Market analysis

Lease or Own?

Examining Market Cycles Can Help Clients Make Better Decisions.

Helping a client decide whether to purchase or lease a property can be a complex process. Apart from the financial analysis, the decision may be influenced by the client's internal operational objectives, which generally fluctuate from year to year. The analysis also typically hinges on tenuous estimates of the property's future sales price and rental rates.

In the long-term, owning commercial real estate usually is more cost-effective than leasing, assuming a modest amount of appreciation. However, no general answer applies to all cases. Each individual situation requires a financial analysis, including a thorough examination of market cycles to estimate future selling prices and lease rates.

A simple spreadsheet or any number of industry software packages can be used to create a lease vs. own analysis. Mathematically, it is just a present value problem; however, as most seasoned commercial real estate professionals know, assumptions such as operating space requirements, cost and availability of capital, future lease rates, and sales price projections easily can skew the analysis. For this reason, property market and capital market cycles should be included in any analysis.

Setting the Stage Preceding a financial analysis, commercial real estate professionals should help their clients understand the basic factors that contrast leasing and ownership.

The factors that make leasing an attractive alternative to real property ownership include:

  • financial benefits such as maintaining capital and lines of credit, off-balance- sheet financial accounting, deductibility of lease payments for tax purposes, stability of costs, and enhanced control of cash flow;
  • space benefits such as flexibility of size and location over time, the ability to expand more quickly into new markets, and the ability to expand and contract as dictated by the business cycle; and
  • subjective factors such as removing ownership risks including obsolescence, loss on disposition, and cap rate volatility, and the freedom to concentrate on core business objectives rather than property management.

Alternatively, factors that favor ownership over leasing include:

  • financial reasons such as eliminating exposure to market rent fluctuations, property appreciation, rental income from tenants, and the company's ability to utilize financial leverage, as well as tax factors such as deductions for depreciation and favorable capital gains treatment upon disposition;
  • space considerations such as the ability to tailor the property to the current needs of the operating business; and
  • subjective issues such as promoting an image of strength and stability, the ability to control real estate operating expenses, and control over tenants and uses within the building.

Market Cycle Factors Every property market goes through distinct periods of expansion, contraction, recession, and recovery. The process of estimating a client's position relative to the market cycle can have a tremendous impact on the lease vs. own decision.

Space markets are affected by a variety of forces. Economic, social, demographic, and technological factors influence the quantity, type, and availability of space in a given market through time. Capital flows and public-policy direction also influence the space markets. All of these forces interact simultaneously to reveal the pattern of real estate space.

Capital markets, on the other hand, tend to lag behind the true space market. Therefore, a developer generally should not assume that a space market is healthy simply because many sources of funds are competing for a proposed development. A positive response from the capital markets never should take the place of thorough property market analysis. The prudent analyst, developer, or consultant diligently must pursue an in-depth analysis of all relevant market factors before drawing any conclusions.

Cycle Position Six key factors determine current market cycle position: demand, supply, vacancy, rental rates, cap rates, and investor interest. The unique interplay among these elements helps identify in which cycle a client is operating.

During analysis, it is critical to know if these variables are increasing or decreasing from previous periods, as well as expectations for their future direction. Interaction of these variables determines market cycle position and each cycle period is unique with respect to these key variables.

For example, characteristics of the expansion phase include steadily increasing property supplies, strong demand, sharply declining vacancy rates, increasing rental rates, steadily decreasing cap rates, and strong investor participation.

In contrast, the contraction phase has supplies at or near peak levels, decreasing demand, rising vacancies, flattening or declining rental rates, increasing cap rates, and fewer willing investors.

In the recession phase, property supply decreases as new construction halts and frustrated investors pull properties from the market. Demand steadily decreases, driving up vacancy rates and driving down rents. Cap rates steadily increase. At the early stage of recession brokers and investors attempt to determine whether the signs truly point to recession or to a temporary market glitch.

Finally, the recovery phase is characterized by a relatively flat supply but increasing demand, declining vacancies, rising rental rates, declining cap rates, and increasing investor interest, especially from astute bargain hunters. 

Historically, the capital markets have lagged behind the property markets due in large part to the inefficiencies in the dissemination of real estate data. However, with increased institutional ownership of real estate assets and a variety of publicly available data sources, the lag decreases significantly and the accuracy of cycle predictions increases.

