As a broker, leasing agent, or consultant, you may be asked to advise a client on the merits of owning or leasing commercial real estate. Or as a business owner or shareholder yourself, you may need a method of comparing leasing and financing options. To come to a decision, you need a firm understanding of real estate value versus business value, as well as a formula for comparing the financial aspects of leasing to those of owning a business property.

Real Estate Versus Business Value
"Every person who invests in well-selected real estate in a growing section of a prosperous community adopts the surest and safest method of becoming independent, for real estate is the basis of wealth."
-Theodore Roosevelt

Shareholders of operating businesses would disagree with Mr. Roosevelt. For them, real estate is not the basis of wealth; company cash flow is. Real estate is a capital asset required by the business so that it can produce cash flow.

A simple example illustrates this point. A multiunit franchisee of a national restaurant chain decides to build two restaurant properties for $1 million each. After a year of operation, one site achieves revenues of $1 million and the other site achieves revenues of $1.5 million. Despite the disparity in sales, the real estate values have changed little, since real estate is generally bought and sold on the basis of market comparables, reconstruction costs, and market rents.

Thus, the success of a business is not likely to alter the value of the real estate on which it is located. What has changed is the value of the business. Because profits tend to be greater on a marginal dollar of sales, the 50% higher revenues in one restaurant produce a nearly 340% increase in pre-tax profits. Since businesses are bought and sold based on cash flow, the value of the higher-volume restaurant is potentially 4.4 times the value of the lower-volume restaurant. In both cases, the value created by the cash flow far exceeds the likely appreciation of the real estate.

Institutional investors have long known that real estate values are not business values. On the one hand, institutions hold large blocks of stock in such retail giants as Federated, Wal-Mart, and The Limited. On the other hand, these same institutions also have investments-either directly or indirectly-in the real estate used by these retailers. Furthermore, the decisions to invest in the stock of retailers and in real estate leased to retailers are made separately, generally by different investment managers having expertise in stocks and real estate.

Investments in real estate and stocks in operating businesses have different return attributes. Real estate is forecast to be less volatile, with a larger portion of returns coming in the form of current cash distributions. Real estate is generally not viewed as a growth investment and has little operating leverage to achieve economies of scale. A review of the Russell-NCREIF Index, which measures the historic returns for institutional real estate returns, bears this out. During the relatively favorable years from 1981 to 1985, gross institutional real estate returns before management fees averaged approximately 13%. The subsequent poor returns and losses in investment-grade portfolios that occurred from 1986 through 1993 have been well publicized. In its 1994 National Investor Survey, CB Commercial sought to determine expected future investor returns on real estate holdings. The survey showed an anticipation of future nominal real estate returns averaging from 12% to 14%, depending upon the quality of real estate.

Lease or Own?
Although the value of a business has little affect on the value of the real estate, owning real estate as a business asset offers some positive financial advantages. For instance, financing options are more numerous for real estate than for other capital assets. Because real estate is viewed as an investment with a virtually unlimited lifespan, it can be financed with equity, mortgage loans, or sale-leaseback financing. This last option-which is somewhat analogous to an interest-only loan with no requirement to ever repay the principal-is not available for equipment, which, in comparison, has a brief lifespan and is more subject to functional obsolescence.

The best way to compare the value of owning commercial real estate to leasing it is to create a purchase versus lease model, similar to comparisons for other business investments. However, being able to either own or lease real estate makes analyzing financing alternatives more complex. With equipment, options are often limited to loans or capitalized leases, which are both debt equivalents. Therefore, comparisons are based on one factor: rate.

We can also make rate comparisons for real estate mortgages and operating leases. However, the analysis is complicated by the different tax ramifications and the need to factor in real estate appreciation and lease escalations.

