Should I Buy or Rent My Location?
Buying your business’s real estate is not a black and white decision. It will depend on what your long term goals are.
McDonalds always owns their real estate, but Walgreens never owns their own real estate. How can both be right?
We at Leaders Real Estate advocate for real estate ownership as an investment and diversification tool. However, we rarely advocate owning the real estate if your business is the primary tenant because the value of the asset is tied the success of the business. If the business has to shut down, the value of the real estate will take a huge hit.
Buying the real estate for your business doesn’t have to be a long term strategy. One strategy is purchasing or developing the real estate on behalf of your business and immediately selling it for upfront capital. For example, a doctor could purchase the real estate for his practice and sign a 10 year lease to himself. Since the lease is the primary value driver of the building, the doctor can sell the real estate for a profit as soon as the lease is signed.
Let’s say an empty 3500 sf building is be worth $1 million. If the doctor buys it and signs a 10 year lease at $36 per square foot, the total income would be $126,000. If there is $20,000 in annual maintenance and taxes, the net operating income, NOI, would $106,000. The real estate for healthcare practices often trades at a capitalization rate of 8.5%. In order to calculate the value of a building, take the NOI and divide it by the cap rate.
$106,000/8.5% = $1,247,000.
The doctor has increased the value of the building by $247k by signing the lease. The quickest value jump happens the moment the lease is signed. At this stage, he will have to evaluate whether he will get a better ROI by holding his real estate or selling it to an investor and reinvesting the money in other real estate or his own business.
Many healthcare operators we work with have a plan to scale to multiple locations. Typically, the operators get a 30% to 50% return on their money when they invest it into growing their core business. Over time, investing in the real estate of their practice locations yields somewhere between 9% and 11% ROI.
This is why so many well known, successful businesses rent their locations. The ROI is simply much stronger by investing in the growth of their business than the real estate the business sits on.
Likewise, some businesses with deep pockets develop the real estate for their new locations so that they can flip them for upfront capital. Generally, it’s not worth holding the real estate after the value creation since they can get a better return by replicating this process or investing in the business.
In this episode we break down the pros and cons of both options so you can get a clear picture of what to look out for when answering this question.
If you need help finding the perfect location for your practice or you’re ready to invest in commercial real estate, email us at podcast@leadersre.com.
You can also download the Top 10 Site Selection Factors or view our entire podcast library.
transcript
Austin 0:31
Hey guys, welcome to the podcast. This is Austin Hair. And I’m here with my partner, Nate Palmer today and we’re going to be discussing a very popular question that we get a lot which is should I buy or rent my Location? So Nate, how would you answer that question?
Nate 0:47
Yeah, man, a loaded question. Great topic. There’s not one right answer for everybody. I’ll do my best to answer or at least make Some observations on what we’ve seen from our clients anywhere from, you know, small independent operators to groups with hundreds of locations. The answer is really that that simple you know, there’s not one right answer for everybody you know some of it depends on the practices or the doctor for that matter, his long term kind of growth and wealth portfolio.
So there’s some inherent characteristics about owning your own building that are positive and there are some that are are less positive, I mean, the less positive attributes might be if you look at this as a separate business, a separate investment from your practice, you now have a building and practice where you’ve got all your all your money, all your eggs in one environment. We 100% advocate owning real estate, but but Much like, as you’ve seen, from large national companies, CVS, whoever, you know, largely, there’s not an appetite to own your own building, because the day that that that building no longer makes sense for your practice, the value is decimated.
And so, you know, we a lot of times work with people to understand and think through the benefits or the abilities to own real estate, but maybe, but maybe not own the physical real estate long term that you occupy, unless there’s some strategic advantage, or some unique circumstance that that we could talk about. But largely, that’s the conversation for a lot of our clients who are multi unit or have the aspirations to be multi unit.
The other challenge with with owning real estate is you have a lot of sunk equity into real estate that could be invested into your practice. And so I’ll give you one example one of the groups that we first worked with, my god, it’s been 9-10 years ago now. It was a physician group, they had 11 practices, they own the real estate at six of them. They had tapped business lines of credit, basically, to get to that point. And they felt to continue to build their wealth, they needed to own some of their real estate. So here we are, they have 11 locations, they own six of them. We did an analysis for them after the end to know them a little better, understand their business and how much revenue they were doing. We found out that, you know, they’re basically paying themselves about a 9% return on the dollars they invested in the real estate, but their business was generating more than 50% returns on every dollar that they use invested into their practice.