Lease vs. Own Fern The following hypothetical lease vs. own scenario focuses on the assumptions of future selling prices and lease rates and on the sensitivity of the analysis in light of market cycles.

The Scenario. Conrad Manufacturing specializes in consumer products with a staff of more than 65 employees working in part of a 40,000-square-foot high-technology research and development facility. The space originally accommodated four 10,000-sf users; however, Conrad Manufacturing has taken over two of the four units as other tenants have vacated.

The other remaining tenant in the building has announced plans to leave, so the property owner has approached Conrad Manufacturing about either leasing the balance of the space or purchasing the entire property at a price of $4 million ($100 per square foot).

The basic assumptions for the lease vs. own analysis consider selling price, rent, and operating expenses during a 10-year period. If Conrad Manufacturing purchases the property, after 10 years it could sell the building for more than $4.4 million, assuming 1 percent appreciation. If it leases, rent for each of the first five years would be $300,000 ($7.50 psf), and operating expenses would be $100,000 ($2.50 psf). For the last five years, rent would increase to $368,888 ($9.22 psf), and operating expenses would increase to $120,000 ($3 psf).

The Before-Tax Fern. Tables 2 and 3 show the results of the before-tax analysis. If Conrad Manufacturing leases, the total annual cost of occupancy will be $400,000 per year for five years and then $488,888 per year for the next five years. If the company's opportunity cost of capital is 14 percent, then the total present cost of this alternative is $2,559,228.

 

Table 2: Present-Value Cost of Lease Option

Year

Total Occupancy Cost

PV at 14%

 

 

 

1

$400,000

$400,000

2

$400,000

$350,877

3

$400,000

$307,787

4

$400,000

$269,989

5

$400,000

$236,832

6

$488,888

$253,913

7

$488,888

$222,731

8

$488,888

$195,378

9

$488,888

$171,384

10

$488,888

$150,337

Totals

$4,444,440

$2,559,228


Table 3: Present-Value Cost of Purchase Option

Year

Initial equity

Debt service

Operating expenses

Equity reversion

Total occupancy cost

PV at 14%

0

$ (1,000,000)

 

 

 

 

$1,000,000

1

 

$323,901

$100,000

 

$423,901

$423,901

2

 

$323,901

$100,000

 

$423,901

$371,843

3

 

$323,901

$100,000

 

$423,901

$326,178

4

 

$323,901

$100,000

 

$423,901

$286,121

5

 

$323,901

$100,000

 

$423,901

$250,983

6

 

$323,901

$120,000

 

$443,901

$230,548

7

 

$323,901

$120,000

 

$443,901

$202,235

8

 

$323,901

$120,000

 

$443,901

$177,399

9

 

$323,901

$120,000

 

$443,901

$155,614

10

 

$323,901

$120,000

$ (1,958,105)

$ (1,514,204)

$ (465,630)

Totals

$(1,000,000)

$3,239,010

$1,100,000

$(1,958,105)

$2,380,905

$2,959,193

 

Should Conrad Manufacturing purchase the facility at the agreed-upon terms, its total occupancy cost will equal the annual operating expenses and debt service. The company will need to come up with $1 million in equity for the transaction, yet it also will enjoy the benefit of an equity reversion at the end of the 10-year holding period. However, in this case, the total present cost of the purchase option is nearly $400,000 higher than the leasing option.

The Tax Implications. Leasing the property also will allow the company to depreciate the land, as lease payments are a deductible business expense. Conrad can deduct 100 percent of the lease payments against its taxable income. Consequently, leasing almost always results in a lower after-tax cost for the company than any alternative form of financing.

Tables 4 and 5 show the after-tax cash flows, and the advantages of leasing are now more pronounced. Conrad Manufacturing will save more than $450,000 in after-tax present value under the lease alternative.

