Nonprofit Accounting Basics

Buy vs. Lease

Author: 

Tommy Fuge

West, Lane & Schlager Realty Advisors, LLC
Topics: 

While some organizations view office space as a place to house employees, forward-thinking nonprofits understand office space is a tangible extension of their missions, and a critical tool for marketing, branding, and attracting talent. As part of any good due diligence process, nonprofits should always evaluate the costs and benefits of leasing vs. buying. Both offer very different and compelling financial cases, however, the ultimate test needs to factor operations and mission as well.

The basic considerations

1. Buying vs leasing.

The single biggest hurdle to justify a purchase is the down payment. Typically, nonprofits need to come up with 25 percent to 35 percent of the total purchase and renovation costs at closing. Through a well-conceived capital campaign, nonprofits can eventually pay down the debt, leaving only operating costs and real estate taxes.

Conversely, leasing requires very little up-front costs. In fact, landlords today provide concession packages (allowances and free rent) that require virtually no out-of-pocket cost to design, build, furnish, equip, and relocate to the new building.

So which option is the right option? If a nonprofit has the funds for the down payment, then the annual cost of ownership should be less than the cost of a lease.

Opportunity costs: While interest rates may be low, any board finance committee will need to consider if deploying internal funds toward a down payment is the best use of the nonprofit's money. This analysis, called the opportunity cost, looks at the use of funds to purchase office space relative to the return rates of the current investments. Be prepared to show how the real estate can appreciate relative to a diverse portfolio of securities.

Interest rates are at a historic low: With interest rates at historic lows and motivated lenders, nonprofits have an unprecedented opportunity to maximize loan-to-value ratios at a low cost. In addition, most jurisdictions offer tax-exempt bond financing to purchase real estate at an even lower interest rate than conventional financing.

2. Long-term cost benefits of ownership.

A major driver to own real estate is cost control. In Washington, DC, the typical cycle is a ten-year lease followed by a five-year renewal. At the end of that period, the nonprofit moves. In each lease "event" the costs increase. Owning office space allows a nonprofit to first flatten and then reduce its costs relative to leasing.

Many organizations focus on asset appreciation. Over time, real estate values should appreciate; but that horizon needs to be 20 to 25 years. In the near term, external factors can impact values, such as the overall economy, real estate cycles, interest rates, macroeconomic shifts in a submarket, and so forth. A good rule is to look at holding the real estate through at least two cycles to achieve true asset appreciation.

Leasing offers short-term benefits through flexibility. Even in the middle of the long-term lease, there are opportunities to renegotiate the term and reduce costs or “right size” the space.

3. Owning real estate involves risk.

While most planners project the worst case scenario being a significant staff reduction, the opposite is also true: What if the nonprofit outgrows its space sooner than projected and is forced to sell the building? It is smarter to plan for growth. Purchase more space than immediately needed. With a 20 to 25 year horizon, purchase 30 percent to 75 percent more space than currently required. That excess space can then be leased out until needed by the organization.

Unanticipated events just happen: What if the roof needs to be replaced or a boiler breaks, and there are limited funds available for those repairs? That can overwhelm a budget. Or, what happens if the nonprofit has to sell the property but the value is less than the purchase price?

Nonprofits should always have an “exit” strategy in place. This strategy should be reviewed annually and adjusted depending on current market conditions.

4. Ownership takes time and attention.

In a lease, the landlord generally maintains the space. Even if an owner outsources property management, someone within the association will need to oversee the project. For most nonprofit executives, managing real estate is not a core competency. It can easily become another “hat” to wear for the head of operations, finance, or administration. An organization must be aware of this added work and make sure itis prepared to take it on.

5. Tax factors.

All tax, legal, and financial considerations need to be evaluated by an attorney and tax professional. Certain rental scenarios may generate tax liabilities the nonprofit would have to address.