LEASE vs BUY ANALYSIS

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Lease versus buy analysis refers to the comparison of two real estate financing alternatives. It is an important component of the strategic planning for any real estate transaction or portfolio. This type of analysis is designed for a user or tenant to compare the costs of ownership of a particular real estate asset, with the costs of leasing space instead. The best way to compare the value of owning commercial real estate to the value of leasing it is to create a lease vs. buy model. Commercial Concepts uses this approach to help our clients compare the financial aspects of leasing to those of owning a business property, so that they can decide what is best for their particular business and their company’s goals.

OBJECTIVES OF CONDUCTING AN INITIAL LEASE VERSUS BUY ANALYSIS:

  • To recognize the critical factors, both financial and non-financial, that influence the lease vs. own decision.
  • To compare and contrast leasing vs. owning as a means of maximizing the physical and/or economic use of a property.
  • To calculate and interpret the net present value of leasing vs. owning in a particular market or transaction.
  • To calculate and interpret the internal rate of return of the differential after-tax cash flows from leasing vs. owning.
  • To calculate and understand the sales price point of indifference where the net present value of leasing and owning are the same.
  • To understand the impact that generally accepted accounting principles can have on a user’s financial statements.
 

Advantages of Leasing

  • Financial Flexibility/Cash Flow
    • Leasing can provide more flexibility for users who need cash to invest in their business, as opportunity and capital costs are important user considerations.
    • Lease arrangements often have fewer restrictions.
    • Leasing is well suited for piecemeal financing.
  • Additional Tax Deductions
    • Lease payments are fully tax deductible and reflect rent paid on both land and improvements.
    • Operating expenses are tax deductible.
  • Source of Financing
    • Leasing is 100% financing, which is diminished by each lease payment (commercial loans require a down payment of 10% to 35%, depending on the loan).
  • Location
    • Leasing allows a user to have their business in a premier location that otherwise might not be affordable.
  • Low Risk of Obsolescence
    • Ownership has obsolescence risk that leasing does not have.
  • Stability of Costs
    • Continual periodic outlay allowing easy monitoring of cash flow.
    • Very important for users with seasonal cash flows.
  • Spatial Flexibility
    • Allows more flexibility if a user needs to relocate.
  • Business Focus
    • Leasing allows users to concentrate on their primary business without the distraction of managing real estate.

Disadvantages of Leasing

  • Cost
    • For users with good earnings, access to financing and the ability to take advantage of the tax benefits of ownership, leasing is often a more expensive alternative.
  • Loss of Salvage Value
    • Improvements that are important to a user’s business needs could substantially alter the property or reduce its range of uses.
  • Contractual Penalties
    • If a property becomes obsolete, the user is still obligated to pay the rent.
  • No Appreciation Benefits
    • Leasing does not allow for participation in appreciation.
  • Lack of Control
    • Leasing does not allow for control, which may create negative operational, physical, or image demands.
 

Advantages of Owning

  • Tax Savings
    • The user could be entitled to tax savings and mortgage interest.
  • Appreciation
    • The user is entitled to all appreciation in value.
  • Income
    • Income received from any tenants can be used to pay down the mortgage or for other investments.
  • Control
    • Within the limits of the law, a user can operate the building as seen fit.

Disadvantages of Owning

  • Initial Capital Outlay
    • Down payments require cash that could be used for other investments/operations.
  • Financing
    • Financing is dependent upon users’ financial condition and the financial marketplace.
  • Financial Liability
    • Commercial loans affect the balance sheet by increasing long term debt and related debt restrictions by lenders.
  • Legal Compliance
    • Compliance with laws or zoning may be unforeseen and costly.
  • Risk
    • Damage, obsolescence, and inability to sell at a preferred price and time are all risks.
  • Inflexibility
    • Space may be inflexible to be enlarged or reduced due to business fluctuations or other external forces.
 

Cash Flow After Tax and Net Present Value vs. Internal Rate of Return Techniques

  • Cash Flow After Tax
    • Since the tax implications of owning and leasing are dissimilar, both the Net Present Value (NPV) and Internal Rate of Return (IRR) comparison techniques require the use of CFAT.
    • CFAT is the amount of money left after accounting for all operating expenses, property taxes, financing costs, and income tax obligations.
  • Net Present Value Method
    • Compares the NPV of cash flows for each of the alternatives.
    • NPV method reduces each alternative to its periodic CFAT, using the appropriate discount rate.
    • The greater the NPV is always the better economic choice.
  • Internal Rate of Return Method
    • Calculates the IRR on the difference between owning and leasing cash flows.
    • IRR method subtracts CFAT of lease alternatives from own alternatives and calculates an IRR on the differential.
    • This method allows the user to identify the discount rate (opportunity cost) at which the cost to own or lease are equal.
    • When discount rate is higher than this equilibrium, leasing is preferred.
    • If the user chooses to own, the IRR of the differential of cash flows indicates the after-tax yield on the capital invested in the ownership alternative. This yield can be compared to alternative investment opportunities such as investing in the user’s core business.
 

Example - To Buy or Not to Buy

A corporate user is considering whether to lease or buy a 25,000 square foot office building in Torrance, California.

  • USER ASSUMPTIONS

    • 25,000 square foot office building
    • Corporate entity
    • Tax rate 35%
    • Discount rate 11%
    • 10-year hold period

Lease Assumptions

  • $22/SF Gross (plus utilities & janitorial)
  • 3% annual gross rent

Own Assumptions

  • Purchase Price $3M
  • Acquisition cost $30K
  • Building/Land allocation 75%/25%
  • 75% loan to value ratio
  • 25-year amortization
  • 15-year term monthly payments
  • 9% interest rate
  • 2 discount points
  • 10-year sales forecast $3.5M
  • Cost of Sale 6%

Net Present Value of Leasing

End of Year Cash Flow Before Tax Minus Tax Saving (35%) Cash Flow After Tax
1 $550,000.00 $192,500.00 $357,500.00
2 $561,000.00 $196,350.00 $364,650.00
3 $572,220.00 $200,277.00 $371,943.00
4 $583,664.40 $204,282.54 $379,381.86
5 $595,337.69 $208,368.19 $386,969.50
6 $607,244.44 $212,535.55 $394,708.89
7 $619,389.33 $216,786.27 $402,603.06
8 $631,777.12 $221,121.99 $410,655.13
9 $644,412.66 $225,544.43 $418,868.23
10 $657,300.91 $230,055.32 $427,245.59
NPV @ 4.50% $5,865,794.55

Net Present Value of Owning

End of Year Cash Flow After Tax Sale Proceeds
0 $870,000.00
1 $215,672.00
2 $217,270.00
3 $219,829.00
4 $222,506.00
5 $225,309.00
6 $228,248.00
7 $231,332.00
8 $234,573.00
9 $237,983.00
10 $242,428.00 $1,145,635.00
NPV @ 4.50% $2,742,292.43