Owning vs. Leasing – Commercial Real Estate

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Imagine you are a mid-level manager at a fast growing small business.  As part of the company’s expansion plans, you have been tasked with finding office space in a new city and deciding whether to lease it or purchase it.  

Fortunately, there is an objective way to make this decision.  But, it can be a little bit complicated.  In this article, we are going to introduce the key concepts in lease vs. own analysis and apply them with a case study.

Lease vs. Own – Reasons for Each

For many, buying a property is automatically assumed to be the best choice.  In many cases it may be.  Property owners benefit from increases in the asset’s value over time and from the tax benefits of depreciation.  In addition, they may benefit from leasing excess space to other tenants, favorable loan interest rates, and the comfort in knowing that their rent isn’t subject to the whims of a landlord.  

However, buying a commercial property also requires a significant capital investment in the form of a down payment on the property and in the improvements made to the interior.  Depending on the capital needs of the corporation for other projects, it may not always be the best choice.

On the other hand, leasing commercial real estate requires little to no upfront investment.  In fact, the landlord may even provide a tenant improvement allowance to fund all or some of the interior buildout.  In addition, lease payments are qualified operating expenses so they reduce the company’s taxable income and leasing relieves the company of the burden of property management and does not tie up capital that could be otherwise used to fund growth.

On the downside, there is no opportunity to earn a profit on a lease and lease rates can be subject to change based on the local market and the property owner’s return requirements.

The point is this, there are a variety of equally valid reasons to lease or buy a property.  Some of them are based on the company’s specific needs while others are strictly financial.  Lease vs. Own analysis tackles the financial aspect only.  It can provide an objective outcome from a financial perspective only, but there are considerations that go beyond finances that vary from one company to another.

Lease vs. Own Analysis – Basic  Concepts

The basic concept behind lease vs. own analysis is that the cash flows for each option need to be evaluated from both pre-tax and after-tax perspective.  There are two ways to do this:

  1. The Net Present Value (NPV) Method:  The NPVapproach considers the present value of all future after-tax cash flows and discounts them back to the present time using the investor’s required rate of return.  A rational actor would choose the option with the highest NPV.
  2. The Internal Rate of Return (IRR) Method:  This method seeks to perform cost/benefit analysis between the cost of buying the property and the benefits that are received from owning it.  The resulting IRRis the rate of return that can be earned from buying rather than leasing the property and it can be compared against other factors like weighted average cost of capital (WACC), required rate of return, and opportunity cost associated with alternative investment options.

While the concept itself is relatively simple, the actual analysis can be much more complex because it needs to incorporate details specific to the transaction like: lease term, potential lenders, property occupancy, property taxes, loan amortization, capital gains, closing costs, loan debt service, income escalations, the property’s purchase price, tax rate, deductible depreciation, and the monthly payments associated with the lease.

Lease vs. Own – A Case Study

To illustrate how business owners can deploy lease vs. own analysis, an example is helpful.  We’ll start by setting it up and then go through the calculations.

Case Study Setup

Extending the example from above, assume the small business has found a 10,000 square foot commercial space and they need to evaluate the cost of leasing it versus the cost of purchasing it outright at its current market value.  Let’s start with a review of the lease cash flows.

Required Lease Inputs & Analysis

To calculate the Net Present Value (NPV) of the lease payments, the following inputs are required:

  • Marginal Tax Rate:  35%
  • Discount Rate:  7%
  • Improvement Expense:  $15,000
  • Commercial LeaseRental Rate:  $20 Per Square Foot 
  • Rental Increases:  3% Annually
  • Operating Expenses:  $6 Per Square Foot 
  • Operating Expense Increases:  2% Annually

Using Microsoft Excel or a similar spreadsheet program, these inputs can be transformed into the following analysis (NOTE:  Only the first 5 years of a 20 year lease is shown):

graph 1

Let’s go through how each line item in the analysis is derived for Year 1 of the lease period:

  • Base Rent: Base rent is calculated as the total rentable square feet (10,000) multiplied by the per square foot rental rate ($20). Year 1 outflow is $200,000 and it rises 3% annually.
  • Operating Expenses: The tenant is also responsible for operating expenses of $6 PSF, multiplied by 10,000 SF. It rises by 2% annually.
  • Capital Expenditures: The tenant is responsible for $15,000 in CapEx in year 0. This is a direct input. There are no further capital expenditures.
  • Annual Cash Flow: Equal to the sum of total rent payments plus total expenses (including CapEx). In year 1, it is ($260,000) and it rises in each year of the lease.
  • Total Marginal Tax Rate: The company has estimated their own marginal tax rate at 35%. This is a direct input.
  • After Tax Cash Adjustments: Remember, monthly rental payments reduce the company’s tax burden. So, there is some tax benefit from the lease and it is calculated as the total outflow ($260,000) multiplied by the marginal tax rate (35%). The benefit is $91,100, meaning this is the tax savings from the rental expense.
  • After Tax Cash Flow: Equal to the before tax cash flow (-$260,000) plus the after tax cash adjustment ($91,100). This is the key number in the analysis.
  • After Tax Cumulative Cost By Year: This line item is calculated as a running total of the annual after tax cash flows. For example after tax cash flow for year 0 is ($9,750) and ($169,000) for year 1. Together, this is ($178,750). This continues for the analysis period.
  • After Tax NPV By Year: This line item is calculated as the cumulative cash flow discounted at the specified rate (7%) for the relevant number of periods.

The Excel model makes these calculations for each year in the analysis period and the after tax cash flow is summarized in the table below:

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