Owning the premises feels safer than renting from the seller. Priced as its own investment, with the loan, the tax and the exit, it is usually a modest real estate return bought with scarce cash.
Only if the building earns its own return. Priced as a separate deal, an illustrative 1,000,000 building financed 90 per cent over 25 years at 9.0 per cent needs 130,000 of extra cash, costs more than the 85,000 rent it replaces in year 1, and returns 9.8 per cent a year after tax over ten years if it appreciates 2 per cent a year, and 3.1 per cent if it does not. Meanwhile the combined debt coverage falls from 1.60x to 1.41x.
Worked in full in Buying a Small Business by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
When the seller owns the premises, the buyer is offered a choice: buy the building too, or sign a lease with the seller as landlord. Owning feels safer, because nobody can raise the rent or refuse a renewal, and lenders will finance real estate over 25 years under SBA 7(a), against 10 years for the business. But the building is a second investment with its own price, its own return and its own claim on your cash. The right comparison is incremental: what you pay and receive by owning, against what you would pay by renting the same space.
| Item | Value |
|---|---|
| Building price | 1,000,000 |
| Closing costs | 30,000 |
| Loan, 90% of price | 900,000 |
| Rate, amortisation | 9.0%, 25 years |
| Market rent, triple net, year 1 (8.5% of price) | 85,000 |
| Rent growth | 2.5% a year |
| Owner's repairs to roof and structure, expensed | 5,000 a year |
| Tax rate on business income | 30% |
| Depreciable share, life | 80%, 39 years |
| Hold, selling costs | 10 years, 6% |
The lease is triple net, so property tax, insurance and routine maintenance fall on the business either way and drop out of the comparison. What owning adds is the loan, the structural repairs and the depreciation. The 5,000 is treated as deductible repairs; a replacement roof would instead be capitalised and depreciated.
Extra cash = 1,000,000 − 900,000 + 30,000 = 130,000
Debt service = PMT(9.0%/12, 300, 900,000) × 12 = 7,553 a month, 90,633 a year
Year 1 tax effect = 30% × (85,000 rent no longer paid − 80,593 interest − 20,513 depreciation − 5,000 reserve) = −6,332, a saving
Year 1 incremental cash = 85,000 − 90,633 − 5,000 + 6,332 = −4,302
Before tax, owning costs 10,633 more than renting in year 1. Of the 90,633 paid to the lender, 10,041 is principal, which is saving rather than cost, but it is saving you cannot spend until you sell or refinance.
| Year | Rent avoided | Interest | Tax effect | Net cash |
|---|---|---|---|---|
| 1 | 85,000 | 80,593 | −6,332 | −4,302 |
| 3 | 89,303 | 78,620 | −4,449 | −1,881 |
| 5 | 93,824 | 76,261 | −2,385 | 576 |
| 7 | 98,574 | 73,438 | −113 | 3,054 |
| 10 | 106,153 | 68,131 | 3,753 | 6,767 |
| Years 1 to 10 | 12,103 |
At 2 per cent a year the building sells for 1,218,994 in year 10, 1,145,855 after costs. The loan has amortised to 744,653, and tax on the gain, with depreciation recaptured at 25 per cent and the rest at 20, is 74,453. Net proceeds are 326,749.
IRR of −130,000, the ten yearly flows, and 326,749 at exit = 9.8% after tax; 2.61x the cash put in
Excel: =IRR(B2:B12) on the incremental column
| Annual appreciation | Rent 75,000 | Rent 85,000 | Rent 95,000 |
|---|---|---|---|
| 0% | −1.9% | 3.1% | 8.2% |
| 1% | 2.4% | 6.7% | 11.1% |
| 2% | 6.0% | 9.8% | 13.8% |
| 3% | 9.0% | 12.5% | 16.1% |
The column matters as much as the row. If the seller would lease you the space at 75,000 because that is the real market rent, the building is overpriced at 1,000,000 and owning it returns 6.0 per cent even with 2 per cent growth. The rate matters too: at 7.5 per cent the base case returns 14.0 per cent; at 10.5 per cent, 5.4.
Lenders test coverage on the whole borrower. Suppose the business generates 400,000 of cash for debt service after rent and carries 250,000 of acquisition debt service: 1.60x. Buy the building and the rent comes back into cash flow, less the 5,000 reserve, while 90,633 of mortgage joins the debt service.
Renting: 400,000 / 250,000 = 1.60x
Owning: (400,000 + 85,000 − 5,000) / (250,000 + 90,633) = 480,000 / 340,633 = 1.41x
The 130,000 is also cash that is not in the business. The equity injection, the working capital and the reserve for a bad first year compete for the same savings, worked in how much cash you need to buy a business with an SBA loan. A business bought at 3x SDE should return far more on each dollar than a building yielding 8.5 per cent, so the building has to justify the cash it takes away.
Comparing the mortgage payment with the rent and calling the difference the cost. That ignores the down payment, the tax effect, the principal and, above all, the exit. The second mistake is accepting the seller's rent as the market rent. A seller who keeps the building has every reason to set a high rent; a seller who sells it has every reason to set a high price. Get an independent rent opinion and price both options from it.
The book works the business side of the deal, from SDE to the SBA loan and the seller note; the free workbook for this case runs ten years of coverage after capex and tax.
In year 1 usually not. In the worked case the 900,000 loan costs 90,633 a year against 85,000 of rent, and after a 5,000 reserve and the tax effect owning costs 4,302 more. Owning pays through principal repayment and appreciation, which arrive only when the building is sold or refinanced.
In the worked case, 9.8 per cent a year after tax on the 130,000 of extra cash over ten years, if the building appreciates 2 per cent a year and the rent it replaces is 85,000. With no appreciation it falls to 3.1 per cent; if the market rent is only 75,000 and values are flat, it is negative at minus 1.9 per cent.
Yes. Rent leaves the expenses but the mortgage payment joins the debt service. With 400,000 of cash flow and 250,000 of business debt service, coverage of 1.60x falls to 1.41x once 90,633 of building debt replaces 85,000 of rent and a 5,000 reserve is set aside.
This article is one calculation from Buying a Small Business. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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