  Since each situation is unique and each individual is impacted in a different way based on his/her particular situation and long-term strategy, it is critical to analyze every element of the situation: cash flow, tax implications, expectations for rent increases and property value appreciation, interest rates and alternative uses for the property. You will gain the best understanding by working with a real estate broker that is familiar with the educational industry and a personal tax advisor who understands how these decisions will affect you in the future.

The bottom line is that the decision to lease or own your real estate  boils down to cash in-hand and long-term plans and is as much of a personal choice as it is a financial one.   As you are considering your options, remember these key questions:  Are your capital investments capable of producing higher rates of return when they are placed in your core business cycle or when they are placed in real estate investment?  Are you comfortable leasing your real estate from a third party and managing that relationship in a way that is healthy for your company?  And finally, are you comfortable with the idea of retaining ownership of your real estate as you exit the business in the future?  Whatever your current cash and tax situations are and whatever your future plans involve, taking the time to explore all aspects of real estate leasing or owning leads to great potential rewards in the future.

For more information about this article and how HINGE can support your real estate needs, contact Mike Pepper