Like many businesses, law firms often face the quandary of deciding to purchase or lease office space. While property ownership comes with several potential financial and tax benefits, it also frequently brings hassles and headaches that you can avoid by leasing space. The correct choice will depend on your firm’s current financial, competitive and geographic circumstances.
The Pros and Cons of Buying
One of the draws of buying your space is the control of both the property and the costs. You can make substantial improvements without requiring landlord permission and you avoid the risk of the landlord deciding to use the property for a different purpose. By locking in your long-term cost with a mortgage, you escape inevitable rent increases.
Location can be another reason to buy. Buying office space in an area likely to experience rising property values means you will benefit from the appreciation and will not have to worry about getting priced out by escalating rents down the road.
Income and equity may also favor buying. If the property is large enough, you can rent out space to other tenants and enjoy the additional income. As time passes, the firm will build up equity that it can later use as collateral.
As for tax advantages, you can recover the purchase price over time through depreciation deductions. If you have tenants, you can deduct repairs the year in which they occur and amortize improvements. You can also deduct property taxes and mortgage interest. Depending on the structure of your law firm, you might want to purchase the property in a separate entity.
So, what are the downsides? One deterrent is that you forfeit some flexibility when you buy. For example, your upfront costs will be much higher as opposed to leasing, including down payments, closing costs and potential improvements. Furthermore, if you need more space, you might have to sell the existing property and find a new location.
Perhaps the biggest drawback is the burden of property management, which can divert you from money-making activities. You can always hire a property manager to handle repairs, maintenance and tenant issues, but that inflates your costs and eats into your bottom line.
The Pros and Cons of Leasing
The lower upfront costs of leasing are appealing if your cash flow is precarious or if your firm is still in its infancy. Generally, you only need to cover a security deposit of one month’s rent and possibly a broker fee. Also, leasing might be the only available option if your firm does not yet have the credit rating to secure a mortgage with a reasonable interest rate. For tax purposes, you can deduct rent in the year in which it is paid.
Leasing also leaves you with greater working capital, which gives you the ability to respond to unexpected opportunities.
In addition, commercial leases typically assign the maintenance responsibilities to the landlord, sparing you the time and costs. Leaky roof or piles of snow that need clearing? Not your problem. Instead, you can focus on growing your business.
The flexibility is obviously greater with leasing. With proper notice, you can relocate if you require more or less space, want to be closer to a major client or find more appropriate offices elsewhere.
Leasing may also prove particularly wise in areas with uncertain property values. If you have doubts on whether or not values will rise, you can put the risk of decline or stagnation on the landlord.
Of course, leasing is not without its downsides. For example, you will probably be subject to annual rent increases and your landlord could hike the rent even more when it is time for lease renewal.
Cash Flow Considerations
Sitting on the fence about buying or leasing? If the major pros and cons seem to balance out fairly equally, a cash flow analysis could break the tie for you.
A cash flow analysis estimates the amount of cash you will need to set aside in order to pay the after-tax costs of each alternative, also known as the present value. The option with the lower present value usually is the smartest choice.
A cash flow analysis requires several items of information, including:
- The property’s estimated value;
- The purchase and financing terms (including closing costs) or lease terms;
- The estimated useful life of property to be purchased (for depreciation purposes);
- Your costs of capital;
- Your combined federal and state income tax rates; and
- Any incurred costs for leasing or buying (for example, maintenance costs or property taxes).
Look Before You Leap
There is no universal answer to the question of deciding to buy or lease your office space. The best choice will turn on your firm’s individual circumstances. So, take the time to examine them carefully before signing on any dotted lines. Your financial advisor can help you ensure that you consider all of the relevant data.
For more information, contact Kalman Shiner at 312.670.7444. Visit ORBA.com to learn more about our Law Firm Group.