And so we went through a strategy and a methodology whereby we sold the buildings they own as investment sales. They signed long term leases on those buildings, we sold them, and they were able to get top dollar for them. We use the proceeds of that to pay down or pay off their business line of credit, it freed up a lot of equity. We then utilized with that client specifically, we then utilize that strategy in five years to take them from 11 to a little over 30 locations before they were then acquired, so they used they use the idea of real estate ownership to help fuel their growth, but only taking temporary ownership ultimately in their buildings.
So it’s a big it’s a big conversation. It can have a lot of different applications depending on our client’s desires and interests. You know, sometimes we meet folks where they don’t have the aspiration to open another office, they just have their single office, they’re happy with it. They’re probably never going anywhere. Obviously your risk at that point is much less but but the thing you have to think about is is kind of the State or exit planning component and you know, likely when you no longer want to work, whether you give the practice to somebody, you sell it or whatever happens to it, that new owner is going to then evaluate if that real estate makes sense for that business and if if they believe it’s going to still make sense for the following 10 to 20 years. So we’ve had a number of instances and we’ve been involved and are still involved in many, many cases where we have clients who are in the process of acquiring locations.
The folks that we are acquiring those practices from own the buildings therefore, certainly the doctors who are selling the practice, who own the building don’t want to be stuck with the building if we were to relocate the practice. So inevitably, we have to work out something to also buy the building. However, it’s a location that we do not long term want to operate in. So as we are negotiating to acquire that practice, ultimately it’s getting discounted because of what we feel like we’re going to have to do in the disposition process for that physical building.
So to be clear, we will always advocate real estate ownership. We believe it’s a great wealth building vehicle. But we will also always advocate that usually the risk involved in owning your own real estate is much better mitigated by participating in real estate opportunities, where you’re not also the tenant and using that real estate vehicle to help build your wealth system.
Austin 6:42
That’s good. That was a really good distinction. Because you look at from the outside looking in I mean, you’ve got companies that are wildly successful, like McDonald’s who always own their own real estate. And then you also got companies like Walgreens who are wildly successful, who never own their own real estate. And how can both of those companies be right? The answer is because it depends, like a lot of other things.
So I think the question that you have to ask yourself, and I’m kind of just reiterating what Nate already said, is how many practices and how many locations Do you want to own? And how much do you want to grow? Now at the end of the day it’s really just a math question because typically, real estate can get you about a 10% return on your investment, sometimes more if if you develop it. But if your practice is giving you 30, 40, 50% return, then it just doesn’t make sense for you to invest the money in real estate, if you can invest in opening up new practices. Now, that being said, if your goal is to get, you know, one location and build that up as much as you can, then yeah, it’s a great way to diversify your income stream. So I think it’s really interesting what you said about being able to participate in both by investing in real estate but just not necessarily your own real estate, which is another way to mitigate.
Nate 7:58
Or maybe temporarily, right? Maybe with a plan to buy it redevelop or develop it and then immediately sell it and get all your equity back and move on to something else.
Austin 8:10
Yeah, like you said, you know, as the primary tenant, you are driving the value of that building. If you were to go buy a building, with no tenants, as a hypothetical example, that might be worth a million and a half. If you fill that building with amazing, accredited, you know, a plus tenants, you could drive the building up to $3 million. And then if you got a decent credit somewhere in between, I mean, you’re still looking at adding 500,000 to a million in value from that building. So you by being a healthcare operator, renting the building, you can drive that value up by a significant amount. You could potentially sell that, rent it to yourself and take the cash in order to invest in opening up new locations. I mean, there’s really a lot of strategies that we’re going to go into on this podcast.
So the short answer is that is just situational. But hopefully that sheds some light for you guys on at least what questions to ask yourself when it comes to looking at renting or buying because you’re not an idiot if you rent and you’re not an idiot if you buy, it really just depends on what your long term goals are. So that’s all for that topic, guys. Have a great day.
And if you missed our our topic about cap rates, if that sounds confusing to you then tune into the podcast. Before that we’ll break down what a cap rate is and what determines its value. So, we will talk to you next time and bye for now.
You can also download the Top 10 Site Selection Factors or view our entire podcast library.
If you need help finding the perfect location for your practice or your ready to invest in commercial real estate, email us at podcast@leadersre.com.