To Lease or not to Lease?
That is the question corporate managers must answer.
By Christopher H. Volk |
A principal goal of
corporate management is to make a business worth more than the cost of its
underlying assets. To create such shareholder wealth, management has three
levers at its disposal: asset efficiency, operating efficiency, and capital
Asset efficiency is the ability to limit the amount of
assets that have to be funded with shareholder equity. It primarily entails
managing fixed asset costs and working capital levels. Operating efficiency is
the ability to improve operating profit margins, which is accomplished by
finding ways to increase sales, raise prices, and control expenses. Capital
efficiency is the ability to reduce the weighted cost of debt and equity
capital. Managers must harness equity in concert with various forms of outside
capital to lower corporate costs of capital.
Combined, the three efficiency levers work together to
generate shareholder returns. Companies that can produce the highest returns
with the least financing drag on cash flows tend to create the highest
percentage gains in shareholder wealth, not to mention higher current equity
cash flow yields.
The Role of Real Estate
The decision to lease or own real estate is centered on
capital efficiency, which is measured by pretax rates of shareholder return. To
be sure, there are tax implications to real estate financing decisions. The
benefits of real estate depreciation, which can shield income from taxes, can
be alluring. However, such benefits are nominal, since buildings are
depreciated for tax purposes over a lengthy 31.5 years, and land has no
Moreover, the tax benefits are merely a tax deferral,
since real estate sold after a long holding period is subject to gains from the
recapture of accumulated depreciation. The many public companies that are
shackled by the potential for severe tax consequences from imbedded real estate
gains serve as a reminder that the better route is to focus on pretax equity
rates of return cannot be properly computed from a financial statement: They
are a financial, as opposed to an accounting, concept. If a company invests $1
million into a building and finances 70 percent of the cost, then the
percentage of equity is 30 percent. The equity percentage never changes unless
the debt is paid down, in which case the mix of debt and equity shifts. This is
what happens when real estate is owned and related mortgage debt is repaid. As
the percent of the real estate funded with loans declines, the amount of equity
rises, which has an adverse impact on shareholder equity returns over
Apart from depreciation, there is a second allure to real
estate ownership, which is the potential for appreciation. Without question,
this is a subject worth considering, but not in concert with the proper means
of corporate capitalization. Business leaders are rewarded first for focusing
their attention on optimizing the three corporate efficiencies. Real estate
appreciation, which is a part of real estate returns, is not a business
activity; it is an investment activity. The attractiveness of real estate as an
investment for companies will be addressed later in this article.
Computing Equity Returns
TheV-Formula is a simple shortcut to compute current pretax
equity returns. The formula harnesses all three of the corporate valuation
The financial model based upon the V-Formulaillustrates
the impact of real estate financing decisions on corporate valuation. The
V-Formula calculates pretax rates of return on equity, which means that the
relative return comparisons are the same, irrespective of the dollar values of
the real estate and business. That said, the model assumes location revenues of
$1.5 million for the purposes of demonstrating the magnitude of the
capitalization decisions on corporate cash reserves.
The model inputs are self-evident, perhaps with the
exception of the expansion capital input. That figure represents the amount of
company capital that has to be invested in start-up or other costs associated
with the location financed. Many businesses also require capital for equipment
related to new locations. For simplicity, the model does not take such
investments into account, nor does the model include an allowance for ongoing
replacement capital expenditures.
Model results were prepared for both the first year and
the fifth year. This is because returns on equity change over time as a result
of anticipated sales and profitability growth and as a result of changes in
corporate capitalization as debt is repaid.
Based on the model assumptions, corporate pretax equity
rate of return in the first year is 85 percent if the location is leased. (See
V-Formula sidebar for computations.)
The model results illustrate that the current pretax
returns from the decision to lease real estate are more than 2.2 times greater
in the first year and rise to nearly 2.7 times greater by the fifth year. The
magnitude of the difference is significant and the company is immediately able
to conserve more than $423,000 in equity in the first year. Moreover, to the
extent the company can apply the equity saved to further growth, an additional
two leased locations can be added.
Over five years, the three combined locations would
provide nearly $1.7 million in pretax equity cash flows over and above the cash
flows that would be realized from the alternate decision to own real estate in
a single location.
What could be done with that extra $1.7 million? Well,
after taxes are paid, another five locations could be opened, which would
generate even more extra cash flow and more opportunities to expand shareholder
While 100 percent financing can create a drag on cash
flows, the drag is less than the added percentage funded because leases have
lower payment constants than any other source of outside capital. Plus, since
leases conserve precious corporate equity, more equity can be applied to
growth, which can reduce corporate risk and add to corporate cash flows through
greater location diversity.
In today’s credit markets, leasing real estate will
almost always be preferable to real estate ownership. The principal determinant
of the relative desirability of leasing versus owning is the percentage of
financing and the loan terms available from debt providers.
The 2010 passage of the Dodd‑Frank Act and the
added lending constraints imposed on banks by the Basel Accords have combined
to make the extension of real estate credit restrictive for the foreseeable
future. In this current light, where debt providers are generally limited to
advancing between 60 percent and 80 percent of project cost, leasing is not
simply a debt substitute, but a debt and equity substitute, because the
landlord provides 100 percent of the real estate capital. As a result, real
estate leasing allows business leaders to avoid the costly options of infusing
added equity capital or constraining corporate growth.
A Wise Investment?
The preceding analysis overlooks the question of whether
corporate real estate ownership is a wise investment for companies to make.
However, the answer is fairly clear: Real estate investing tends to be nowhere
near as lucrative as corporate investing. This is the basic reason why
companies that own their real estate tend to post lower equity returns and
create less shareholder value; strong business rates of return are depressed by
the lower rates of return from real estate investing.
In the previous model example, the five-year average
returns from corporate investing (assuming locations are leased) would actually
be more than seven times those for the landlord who owns the leased locations.
The implication for companies having surplus cash flow is that investing in
real estate will tend to lower returns and erode shareholder wealth. As a
result, the corporate valuations of businesses having surplus cash flows tend
to be better supported by paying out the cash in dividends or by buying in
shares, rather than by directing free cash flows to real estate investments.
One look at a cross-section of public companies laden
with real estate will bear this point out. For closely held LLC or Subchapter S
companies, shareholders may desire to direct their surplus free cash flow into
real estate ownership in lieu of other personal passive investments, which is
fine. Here, the catch to watch out for is trapped equity. On one hand, it is
always smart to undertake long-term real estate debt so as to avoid floating
rate risks and lock in spreads. On the other hand, long-term loans can be
subject to severe prepayment restrictions, as well as restrictions on assignment
or assumability. Such restrictions can, at the least, lower property valuations
and, at the worst, limit the potential to freely sell real estate.
Real estate leasing is just one of many tools that are at
the disposal of corporate leaders to minimize corporate costs of capital. As
demonstrated above, the advantages of this tool include:
• an ability to conserve equity capital that can
be directed into growth;
• an ability to lock into a wealth-creating
capital structure for a long time; and
• a lower payment constant compared to other
external capital alternatives.
Combined, the three advantages of leasing spell a lower
cost of corporate capital. The result is greater shareholder value created
through capital efficiency.
Christopher H. Volk is chief executive officer of STORE Capital, which
specializes in single-tenant sale-leaseback transactions. Contact him at