Although not unique to this industry, woodworking shops of all types are experiencing diminishing profits and constantly seeking ways to improve money-management techniques. Among others, this raises the question of whether it is better to own or lease one’s shop space.
Geordie Ellison of Geordie’s Woodworking, a custom cabinet builder in Lloydminster, Alberta, is convinced that owning is the only way to go. Ellison has developed what may be the ideal solution for the small woodworking shop. In a growing commercial area on a secondary highway, he has developed a 10,000-sq.-ft. building of which he occupies 6,400 sq. ft. and leases the remainder to a telecommunications company on a net lease. The front doors, windows and rear overhead doors for four 2,500-sq.-ft. service bays are already installed.
If he wishes to expand his shop, he can occupy the 3,600 sq. ft. he now rents out. Conversely, if he wants to contract his shop size, he can install partition walls and rearrange utility services so he can rent out one or more of the service bays. Because of the highway visibility and building layout, the bays would be ideal for tenants such as electricians, plumbers, or small service companies. The building, which he could also lease or convert to condominiums, is a major part of his pension plan.
On the other hand, big-box stores and industrial warehouses usually lease real estate, providing greater flexibility and allowing them to make more money by investing in saleable merchandise rather than bricks and mortar. Still, their concerns are different since most are publicly held corporations where the interests of the shareholders are quite different than those of the small- or mid-sized shop owner. A small shop’s profit is increased by producing more finished wood products at a lower per-unit cost, not stocking more supplies, having a large unsold inventory, or running a business where you stock everything for everybody.
To buy or not to buy
The buying-versus-leasing equation can only be resolved when weighing the optimum use of available capital. Money is made, not by ownership of an asset, but by the use made of it. Having adequate working capital is usually more germane than owning capital assets.
If we assume the building of a custom cabinet or millwork shop is 10,000 sq. ft. and situated on one-half acre of industrial land, the real estate investment would be in the $1 million range. If mortgaging $800,000 at 7.5 percent for 15 years, the annual debt service would be approximately $88,500. If leasing, the annual net rent (taxes, insurance, utilities and maintenance are additional) could be at least $120,000 a year. Assuming that the equity capital to buy is available, or even if borrowing all of it from the bank, with buying you could still be ahead. This suggests that owning the real estate is the best way to go. Yet, when adding the required equipment to this, the total capital investment could be in excess of $1.5 million.
Before buying, ensure that the building: Complies with all zoning and other municipal bylaws Meets with all building, electrical and fire codes Is structurally sound, is not obsolete, is in good repair and suitable for your use, or is adaptable at a reasonable cost Has a sufficient site area for outside storage of raw inventory, parking, etc. The location should be: Easy to find and accessible In an improving neighborhood where there is demand with a high resale and lease potential In a neighborhood where there is a predominance of owner-occupied buildings Where there is a low vacancy rate. Avoid a neighborhood where: Property values are declining or remaining stable More tenants are moving out than in Rents are low There is a poor atmosphere. Finally, remember that if a property is real cheap, there is a reason.
If the equity capital is not there or the bank says no when it comes time to borrow it, then leasing is the only option. If the equity capital is there or the bank says yes, the repayment period might be short, thereby making the occupancy cost higher and distorting cash flow and consuming working capital. With leasing, the big question really is with your financial commitments: Are you ready, willing, and able to take on this much debt? If buying the real estate and also leasing or financing equipment, how will your working capital, balance sheet, credit lines, and borrowing ability be affected? Although leasing has some distinct disadvantages, it provides 100 percent leverage on one’s dollar, usually leaving your financing capacity unimpaired.
Real estate as an investment
Over the long haul, few investments provide better long-term return than real estate. Equity increases through mortgage pay-down and value appreciation. Although not as advantageous as in past years, it still offers tax advantages not available from many other investments.
Still, there are downsides. Real estate is landlocked. You can’t pick it up and move it to a better location. If you pay too much, buy too big, finance too much, or manage poorly, it could be a loser. Leverage works both ways. It is not as secure as bank guarantees, nor is it a quick in-and-out as with many stocks. Reselling could be a slow process. Most woodworking shops are industrial-type buildings in semi-commercial, light-industrial locations, out of character with the neighborhood, often reducing their value. And the fortunes of real estate are often governed by circumstances you can’t control. With leasing, 100 percent of the rent is tax-deductible.
One of the ways to minimize the risk is to develop the property at a size larger than what is immediately required, and then rent the unused space to others. Although this will increase the initial capital investment, the rental income will assist in making the mortgage payments and provide the future opportunity to expand the shop with a minimum of further outlay.
Property as a separate company
Although intended to house your woodworking shop, owned real estate should never be considered as a part of the shop’s business. It should be a separate investment, owned by a separate company, and leased to your woodworking company. This offers several long-term advantages and it protects your investment against any legal liability, which might be incurred from your day-to-day operation. To avoid problems with the IRS, rent should be at market rate, the same as if you were renting to or from a third party. Keep the property and shop expenses separate. On paper, consider yourself as a tenant, no different than if you were renting from a stranger. Compare the property’s benefits, hazards and returns with other investments, and then determine if this is the best way to achieve your objectives with the minimum financial risk and the maximum reward.
When you buy or build, envision not only your present requirements, but also the long-term potential of the property for alternative uses. There are three important considerations: your own occupancy, future resale, and the possibility of renting to others sometime later. First, you will want to house your woodworking shop. As such, the initial and most important criteria will be related to your operation and how the property fits with your present operation and anticipated growth. Consider location, visibility, ease of entry and exit, land-to-building ratio, type, size, and condition of the structure, operating cost, deferred maintenance, and adaptability to your long-term needs.
Someday you may wish to resell the property. Although nothing sweetens the pot like cash, holding a large take-back mortgage beats bank interest and is normally quite safe. For this purpose you need to consider it from the perspective of a future buyer. A building’s location and its adaptability for other uses will likely improve its worth. Only select a property that will be in demand and is in a neighborhood where values are increasing.
At a future time, you may wish to rent out the property. It could be that you will sell the woodworking business and, like Ellison’s intentions, retain the real estate as an investment. Nothing contributes better to one’s pension than a good lease to a strong tenant. Accordingly, ensure that the property can now, and in the future, provide a satisfactory return, one that stacks up with other investments. Avoid the temptation to build inflation into your calculations. Use constant dollars.
Clarify your objectives
Only buy or build after you have considered all factors and determined that owning your shop’s real estate is preferable to leasing. Good real estate is one of the world’s better long-term investments, but it is not without its shortcomings. Develop a strategy that will enable you to achieve your objectives and overcome your constraints. Should you own your own real estate? Yes, no, maybe, sometimes — and all with qualifications.
Lloyd Manning is a semi-retired business and commercial real estate appraiser, broker and financial analyst, and a freelance business writer.
This article originally appeared in the March 2009 issue.