In addition, real estate ownership carries a potential opportunity cost. Owning real estate through either equity or mortgage loan financing is likely to exclude further investment in the business, such as expansion or renovation. Further operations investment might produce greater returns than the real estate investment, thus creating an opportunity cost that accompanies real estate ownership. As a result, any comparisons made between owning and leasing should include an opportunity cost comparison as well as a rate comparison.

Designing the Model
Because real estate and business values are distinct from one another, any lease versus purchase model is essentially a three-step process. The first step compares the effective after-tax interest rate of leasing versus owning. The second step determines the extent of any opportunity cost brought about by owning investment property. The third step creates a single number that incorporates the two previously calculated factors.

To make the comparison, we use as a model a $1 million chain restaurant property. Table 2 lists the starting assumptions for our model.

Step One:
Comparative Interest Rates
Effectively comparing the interest rates of commercial mortgages and long-term real estate leases is complicated by many factors. These are detailed below with suggestions to facilitate the comparison.

Fixed vs. Floating-Establish a true rate comparison over an equivalent time period. The first apparent difficulty is comparing fixed and floating interest rate options. For example, many commercial mortgages have variable interest rates or balloon payments. However, even a balloon payment can be considered an adjustable interest rate, since the balance would theoretically be refinanced at the prevailing rate. To compare loan and lease rates, the rates should be for equivalent time periods.

Accepting a short-term interest rate option means that you also accept the risk of interest rate movements. This risk should be distinct from any basic rate comparison.

Interest rates are correlated to Treasury bill and note rates. The variance of Treasury obligations over time-referred to as a yield curve-is typically upward sloping, meaning that long-term rates tend to be higher than short-term rates. A simple means of making a true rate comparison adjusted for time is to compare the rates to Treasury borrowing rates for the same period of time.

For example, the prime lending rate as of August 31, 1994, was 7.75%, roughly 3.5% above the 30-day Treasury bill rate. A 20-year lease with a base rent of 11% was also approximately 3.5% above the yield on 20-year Treasury bonds. Therefore, given the same spread over Treasuries, a true rate comparison would begin using the same rate. Themodel uses an 11% borrowing and 11% base lease rate.

Loan Interest Rate-Use the highest rate. In today's world of increased loan securitization, some loans require the borrower to commit to repay more than the borrowed amount in case other borrowers within the same loan pool default on their commitments. Essentially, each borrower "credit enhances" the loan pool and therefore is contingently liable to repay more than is borrowed. Thus, the effective loan interest rate is potentially much higher in the event the contingent liability is called.

For a pure rate comparison, use both the face interest rate and debt service as well as the highest possible effective rate and debt service.

Appreciation vs. Escalation-Consider a variety of rate comparisons. The greatest difficulty in making a rate comparison between leasing and financing is that the cost of each is, in part, a function of expected real estate appreciation and lease escalation levels. First, the more real estate appreciates, the less it costs to own it and the more it costs to lease it. Second, leases typically have escalation clauses. The greater the escalations, the greater the effective lease rate.

Because of the variety of possible combinations of property appreciation and lease escalations, there is no such thing as a single rate comparison. Instead, there are a variety of possible rate comparisons, depending upon assumed appreciation and lease escalation levels. Tables 3 and 4 illustrate such varying rate comparisons.

Real Estate Ownership
To determine the effective after-tax cash flows for a commercial real estate mortgage, calculate the five components below. Then discount the after-tax cash outflows back to determine the effective after-tax mortgage financing rate.

Interest Expense-Determining the after-tax effective interest rates begins with calculating the loan amortization schedule. For this model use a 20-year amortization schedule.

Depreciation Schedule-Depreciation time frames for real estate have become progressively longer since 1986. Following the Budget Reconciliation Act of 1993, the allowable depreciation is 39 years.

Property Appreciation-The taxable gain from property appreciation includes the increase in value of the property in addition to any depreciation recapture. In this analysis, any gain from investing in real estate essentially reduces the cost of financing the property. The model assumes an annual appreciation rate of 3%.

