Lease vs. Own - Part II Calculations
When Does It Make Sense?
Charlotte’s current economic climate is prompting many business owners to examine the option of property ownership.
If you have not read Part 1, please click here to view the first article on this topic.
In the previous article, we looked at the advantages and disadvantages of leasing vs owning office space. As mentioned in the article, there are many interrelated factors, aside from the obvious financial considerations, that should be analyzed carefully. Making a prudent decision goes far beyond short-term financial goals. We expanded on this broad process and the necessity of diligently examining the following factors.
Merits of Owning and Leasing
Company Structure / Goals & Objectives
Operating Space Requirements
Market Conditions
Financial Analysis
In this article we will focus on the financial analysis piece. Without question this segment of the process is the most vital and any mistakes made here could be costly. For simplicity and understandability of the article, many factors that may contribute to the decision making process are being left out. Analyzing the full financial ramifications of leasing and ownership is not an easy task, and business owners should seek the help of a professional real estate consultant.
Definitions
-
A “discount rate” is used to establish what the value of the money received from the sale of the building would be in today’s terms. This provides a more accurate representation of the value of an asset by accounting for the time value of money and investment risk. This is the rate used to determine the “Net Present Value”.
-
IRR, or internal rate of return, is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis. In general, when comparing investment options with other similar characteristics, the investment with the highest IRR probably would be considered the best.
IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is not the actual dollar value of the project. It is the annual return that makes the NPV equal to zero.
Generally speaking, the higher an internal rate of return, the more desirable an investment is to undertake. IRR is uniform for investments of varying types and, as such, can be used to rank multiple prospective investments or projects on a relatively even basis.
-
A value to help quantifying the cost and/or benefit of an investment. It utilizes the initial investment/purchase price, the cash flow for each year of the holding period, the length the investment in held and the discount rate in a calculation to convert money spent over the term into an amount that equals what it would be if it was all spent today.
-
A Loan-to-Value ratio is a metric used by lenders to determine the risk to the lender. The lower the LTV, the lower the risk is to the lender and may lead to better loan terms.
Loan-to-Value is often influenced by the relationship between the lender and borrower.
The Financial Analysis
Below is a scenario comparison in which the client has the option to continue leasing space or to purchase. This example will show which is more beneficial to the client.
ABC Company is evaluating the financial implications of continuing to lease space in their current building and purchasing a building in the same area of town, or submarket. The following assumptions are used in the analysis:
Option to Lease:
ABC Company requires 5,000 SF and the annual rent starts at a rate of $35/SF (annualized to equal $175,000) with a 3% annual increase built into the lease. This lease rate includes base rent and all operating expenses.
Option to Purchase:
A 5,000 SF building is available in the same submarket as ABC Company’s current lease. The purchase price of the property is $1,500,000, closing costs are 2%, or $30,000, and the building will require an additional $250,000 of upfit costs to meet the needs of the client. The money allocated for the down payment is $221,691 (Loan to Value ratio used is 88.1564%) making the total loan amount $1,528,309. ($1,500,000 + $250,000 - $221,691 = $1,528,309)
The interest rate on this loan is 6.5% annually for 25 years. Operating expenses for the building are $6.00/SF.
The holding period for both options is 10 years, but it is assumed that at the end of Year 10, ABC Company will sell their building.
*A “discount rate” will vary from business to business based on a number of factors. These could include a business’ borrowing rate, the opportunity cost of investing that money back into their own business, or even the rate of return if the money was saved in a money market.
Utilizing a discount rate provides a more accurate representation of the value of an asset by accounting for the time value of money and investment risk.
Obviously, the first consideration is whether ABC Company has the cash fluidity to pay for a down payment and closing costs – if not, then leasing is the only option.
Assuming ABC Company has the funds for the down payment and closing costs, another tool of analytics is determining the Net Present Value (NPV) of the cash outlay over the course of our 10-year period for both the Purchasing and Leasing Options. The NPV calculation takes into consideration initial investment/purchase price, the cash flow for each year of the holding period, how long the asset is held and the discount rate - with the intention of being able to quantify, in today’s dollars, the cost or benefit of the investment. In our example, ABC Company’s discount rate is 7%.
The Table below details the cash flow for ABC Company over the 10-year holding period. You will notice, “Year 0” shows a negative balance of $251,691 in the Own column – this is the sum of the down payment and the closing costs. There are no initial expenses in the Option to Lease, thus “Year 0” is empty for that option.
Years 1-10 in the Option to Own column show a steady cash outflow of $155,000. In calculations not shown here, the mortgage payment for the purchase option was rounded to $125,000 annually while the operating expenses annually equated to $30,000. Thus, the annualized expenses for the Option to own are $155,000.
At the end of Year 10, after fully paying annual expenses, ABC Company sells the building for $420/SF or $2,100,000. After paying off the remaining balance on their loan ($1,184,613) and the 6% closing costs ($126,000), ABC Company ends the year with an annual net income of $789,387.
Years 1-10 in the Option to Lease column show an increasing cash outflow starting at $175,000 – the annualized rent paid for leasing 5,000 SF at $35/SF. This rate increases by 3% each year.
The Differential Cash Flow column details the amount of money spent or saved between the Own and Leasing options. At Year 0, the Differential Cash flow is -$251,691 because of the downpayment and closing costs. However, at Year 1, the annualized Differential Cash flow is $20,000 because you are paying $20,000 less by paying a mortgage and operating expenses than you are paying in your lease (which also includes operating expenses).
Now that we have charted out the cash flows for both the Option to Purchase and the Option to Lease we can calculate the Net Present Value for each option by using the following formula.
In this case, the NPV of the money that will be spent over the course of the 10-year period in the Option to Purchase is $803,998. However, over the course of the same period, the NPV of the money spent in the Option to Lease is $1,386,092. In today’s dollars, you would be spending $582,103 less over the course of the term in the Option to Purchase versus the Option to Lease.
The last metric that we will be looking at for this example is the Internal Rate of Return (IRR). The IRR is the annual rate of growth that an investment is expected to generate. To determine this rate, you analyze cash inflows and outflows over a specified period.
From the table above, the IRR was determined based off the Differential Cash Flow resulting in an IRR of 23%. In this Scenario, the IRR (23%) is significantly higher than the Discount Rate (7%) indicating that the Option to Purchase is going to be a much better Option for the client.
In Summary
No two pieces of real estate are exactly the same, however a thorough comparative analysis can help companies form a solid decision. Of course, the validity of the decision depends largely on the quality of the assumptions used in the analysis: using the most accurate facts will produce a more precise outcome.
Cherry Associates can help clients analyze all aspects of the lease vs. own decision on a qualitative and quantitative basis. If your firm is considering purchasing property, let Cherry Associates help guide you through the complex process.
