SPRING 1995 PUBLICATION 1064INSTRUCTOR’S NOTEBOOK

A Reprint from Tierra Grande, the Real Estate Center Journal

T he decision to buy or lease the spaceneeded for conducting the firm’s businessactivities is important. Although spacecosts are significant business expenses, the

buy or lease decision is more than a financialdecision. This “Instructor’s Notebook” focuses on theanalytical framework for making this decision.

Although there are many variations, the buy orlease decision typically arises in the following cir-cumstances:

1. A business requires new or additional space. Itsneeds can be satisfied by leasing space or by con-structing or buying a single-tenant or a multi-tenantbuilding.

2. A business is currently leasing satisfactoryspace in a single-tenant or a multi-tenant buildingand has the opportunity to purchase the building.

The decision is a three-part process: the marketanalysis, the financial analysis and otherconsiderations.

Market AnalysisReal estate market research considers those factors

that affect the supply and demand for a particulartype of space within the specific market area.Conducting this research is a vital step in decidingto buy or to lease because the property must be agood real estate investment if it is purchased.Market information is crucial to negotiating acompetitive lease if the property is not purchased.

If rental rates are expected to rise (or fall) duringthe analysis period, property values should rise (orfall) as well. When it is concluded that rental rates

and property values will increase, buying the prop-erty is supported and vice versa. Because theseconclusions are so important for the financial analy-sis, the data used to reach them must be carefullydeveloped through market analysis.

For a basic outline of the real estate marketresearch process, see “Investment by Design” in theReal Estate Center Journal, October 1988.

Financial AnalysisIn making the buy or lease decision, the financial

analysis is used to identify the financial advantageof one alternative over the other. The principalfocus of the analysis is to choose the alternativethat will provide the needed space at the least netcost. To determine this, the present value of theafter-tax cost and benefits of owning the property iscompared with the after-tax cost of leasing thespace. All other things being equal, the course ofaction with the least net cost is chosen. Becauselease payments, operating expenses, depreciation andinterest are deductible expenses, the analysis isusually made on an after-tax basis.

When the choice is between buying or construct-ing a multi-tenant building and leasing space, theconsequences of becoming a landlord are added tothe analysis. By investing sufficient equity to pur-chase or construct a multi-tenant building, theowner acquires the present value of the after-taxincome stream from the building’s other tenants andthe present value of the building’s after-tax cashflow from resale and avoids the present value of theafter-tax cost of leasing space.

Instructor's Notebook presents a lecture on a basic real estate subject. Written by an expert, Instructor'sNotebook takes readers into the classroom to hear the professor's talk. This regular feature is designedas an introductory lecture on a different topic each issue.

By Wayne E. Etter and Fred F. Caldwell

Buy or Lease? CommercialProperty Decisions

The firm’s required rate of return (or its cost ofcapital) is used as the discount rate to calculate thepresent value of the cost to lease and the cost toown. Because different firms have different requiredrates of return (or costs of capital), they might usethe same assumptions about the costs and benefitsof buying or leasing but reach different conclusionsabout the best course of action.

The basic elements of a buy or lease analysis areillustrated in the table. Assume the owner of anunincorporated business with a 31 percent marginaltax rate can either purchase a building or lease itfor five years. If it is purchased for $100,000 plus$3,000 closing costs, the initial cash investment willbe $28,000. The balance can be financed with a$75,000, 9.5 percent, 20-year mortgage. Thebuilding’s depreciable value is $83,000. The firstyear’s operating expenses of $3,500 are estimated toincrease 3 percent annually. Because annual operat-ing expenses, depreciation and interest are tax-deductible, the actual annual cash outflow associatedwith purchasing the building is the sum of theoperating expenses and the mortgage payment lessthe tax shield provided by the deductible expenses.To make an appropriate comparison with a five-yearlease, it is necessary to assume the property will besold at the end of the fifth year and to estimatethe after-tax cash flow from resale. The property’sestimated resale price at the end of the fifth year is$116,000; the estimated after-tax cash flow fromresale is $33,454.

If the building is leased for five years, the firstyear’s lease payment will be $10,000. Thefollowing year’s lease payments are scheduled toincrease 3 percent annually. Annual lease

payments will be due in advance. The tenant willpay all operating expenses; annual operating ex-penses are estimated to be the same as if thebuilding is purchased. Because the lease paymentsand the operating expenses are tax deductible, theafter-tax cost of leasing is the sum of the leasepayment and operating expenses less the tax shieldprovided by the deductible expenses.

