Imagine you are a mid-level manager at a fast-growing small business tasked with finding office space in a new city as part of your company’s expansion plans. You have to decide whether to lease or purchase the property. This is a significant decision, but fortunately, there’s a structured way to approach it.
Lease vs. Own – Reasons for Each
Many people automatically assume that buying property is the best choice. While there are numerous benefits to owning, such as property value appreciation, tax benefits of depreciation, and generating rental income from leasing excess space, it also involves substantial capital investments, including down payments and interior improvements. Given a business’s capital needs for other projects, purchasing may not always be feasible.
Leasing, on the other hand, requires minimal upfront costs. Often, a landlord provides a tenant improvement allowance to cover buildout costs. Lease payments are operating expenses that lower taxable income, alleviating the company from property management burdens, and freeing up capital for growth opportunities. However, leasing does not provide an opportunity for profit, and lease rates can fluctuate based on market conditions.
Ultimately, the choice between leasing or buying hinges on specific company needs and financial implications. While lease vs. own analysis provides a financial perspective, it’s essential to consider non-financial aspects that vary across businesses.
Lease vs. Own Analysis – Basic Concepts
The core of lease vs. own analysis involves evaluating cash flows from both pre-tax and after-tax views. This can be achieved using two primary methods:
- Net Present Value (NPV) Method: This method calculates the present value of future after-tax cash flows, discounted at the required return rate. The option with the highest NPV is usually the best choice.
- Internal Rate of Return (IRR) Method: Here, the analysis compares the cost of purchasing property against the benefits of ownership, yielding an IRR that can be assessed against the weighted average cost of capital (WACC), required return rates, and opportunity costs tied to alternative investments.
While these concepts are relatively straightforward, executing the analysis can become intricate, as it must account for elements unique to the transaction such as lease term, lender options, property occupancy, taxes, amortization, capital gains, closing costs, debt service, and income escalations.
Lease vs. Own – A Case Study
To better understand how lease vs. own analysis is applied, let’s examine a hypothetical case study. Suppose the small business has identified a 10,000 square foot commercial space for evaluation. We will start with the lease cash flows.
Required Lease Inputs & Analysis
To calculate the NPV of lease payments, the following inputs are necessary:
- 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 a spreadsheet, inputs can be analyzed to derive cash flow for the lease period. For clarity, we will summarize calculations starting from Year 1:
- Base Rent: Calculated as total square footage (10,000) multiplied by rental rate ($20), resulting in a Year 1 outflow of $200,000, with an annual increase of 3%.
- Operating Expenses: The tenant incurs operating expenses of $60,000 for Year 1, which also rises by 2% annually.
- Capital Expenditures: The tenant must invest $15,000 in Year 0.
- Annual Cash Flow: The sum total of rent plus expenses results in a Year 1 cash outflow of ($260,000) which escalates each subsequent year.
- After Tax Cash Flow: Reflecting the tax savings from lease payments, this number can provide significant insight into overall financial health.
Continuing this method across all years, the NPV for lease payments is determined to be ($1,335,799).
Required Purchase Inputs & Analysis
When evaluating a purchase, the following inputs establish the cash flow for ownership:
- Purchase Price: $5,000,000
- Down Payment: $1,000,000
- Loan Amount: $4,000,000
- Loan Amortization Period: 20 Years
- Interest Rate: 5.50%
- Depreciation Period: 39 Years
- Capital Gains Tax Rate: 20%
- Marginal Tax Rate: 35%
- Depreciation Recapture Rate: 25%
- Loan Closing Costs: 1%
- Sale Costs: 4%
- Property Appreciation: 3% annually
- Operating Expenses: $6 PSF, increasing at 2% annually
- Other Rent: $20,000 annually, growing at 2% annually
Each cash flow, such as rental income and total ownership expenses, can be modeled in Excel for the ownership analysis. The cash flows yield an NPV of ownership at ($1,061,886).
Lease vs. Own – Comparison
By comparing lease cash flows with ownership cash flows, we find that purchasing the property yields a preferable financial outcome, given its greater (or less negative) NPV. The analysis also reveals an IRR of 9.17%, exceeding the 7% discount rate, further solidifying the purchase decision.
Final Thoughts
When weighing the options of leasing versus owning real estate, it’s crucial to model cash flows over the holding period and assess their present value. The option with greater cash flows is often the most financially prudent. Nonetheless, decisions are rarely based solely on financial metrics. Considerations such as a company’s capital needs, flexibility requirements, asset management preferences, and zoning regulations significantly influence the final choice.
Disclaimer: As a mid-level manager of a growing small business, you face the ongoing challenge of deciding between leasing and purchasing office space in new locations. The guidance here provides a structured approach to inform your decision-making.
