Your business idea has been germinating in your head for years.
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You've put together the business plan. You have secured funding, and you are ready to operate. Seeing that you won't be able to get the job done out of your home you've decided to acquire an office space. So, do you rent or buy? In this article we will discuss why the answer is different for everyone and give you the tools necessary to make an informed decision.
Length of Stay and Cost of Capital
To make this decision it is important to define a few important parameters: First, how long are you likely to stay at this property? And second, what is your opportunity cost of capital? For a business owner, this should be an easy exercise. If you demand a 10% return on the assets you use for your business, then your cost of capital is 10%. At a very minimum, your opportunity cost of capital should at least be the going rate for a 10-Year Treasury note or something of that nature.
Calculate ALL Costs Including Tax Benefits and Upkeep
You can then project the costs you will have over the horizon at a property. For a rental it is simple. You take the rental rate and multiply it out by the length of stay, accounting for likely bumps in rent.
Accounting for the cost of owning the real estate is more complicated. First, you calculate all of the direct costs you will pay as an owner. This includes the mortgage, maintenance, insurance, capital repairs, and property taxes. Then you give yourself credit for the tax advantages you will get for owning, including any interest deductions.
The next step is to take the cost of renting and subtract the cost of owning in each year that you own the property. In most cases this is a positive number. There is some benefit to owning when you simply compare across these parameters. But there is another important consideration to make.
Discount Cash Flows at YOUR Cost of Capital
Let's say you play on staying 10 years in this property. You have to construct a cash flow that shows the amount you save each year thru owning and include a terminal value for the sale of the property in the 10th year. You then discount these cash flows back to the present using the opportunity cost of capital (10% in our example above). In most instances, this present value will be a positive number.
The final catch, however, is that when you purchased the property you had to make a down payment. This must be subtracted from that final number because you weren't able to make a 10% return on that money for the past 10 years. In many cases this number could be as large as 20-30% of the purchase price. This will have a big impact on whether or not the decision to buy is correct.
In general, the finding is that the longer you plan on staying in a property the more likely it is that you will have some benefits to owning as rents grow over time but your debt payments as an owner remain constant. But keep in mind that a lot of the value comes from the assumption that rents and building values will increase over time. This is not always the case. As we have seen in the last year and a half, rents and property values have plummeted. So make the calculation and take the results with a grain of salt as you make your decision.