A CFO at a medium-sized hospitality industry business – winebar and restaurant – was asked by the major shareholder whether he should buy the building that housed two of the business units owned by the group. “Why shouldn’t I buy the building?” asked the shareholder. “After all, I know how well the business is going and once the rents come up for market review, we’re facing a rent hike.” Sooner or later, every business has to consider whether it is better off owning or leasing office space. Hospitality is one industry but the same question arises across law firms and retailers. Indeed, in the case of law firms there has been a strong trend across Australia for law firms to purchase strata units as these are discrete, small purchases often requiring only modest repayment amounts when compared to the revenue of the firm.
The decision varies across each individual business but the CFO is well placed to add value to the conversation. The most pressing response to the inevitable question is the impact on cash flow of the business.
A business will not need to put out as much money upfront when they lease their premises as they would when they buy. In the case of the Sydney suburban building leased by the wine bar and restaurant owner, the building was offered to the tenants at $2.5 million. Under the current conditions they were paying approximately $100,000 in rent and outgoings. In order to purchase the building they would have put down 30 percent (to satisfy bank loan-to-valuation terms) which works out at $750,000, plus fees for valuation, building inspection, stamp duty, loan fees and other costs, bringing cash costs up to $1 million. At current interest rates the cost of servicing a loan of $2 million would be near enough to $150,000. The cash flow deficit is a significant $50,000 a year and would need to serviced from operating margins of the business.
A business owner and indeed a CFO would view the purchase of a building as offering significants benefits.
1. By purchasing a building a CFO will have a good idea of what the costs are going to be year after year, especially if the building is purchased on a 5-year fixed loan mortgage. Even though a lease has a defined rental for a term, the business is subject to the vagaries of the market when the lease term expires. Many leases also have a clause allowing for an annual cost increase tied to changes in the CPI or market assessment or in some case, turnover of the business.
2. Purchasing a building could offer the business owner an opportunity to add value to the business by renovating in a more customised fashion. This may offer advantage in terms of the business but, on the other hand, may make it more difficult to sell in the future if it too customised.
In market terms, commercial buildings in prime city or suburban locations have, over the years performed well as an asset class and, an owner can generally look forward to long term capital gains which would ameliorate the higher servicing costs experienced in the first few years of ownership.
A CFO should definitely argue the case from a cash flow perspective (will this create a cash flow risk to the business?) but need not be disposed to arguing against the inflexibility of the lease versus buy conundrum. A good business that grows beyond its needs will always have the opportunity to lease a larger premises in the future and act as a landlord for the current building.