Income Taxes-The first three components of real estate ownership are multiplied by the borrower's marginal tax rate. The model uses a tax rate of 40%, which includes federal, state, and local income taxes.

Payment of Principal-Property down payment and the repayment of any mortgage loan principal are not expense items and offer no reduction in income taxes.

Real Estate Leasing
The four components calculated to determine the effective leasing after-tax cash flow are shown below. To determine the effective after-tax lease financing rate, discount back the after-tax cash outflows.

Base Rent Expense-The annual base property rent expense is calculated and spread over a 20-year period.

Percentage Rent Expense-The model uses a sales participation escalation feature, computed to be the amount at which 8% of sales exceeds the base rent. Such a "natural breakover" is common within the chain restaurant industry. Other lease escalation clauses could also be used, such as Consumer Price Index adjusters.

Property Appreciation-The landlord's ability to realize appreciation from the real estate is effectively another cost to the tenant. This is the flip side of real estate ownership: property appreciation reduces the cost of ownership financing and increases the cost of leasing.

Income Taxes- The first three lease components are multiplied by the borrower's marginal tax rate. Again a tax rate of 40% is used, which includes federal, state, and local income taxes.

Rate Comparison Results
The rate comparison for this model shows that the lease has a higher after-tax interest rate than the mortgage. However,a few modifications of the input assumptions would change the rate comparison. These changes are detailed below.

Appreciation-The model presumes a 3% appreciation annually on both the land and the building. If the appreciation were only on the land (50% of the investment), appreciation would be just 1.5%, increasing the effective ownership interest rate and decreasing the effective cost of leasing. At 1.5% appreciation, the cost analysis would still weigh in favor of the loan, but just by 10 basis points. With no appreciation, the analysis favors the lease. This points out one of the rate benefits of leasing: the landlord effectively undertakes the risks of property valuation increases or decreases.

Sales Levels-The model presumes a beginning restaurant sales level of $1.25 million, with sustained sales increases of 3% thereafter. With sales increases of 1.5%, the effective cost of leasing falls 70 basis points, because the amount of percentage rents that the tenant paid declines. This points out a second leasing rate benefit: if there is no sales growth, or if sales fall below $1.25 million, the base lease rate is fixed for the lease term. The landlord has therefore assumed the risks of low sales levels. See Table 3 for pricing comparisons to sales level and property appreciation.

Length of Lease-If reviewed over a 10-year period, as shown in Table 4, instead of 20 years, the rate analysis changes. Presuming the tenant has a fair market purchase option in the lease's tenth year and the 3% sales and appreciation levels, the lease and loan pricing are separated by just 40 basis points. This separation would be even less if the loan had a prepayment penalty.

The reason for closer comparative rates is that percentage rental payments are less a factor if reviewed over just a 10-year holding period. This 10-year rate comparison points to a third leasing benefit: a fair market value purchase option effectively reprices the cost of real estate occupancy.

Step Two:
Analysis of Opportunity Cost
Real estate ownership tends to absorb more cash flow than a lease since property loans generally require down payments and loan amortization. By itself, this favors a decision to lease, because enhanced cash flow tends to reduce overall business risk.

To the extent that an investment in a business is capable of producing higher rates of return than an investment in real estate, an opportunity cost is incurred. As illustrated previously, historical and projected real estate returns tend to be modest in relation to the returns from business investments.

For example, suppose that a licensed restaurant franchisee opens a new restaurant, as in the example shown in Table 1. If the investment in franchise fees, training, and working capital is $100,000, and the property produces a $48,000 pre-tax profit, then a 48% pre-tax return is realized. If the property achieves a sales level of $1.5 million, the pre-tax return is a staggering 210%.

Of course, these types of returns presume that the restaurant operator elects to lease the property and finance virtually all of the furniture, fixtures, and equipment. Many companies prefer to have some investment in the restaurant facility costs in order to reduce the long-term fixed costs. This would be especially true for furniture, fixtures, and equipment, which have a shorter life-span and will need to be purchased anyway. Added investment would tend to raise the cash flow but reduce the pre-tax return on investment as shown in Table 5.