 

  Table 4: Present-Value Cost of Lease Option

Year

Rent

Tax [email protected] 39.6%

After-tax
occupancy cost

After-tax
PV at 14%

 

 

 

 

 

1

$400,000

$158,400

$241,600

$241,600

2

$400,000

$158,400

$241,600

$211,930

3

$400,000

$158,400

$241,600

$185,903

4

$400,000

$158,400

$241,600

$163,073

5

$400,000

$158,400

$241,600

$143,047

6

$488,888

$193,600

$295,288

$153,364

7

$488,888

$193,600

$295,288

$134,529

8

$488,888

$193,600

$295,288

$118,008

9

$ 488,888

$193,600

$295,288

$103,516

10

$488,888

$193,600

$295,288

$90,804

Totals

$4,444,440

$1,759,998

$2,684,442

$1,545,774


Table 5: Present-Value Cost of Purchase Option

Year

Initial equity

Before-tax Total Occupancy cost

Interest
at 39.6%

Depreciation
at 39.6%

Operating Expenses at 39.6%

After-tax Equity reversion

After-tax total occupancy cost

PV at 14%

0

$ (1,000,000)

 

 

 

 

 

 

$1,000,000

1

 

$423,901

$106,013

$33,305

$39,600

 

$244,983

$244,983

2

 

$423,901

$103,930

$33,305

$39,600

 

$247,066

$216,725

3

 

$423,901

$101,647

$33,305

$39,600

 

$249,349

$191,866

4

 

$423,901

$99,150

$33,305

$39,600

 

$251,846

$169,989

5

 

$423,901

$96,419

$33,305

$39,600

 

$254,577

$150,730

6

 

$443,901

$93,432

$33,305

$47,520

 

$269,644

$140,045

7

 

$443,901

$90,164

$33,305

$47,520

 

$272,912

$124,335

8

 

$443,901

$86,590

$33,305

$47,520

 

$276,486

$110,494

9

 

$443,901

$82,681

$33,305

$47,520

 

$280,395

$98,295

10

 

$443,901

$78,405

$33,305

$47,520

$(1,730,072)

$(1,445,401)

$(444,472)

Totals

$ (1,000,000)

$4,339,010

$938,433

$333,048

$435,600

$(1,730,072)

$901,857

$2,002,989

 

Market Cycle Considerations. The assumptions underlying this analysis drive its conclusions. The analysis started with a very conservative estimate of future appreciation, just about 1 percent per year. An increase in value at such a low level is indicative of a long-term contraction and recession cycle, in which case the company would prefer to lease. However, as table 6 shows, changing the future value assumption to slightly less than 3 percent growth closes the leasing advantage gap by more than $200,000. Using a more-aggressive 5 percent annual appreciation rate gives no clear advantage to either purchasing or leasing.

 

Table 6: After-Tax Comparison Assuming Greater Property Appreciation  

After-tax PV cost of leasing

After-tax PV cost of purchase
1% property appreciation

After-tax PV cost of purchase
3% property appreciation

After-tax PV cost of purchase
5% property appreciation

$1,545,774

$2,002,989

$1,806,184

$1,543,344

 

The increase in lease payments over 10 years also was conservative, again indicative of a market in contraction. The primary lease term of $400,000 per year for five years and $488,888 per year for the second five years is only a 22 percent increase. Using a less-conservative estimate of $520,000 per year in the second term, still only a 35 percent increase, and a more-aggressive estimate of $600,000 per year, a 50 percent increase, favors a buy scenario. (See table 7.)

 

Table 7: After-Tax Comparison Assuming Greater Rental Appreciation

After-tax PV cost of leasing

After-tax PV cost of leasing

After-tax PV costof leasing

After-tax PV costof purchase

After-tax PV costof purchase

22% growth

35% growth

50% growth

3% property appreciation

5% property appreciation

$1,545,774

$1,608,525

$1,682,189

$1,806,184

$1,543,344

 

Using historical trends and statistical modeling, commercial real estate professionals can craft a 10-year cycle for any property type in any market by looking at the basic fundamentals of a community's growth. Forecasting for a 10-year period provides a more-certain projection of where the cycle is, consequently offering a more-reliable forecast. Brokers can now define a narrower range of options for clients by looking at market cycle research, instead of an extremely broad range of future sale prices and rental price estimates.

Walt Clements, CCIM, and Jeff Engelstad, CCIM

Walt Clements, CCIM, is a vice president and principal at Colliers Turley Martin Tucker in Kansas City, Mo. Contact him at (816) 221-2200 or [email protected] Jeff Engelstad, CCIM, is an assistant professor in the executive master`s in real estate and construction management program at University of Denver. Contact him at (303) 680-2600 or [email protected]

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