Monetary Wisdom - December 2008

By Charlie Ragland

Adding real estate to your retail business strategy may provide the competitive edge that you’ve been seeking but there are advantages and drawbacks to consider before making the rent versus own real estate decision.

Leasing is often recommended at the beginning and early stages of your business. A combination of factors drives this decision. Efficient management of cash is your first priority, and the size and shape of your business is evolving. Your target customer may change along with the focus of your business, and you may want the flexibility to expand or relocate in the future. Flexibility and cash reserves are a prudent business strategy as you establish your business in the first few years.

Leasing is more affordable in the short run. Leasing frees up working capital to support the operation, growth, and expansion of your business. It allows you to focus on operating your business without the added complications of owning and operating real estate. However, the advantages of leasing begin to diminish in the medium and long term because leasing rates often increase and your landlord could decide to cancel your lease in favor of a more lucrative national tenant.

As your business matures your operating and market plans are more refined and established. You understand your target customer and know the best way to reach them. You are in a better strategic and financial position to consider adding real estate to your business strategy.

Owning real estate increases your control over your business operations. It provides you the opportunity to fix your rent expenses and the potential to benefit from asset appreciation. It also allows you to build out a space that is optimized for your specific business with the right amount of showroom, support offices and inventory space. In addition, you have the option of building additional retail space that can be leased to other shop owners which, in turn, can reduce your fixed costs over time and also increase store traffic.

Securing a premium site can be a challenge, and buying your real estate may be the only way you can secure the most desirable location for your business. Local flooring retailers are often at a disadvantage when competing with national retail brand stores for high traffic retail space to lease, even if they have a good credit rating and a compelling story to tell. Many landlords consider the national brand retailers more desirable tenants. If your business needs a premium retail location, becoming an anchor tenant in your own building may be the best option, and you can lease out any excess space.

There are several accounting benefits to owning your own store. You will be able to lock in your effective rent, lease excess space, realize many tax advantages, and secure capital appreciation. Ownership allows you to build equity and depreciate an appreciating asset. Floorcovering income is subject to personal taxes of 30% or more, while real estate is subject to 15% capital gains. These advantages have the potential to create a tangible asset for a retirement nest egg once the building is paid for.

“The decision to own your buildings is obvious,” said one Texas floorcovering retailer. “You are paying yourself rent, building equity, and creating a tangible asset. Stand-alone floorcovering businesses without real estate can be harder to value and more difficult to sell when the time comes to retire. Only limited opportunities arise when accepted companies like a retail flooring chain decide to enter the market and pay a fair value for your business. Owning real estate gives you the ability to secure a long term benefit for your 20 years of hard work.”

Identifying and securing the right site is extremely important. Many technical details will become important for your consideration. For example, easy entry and exit for your location from all directions is a requirement, and traffic patterns and volume shouldn’t inhibit convenient entry and exit. The store and store signage should have good visibility from the street in all directions. Parking design should allow for easy access and movement around the site.

Conduct a market analysis to determine the potential market and always consider your competition and how your decision is likely to impact the competitive dynamics. Study the local population demographics and ensure that they match your business offering—a complementary demographic location will require less advertising. Determine if the traditional customer appeal of the area supports your product offering. It is also important to work with an experienced commercial realtor.

Our Texas retailer targeted the lower-upper and higher-middle class consumers who frequented premium locations near malls and big box retailers. For him an ideal site was a location near the big box retailers and malls. “The national chains identify the premium locations for you,” he said. “You may pay a premium but secure a site with good appreciation potential.” This retailer advises against looking for the inexpensive location and betting on future growth. He prefers a sure bet at a premium.

Tenant mix is not as important as you might expect. Originally this retailer focused on leasing to complementary tenants. However, this strategy didn’t make much difference and now he focuses on getting the best tenants possible, often the national brands.

With a 20 year time horizon your real estate has the potential to be worth more than the floorcovering business. The real estate will be highly marketable, while the flooring business may be harder to sell. A reasonable strategy for floorcovering retailers is to begin investigating the options of owning your own real estate, becoming the anchor tenant, and leasing the additional space. This strategy provides a hedge against the ups and downs of the business cycle and the future marketability of the floorcovering business.

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