The above illustration supports the idea that the way a business is capitalized is a function of its profitability, plans for future growth, and the assets required to operate the business. Based upon Table 1, presume that the pre-tax "hurdle rate" for new investments in the business is 40%. If the cash flow saved through property leasing could be consistently reinvested in the company to earn a 40% pre-tax return, then the company would generate an after-tax additional cash flow of $3.3 million by year 20. Assuming a valuation multiple of seven times cash flow, the business would have an additional value of $23.3 million at the end of year 20 as a result of the decision not to own the real estate. This is what is meant by the opportunity cost of real estate ownership. In effect, this opportunity cost is an additional cost of the decision to own the real estate.

Step Three:
Deriving a Single Index
The third step of the lease versus purchase analysis is to determine a single number that incorporates both the after-tax interest rate differential as well as the opportunity cost of property ownership. You can do this through a net present value analysis.

For example, in the base model the effective after-tax loan rate is 7.03%. By calculating a net present value of the lease streams at the same after-tax rate, a net loan advantage is computed at $209,825. Similarly, the added terminal business value from the investment of the cash flow savings through leases is discounted at the same after-tax loan rate. The same rate is used because the surplus cash flows would not have existed had the company elected to own the property. The net present value of the opportunity cost is approximately $6 million. Adding the two costs together demonstrates that the decision to lease has a net present value of $5.7 million over the decision to own and represents the best means of property financing.

Qualitative Considerations
This analysis emphasizes the quantitative reasons that most companies should try to avoid tying up their valuable capital in real estate assets. It is also important to look at three qualitative supporting arguments:

There are other qualitative issues to consider as an integral part of the lease versus own decision. For example, leases should provide the tenant with an acceptable level of control over the asset. Among such control issues are assignability, reasonable condemnation and taking provisions, and purchase options. Lease escalation clauses should be manageable and potentially tied to sales growth in order to lessen downside risk. Through percentage rents, which are tied either to sales levels or to capped CPI adjusters, lease escalations should fall below sales increases, thereby contributing to higher levels of potential earnings. Lastly, leases should include minimal financial covenants, in keeping with their long-term nature.

The Final Analysis
Leasing real estate offers a business the ability to occupy and control a property without tying up capital that can be more efficiently deployed. In years past, most companies employing stand-alone buildings had little choice but to own the real estate they occupied. In today's more highly evolved financial marketplace, this is no longer true. Real estate investment companies are capitalized by investors having return parameters that fall far below the investment hurdle rates of most operating companies.

Many companies continue to own substantial amounts of real estate, thus incurring for themselves and their shareholders the opportunity cost of real estate ownership. Within the model, the variables that have an impact on opportunity cost-the lease and loan cash flow discrepancies, the hurdle rate, the tax rate, and the business valuation multiple-also most affect the outcome. The interest rate analysis is comparatively less significant. The decision to own rather than lease a property is likely to limit the company's ability to invest more profitably in operations. Real estate ownership may therefore come at a high cost to business owners and shareholders.

Table 1
Real Estate Value Vs. Business Value
Chain restaurant example

Table 2
Lease Vs. Purchase Model Assumptions
$1 million chain restaurant property

Chart 2
Step One: Comparative Interest Rates
Effective after-tax rate comparison
The loan rate advantage

Chart 3
Step Two: Opportunity Cost Analysis
Impact on business value from lease cash flow savings
The opportunity cost of loans
Year   20   $23,341,525

Chart 4
Step Three: Deriving a Single Index
Net Lease Advantage Table
Shown on a net present value basis

About the Author
Christopher Volk is senior vice president of Franchise Finance Corporation of America, Scottsdale, Arizona. He can be reached at (602) 585-4500.