Buying the building you do business in, often called investing in owner-occupied real estate, can be a great long-term wealth accumulation strategy for business owners.
I have seen entrepreneurs make more after-tax dollars from their property than their business, despite spending 99% of their efforts on the business and very little on their real estate. But is now a good time to consider buying?
First let’s consider the advantages and disadvantages. The advantages include building equity over time by paying off debt and enjoying capital appreciation. The property will provide an income stream into perpetuity and can be a relatively safe retirement asset, whether or not you still own the business. As an owner, you control your destiny, including capitalizing on the improvements you make, controlling timing of capital expenditures and eliminating risks of rent increases and lease renewals.
Disadvantages include the capital required for the down payment and paying more in loan payments than in rent. Buying owner-occupied real estate also carries risks: interest rates might increase, the commercial property market could crash or your business might outgrow the premises. Creativity, prudence and due diligence are therefore required when making the decision.
First, the creative part. Many businesses can access high ratio mortgage financing, in some cases to cover the full purchase price, because the business itself provides a source of repayment ability, in addition to normal rental income. Some lenders can provide up to 100% financing against the purchase of owner-occupied real estate.
The loan is split into two tranches:
•a secured loan, for up to 75% of the value, at five-year fixed rates currently around 4.75%; and
•a second tranche, which is regarded as unsecured and carries a higher interest cost of around 12%, for an overall blended rate not exceeding 6.5%.
Both tranches can have a long amortization period of 20 years to minimize monthly loan payments. The key in this structure is the ability to pay down or refinance the higher interest cost debt as soon as possible.
After five years, assuming annual capital appreciation of 3%, and without making any prepayments, the second tranche can be completely refinanced by a conventional mortgage. In the meantime, the owner will have amassed equity equal to 25% of the property value.
The investment strategy has a tax advantage because loan interest and capital cost allowance are tax deductable, income tax is deferred on business profits reinvested in the property and the eventual gain is taxed at the preferred capital gains tax rate.
The downside is that loan payments will exceed rent, so prudence is required to ensure the business can support the extra cash flow required. In the above example, annual payments would total about 9% of the property value in the first five years. However, this includes principal repayment going to reduce debt, or in other words, build equity. Like a home mortgage, it is akin to forced saving. When compared with capitalization rates of 4% to 6%, the blended interest rate cost of 6.5% is not much higher and provides the opportunity to enjoy capital appreciation.
Business owners contemplating this strategy should ensure the property can serve their needs for the long term. I can’t comment on whether this is the right time to buy, but what is more certain is that interest rates are at record lows and are likely to be heading up in the next few years. Consequently, there is a window of opportunity to build equity while enjoying low fixed rate occupancy costs, provided the business can support the debt. •
