To Buy or Not to Buy
Are you ready to buy a building? It doesn’t always make sense — even if you can afford it.
BY PHIL BOLSTA
When Doug Leaser founded Minnesota Waterjet, Inc. in 2003, he had no intention of living up to his name indefinitely. It took four years, but Leaser is no longer a lessee. The $2 million company, whose machines use ultra-high water pressure to cut and machine materials, moved from a leased facility in Rogers to a newly constructed manufacturing plant in Ramsey on Nov.1, 2007.
Leaser financed the building through St. Paul-based Bremer Bank after the city of Ramsey offered him a tax increment financing (TIF) package that helped achieve the equity required to finance the loan. “We were very particular about where we wanted to build,” Leaser says. “I wanted to make sure it would be in a city that encouraged small-business growth and in an area near other industrial facilities.”
A perfect convergence of circumstances convinced Leaser that now was the right time to move from leasing to owning. First, after four years of robust growth, the company needed to add machines. Second, he viewed a building as a valuable long-term investment in his retirement portfolio. Third, commercial property values and interest rates were favorable.
Perhaps most importantly, a waterjet business requires specialized equipment that’s best suited for a permanent home. “To move a waterjet shop is not the easiest thing to do,” Leaser says. “There are a lot of items that are main stays of the building that can’t sustain moving, like overhead cranes and large cutting tables. We wanted to move into a building that was best suited for our operations and where we didn’t have to worry about moving out. Leasing just wasn’t an option.”
Paul Flood, a senior vice president and regional SBA manager at Bremer Bank, doesn’t consider buying an option for his clients unless, as in Minnesota Waterjet’s case, the numbers add up. “We want to make sure we’re talking about a financial solution,” Flood says. “There can be a misperception among business owners that owning real estate will help make them wealthy. In most cases, the real economic benefit is generally derived from the business that’s occupying the real estate.”
That’s why Flood approves loans only for businesses that are financially healthy regardless of the economic climate. “We focus on the core operation of the business rather than whether it’s a good time to buy real estate from a rate or market price perspective,” Flood says. “Ultimately, what it comes down to is whether it’s the right time and the right thing for the business to do.”
After thoughtful analysis, some businesses are simply better off renting. “Maybe you’re a new business and you don’t have the capital to put down on a new building,” says George Ruth, senior vice president and chief credit officer at Klein Bank in Chaska. “Or you’re a new business that anticipates out growing your building within three to five years, although you’re unsure of the space you’ll eventually need. Or maybe you need a special-use building — like a medical building with examining rooms or a manufacturing plant with reinforced floors — and it’s cheaper to rent it than buy it.”
Another viable option is to buy and rent—except you serve as the lessor instead of the lessee. “Often, a business will build or buy a building, occupy 50 percent to 60 percent for their own operations and sub-lease out the rest so they have room to grow three to five years down the road,” says Peter Miller, a business banking officer at Anchor Bank in Woodbury.
In Flood’s view, the decision-making process always comes down to two words: cash flow. “That’s the number one factor to look at,” he says. “What has the cash flow been historically, and is it expected to hold steady or be even stronger in the future so that the business can continue to afford the debt for the building?”
Market Watch
Business owners scared off by media reports can take heart — the crisis in residential mortgage banking has had limited impact on the commercial market. Indeed, the residential and commercial markets are two different animals. Residential mortgages are cookie-cutter loans that are bundled and sold to an investor. In contrast, before a commercial real estate loan is approved, a banker sits down with the business owner in an effort to understand the business and determine how much debt it can service. Essentially, then, residential loans are transactions while commercial real estate loans become relationships.
Case in point: Minnesota Waterjet had to build a quality relationship before building a quality facility. “Paul Flood was instrumental in finding a way to get this done,” Leaser says. “I had visited with other local banks trying to work out a deal but could never agree on the details. Paul and I had many conversations that went well beyond ‘bankers’ hours’ and he listened to all of my concerns. Paul championed Minnesota Waterjet through Bremer Bank and we were able to come up with terms that fit our budget and long-term goals.”
Other business owners with long-term goals have found a willing partner in the commercial real estate market. “Commercial property has leveled off in the last six to eight months, but we haven’t seen a downturn yet, especially in the stronger markets like the Minneapolis-St. Paul metropolitan area,” says Jim Wiekamp, director of the investment program at Home Federal Investment Services in Rochester. “Some of the outlying areas may have weakened some; if that’s the case and you’ve got the cash, you may be able to save yourself some annual costs by purchasing a building.”
Any weakness in the commercial real estatemarket is largely due to smaller operatorswho bit off more than they could chew. “The biggest decline in the real estate market next to the residential or home market is in multi-family dwellings like duplexes and apartment buildings,” says Anchor Bank’s Miller. “That’s due to people who invested in them with very little or no money down, then didn’t have the financial wherewithal to handle interest rate spikes or unfavorable occupancy rates.”
