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Owning vs. Leasing – Commercial Real Estate

Property Management, Tips & Tricks | 0 comments

Introduction

If you are a mid-level manager at a fast-growing small business tasked with expanding into a new city, deciding whether to lease or buy office space is a critical decision. This article introduces the key concepts in lease versus own analysis and applies them through a case study to help guide this decision.

Lease vs. Own: Reasons for Each

While purchasing a property might seem like the best option due to potential asset value increases, tax depreciation benefits, and additional income from leasing excess space, it requires a significant upfront capital investment. This investment may not always be feasible depending on the company’s other capital needs.

Conversely, leasing commercial real estate demands minimal initial investment. Landlords might even offer tenant improvement allowances to cover some interior buildout costs. Lease payments, treated as qualified operating expenses, can lower taxable income, and leasing also frees up capital for other business growth initiatives, without the responsibilities of property management.

However, leasing does not provide profit from property value increases, and lease rates can fluctuate based on market conditions and the landlord’s requirements.

Lease vs. Own Analysis: Basic Concepts

The fundamental concept behind lease versus own analysis involves evaluating the cash flows of each option from both a pre-tax and after-tax perspective. The two main analytical methods used are:

  • The Net Present Value (NPV) Method: This method calculates the present value of all future after-tax cash flows, discounting them back to the present using the investor’s required rate of return. The preferred option typically has the highest NPV.
  • The Internal Rate of Return (IRR) Method: This method conducts a cost/benefit analysis between the costs of buying the property and the benefits received from owning it. The resulting IRR is compared against other financial metrics such as the weighted average cost of capital (WACC) and the required rate of return.

These analyses incorporate various transaction-specific details such as lease terms, potential lenders, property occupancy, taxes, and other financial factors, making the analysis complex but essential for informed decision-making.

Lease vs. Own: A Case Study

Case Study Setup

Assume the business is considering a 10,000 square foot commercial space. To analyze the costs of leasing versus buying, we start with the lease cash flows.

Required Lease Inputs & Analysis

To compute the NPV of the lease payments, we consider:

  • Marginal Tax Rate: 35%
  • Discount Rate: 7%
  • Improvement Expense: $15,000
  • Commercial Lease Rental Rate: $20 per square foot
  • Rental Increases: 3% annually
  • Operating Expenses: $6 per square foot
  • Operating Expense Increases: 2% annually

Using these inputs, an Excel spreadsheet is used to project the cash flows over a 20-year lease, analyzing only the first five years for simplicity:

  • Base Rent: Calculated as 10,000 square feet at $20 per square foot, increasing by 3% annually.
  • Operating Expenses: $6 per square foot, increasing by 2% annually, also calculated for 10,000 square feet.
  • Capital Expenditures: A one-time $15,000 expense for tenant improvements at the start.
  • Annual Cash Flow: The sum of total rent and expenses, including capital expenditures.
  • After-Tax Cash Flow Adjustments: The tax savings from the lease, calculated as the total outflow multiplied by the marginal tax rate.
  • After-Tax Cumulative Cost by Year: This is the running total of the annual after-tax cash flows.
  • After-Tax NPV by Year: The cumulative cash flow discounted at 7% for the relevant number of periods.

The analysis helps visualize the financial impact of leasing versus buying, providing a clear framework to support the decision-making process.

Conclusion

Deciding whether to lease or buy commercial property involves weighing both financial and strategic considerations specific to your company’s situation. By utilizing detailed financial models like NPV and IRR, businesses can objectively assess the most financially viable option, ensuring alignment with long-term corporate goals and capital allocation strategies.

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