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Some entrepreneurs are content to rent space for their businesses year after year, but others have been anxiously watching the residential housing market, hoping for an opportunity to take their commercial lease dollars and turn them into long-term equity in the real estate market. But will the residential bubble's slow leak (or impending collapse, depending on whom you talk to) make the next one to two years a good time to purchase commercial space?
First off, know that the residential and commercial markets don't move in tandem; while the former has slowed dramatically, the latter is still fairly robust. The commercial market also depends heavily on the particular region and type of product. While office and industrial properties are expected to see improving market fundamentals in 2007, for example, the retail market has seen some overbuilding, leading to a softening on that front, says Rick Davidson, president and COO of Coldwell Banker Commercial Affiliates Inc., based in Parsippany, New Jersey.
That said, the decision depends heavily on why you are buying. If you are hoping to turn the property over for an immediate profit, now is a particularly risky time, says Craig Thomas, senior vice president at CB Richard Ellis in Salt Lake City. "But over a long-term holding period, the outlook for rent gain and income gains are rather strong," he adds, "so you're going to do OK with a 7-year or 10-year hold."
The return on investment is just one of the obvious risks of owning commercial real estate; you're also responsible for the mortgage, the building and all related expenses, plus the hassle of being the landlord. If you don't have the extra cash cushion or anyone to manage that upkeep, you might want to rethink buying now. But if you have the resources, there are several benefits, including tax breaks on the mortgage, maintenance and improvements. Plus, the property can offer an additional income stream if you plan to lease out part of the space.
Depending on the current rental prices in your area, it may be cost-beneficial to pay a mortgage instead. That was the case for the partners of Esquire Title Services, based in Orange City, Florida. The firm's three partners ran the numbers with their broker and found that their cost to own would run $13 to $14 per square foot, while they would pay upwards of $18 to $21 to lease the same size space, says Christine White, partner and co-owner. "And the mortgage is locked in for 10 years, as opposed to--with the rents going up in this area every year--paying $22 to $25 a square foot in a couple of years," she adds. To limit the out-of-pocket expenses of purchasing the land and completing construction on their new building, White and her partners, Kim Booker and Randall Marshall, teamed up with a law firm and a construction company--both of which will own a portion of the property.
In general, Randy Elder, a small-business accountant in Phoenix, recommends against purchasing the real estate within your current business, particularly if you are set up as an S corp or C corp. "It's difficult to get it out, there are tax ramifications and transferring it is not easy," he says. If at some point you want to sell the business but keep the property, that presents another headache, he adds. Instead, Elder advises setting up an LLC that would take ownership of the property. The company then pays the LLC enough rent to cover the mortgage and any expenses, which it can then deduct. The LLC pays tax on the income generated. "But they'll have depreciation that should reduce that income to a loss," he explains.
If you're thinking about purchasing in the next few years, start putting away down payment money now and use the time to observe market trends in your neighborhood via the web and local industry publications. Consult your attorney and accountant to be sure you clearly understand the tax implications of a purchase--and above all, like any other strategic decision, make sure the purchase makes good business sense.
C.J. Prince is a New York City writer specializing in business and finance.