Similar dynamics explain why the residentialmarket is in trouble. “A few years ago, houses were rapidly increasing in value,” says Klein Bank’s Ruth. “You had individuals who bought homes they could not afford because they expected a large return. They were able to do that because aggressive lenders loosened their underwriting to qualify people for mortgages — the lenders were more concerned about their commission than about finding the right product for a customer. Once we looked closely at this subprime lending (the practice of making loans to borrowers who don’t qualify for the best market interest rates because of a deficient credit history), we exited it in 2005 because it wasn’t right for the customer and the reputation risk was too high for the bank.”
While the combination of a steady market and declining interest rates is attractive, Wiekamp offers a word to the wise to would-be building buyers. “If you’ve got limited capital, and you know you want to expand your business, it may make sense to use that capital for business expansion rather than for investing in a property,” he says. “Conversely, if you’re not expanding your business rapidly or you have some excess cash flow, it may make sense to purchase the building. Either way, my advice would be to consult with your CPA or financial adviser.” Another often-overlooked factor to consider is energy costs. “If your cash flow situation warrants that buying makes more sense than leasing, I would look into relocating to a more energy-efficient building or incorporating an energy upgrade into the purchase of your present building because I don’t see energy going down in price,” says Wiekamp, a member of his local chamber’s Governmental Affairs committee. “Energy costs are going to change the business landscape in Minnesota big time.”
The Loan Arrangers
Leaser bought his building with the help of a Small Business Administration (SBA) 504 loan, which is designed primarily to provide long-term financing to small businesses for the acquisition of land and buildings. With an SBA504 loan, the bank lends 50 percent and the SBA504 provides up to 40 percent in subordinated financing with a 20-year, fixed-rate loan, currently 6.26 percent. The business owner contributes just 10 percent. In some cases, if the business is creating a lot of jobs, the local government will kick in some of that 10 percent.
That low initial investment made all the difference for Minnesota Waterjet. “The big advantage was the down payment,” Leaser says. “It allowed us to dedicate more capital for other expenses for the business itself, like adding additional equipment and miscellaneous shop items. It really came down to a cash flow decision.” The Minnesota SBA Office ranks fifth in the nation for the number of 504 Certified Development Company (CDC) loans approved, with 427 loans worth $208.9 million approved in Fiscal Year 2007. Of those, Twin Cities-Metro, the largest of six nonprofit CDCs in the state, gained approval on 168 loans totaling $82.7 million. “We’re the eyes and ears of the SBA,” says Pete Ingebrand, vice president of Twin Cities-Metro. “The SBA doesn’t have the local staff to administer the program by themselves. Our strong partnership with the SBA allows us to promote the program and take a project from application to funding.”
The 504 program is a win-win-win situation for small business owners, bankers and the SBA. Borrowers are able to preserve capital while enjoying the benefits of a low, fixed-rate loan from the SBA, banks can leverage their funds while maintaining a well secured position, and the SBA delivers a relatively low-cost program that promotes job creation and economic expansion.
According to the Minneapolis/St. Paul Business Journal, the most active Minnesota SBA lenders from October 2006 to October 2007 were U.S. Bancorp (546 SBA loans), Wells Fargo SBA Lending (344), Twin Cities-Metro Certified Development Company (168), Capital One (135) and Minnesota Business Finance Corp. (121).
An SBA loan doesn’t solve every challenge. “I talk with a lot of people who are interested in owning their own real estate, but they don’t really have a good opportunity to buy,” says Wells Fargo’s John Thwing, whose license plate reads SBA GUY. “The construction process is complicated, long-range and fairly onerous, and construction materials have seen significant inflation over the last few years.”
Finding the right building isn’t easy either. “In the Twin Cities, there’s just not that much product in the marketplace,” says Thwing, who has offices in Wells Fargo’s Uptown branch. “There’s more availability of product for manufacturers than office space users, but much of it is obsolete or older product that needs to be rehabbed. You have to find a building in a preferred geographic area where moving won’t disrupt your operations and employee base too much. On top of that, you’ll have to make significant improvements to the building and have to deal with environmental issues. So it becomes fairly complex.”
With all of those factors in play, Thwing has three words of advice when the right building comes along: Snap it up! “If a customer finds a building that’s in the right geographic vicinity and has the right attributes to meet their occupancy needs, my advice to them is to hop on it,” he says. “I tell them that they need to recognize that they’re not savvy real estate investors — people tend to sweat the price a little too much and think that they’re going to negotiate the greatest deal on earth. But that $25,000 more on the purchase price isn’t going to add up to much of a difference if you end up not getting the deal and you pay $200,000 more in rent over the next three years.”