Using a cost of capital of 10 percent, estimatingthe after-tax cost of buying the property and leasingthe property is illustrated in the table. These calcu-lations indicate a financial advantage for buying theproperty; however, this advantage is dependent uponthe assumptions made about the resale of theproperty at the end of the fifth year. Without theresale benefits, the total cost of leasing the propertyis less than buying the property. Therefore, theassumption of a 3 percent annual increase in theproperty’s value is critical. This indicates the depen-dence of the financial analysis on the market analysis.

The use of a resale assumption does not implythat the property must be sold; rather, it is used toestimate the net equity in the property so thatbuying can be compared with leasing over the lifeof the lease.Other Considerations

Because most leasing literature concerns leasingbusiness equipment, such as a truck, the buy orlease decision usually is treated purely as a financial

decision. Whether leased or purchased, there is nodifference in the truck’s ability to do the job. Thus,the decision of whether to buy or lease a truck isabout determining the most financially advantageousway to gain the use of the truck for the analysisperiod.

T he decision of whether to buy or lease realestate is much more than a financialdecision, although the financial analysis isimportant. The following points must be

considered:1. Business enterprises need space to conduct

their business activities, but in most cases, realestate is not their principal business. If the firmleases needed space, it can adjust the amount ofleased space as market requirements change. If thefirm owns real estate, adapting quickly to changesin the market may be more difficult because of thetime required to plan and construct a property or tobuy a property when more space is needed or tosell the property when less space is needed. Aretailer, for example, may prefer to lease space sothat store locations can be changed in response tomarket shifts.

On the other hand, an owner may enjoy greaterflexibility in using the property than a tenant. Asspace needs change, an owner can make choicesthat support these needs.

2. If a multi-tenant building is constructed orpurchased, the business also becomes a landlord.Aside from the other consequences of owning realestate, how will being a landlord fit in with otherbusiness activities?

3. An existing building can be inspected todetermine its quality and its suitability for thebusiness enterprise before it is leased or purchased.In certain markets, an existing building’s marketvalue may be less than its replacement cost; if thespace is suitable for the business, it can be obtainedat an attractive price. How does buying an existingproperty differ from constructing the property? Anewly constructed property should have no func-tional (or other) obsolescence and should be designedespecially for the user’s needs; however, whencompleted the new building may be unsatisfactoryand may have cost more than planned or both.

4. Balance sheet issues may be important to acompany making the buy or lease decision. Forexample, future borrowing restrictions resulting fromreal estate debt may be a concern; if so, leasing tokeep real estate off the balance sheet may be anattractive option.

The buy or lease decision melds the market andfinancial analyses with other business considerations.This might result in a decision to lease eventhough purchasing the property appears to be finan-cially advantageous. The possibility of such anoutcome emphasizes the difference between purchas-ing real estate and other business assets.

Dr. Etter is a professor with the Real Estate Center andof finance at Texas A&M University. Caldwell is presidentof CNI Commercial Real Estate and Patrick ThomasProperties. He holds a Texas real estate broker’s license.

Buy or Lease AnalysisA. Buy

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Equity investment $28,000

Operating expense $ 3,500 $ 3,605 $ 3,713 $ 3,825 $ 3,939Depreciation 2,043 2,128 2,128 2,128 2,128Interest 7,125 6,993 6,849 6,691 6,519 Total expense $12,668 $12,726 $12,690 $12,644 $12,586 Tax rate 0.31 0.31 0.31 0.31 0.31 Tax shield $ 3,927 $ 3,945 $ 3,934 $ 3,920 $ 3,902

Operating expense 3,500 3,605 3,713 3,825 3,939Interest 7,125 6,993 6,849 6,691 6,519Principal 1,386 1,518 1,662 1,820 1,992Tax shield (3,927) (3,945) (3,934) (3,920) (3,902)

Annual after-tax cost of buying $8,084 $8,171 $8,290 $8,416 $8,548

After-tax cash flow resale $33,454

B. LeaseYear 0 Year 1 Year 2 Year 3 Year 4 Year 5

Lease payment $10,000 $10,300 $10,609 $10,927 $11,255Operating expense 3,500 3,605 3,713 3,825 $3,939 Total expense $10,000 $13,800 $14,214 $14,640 $15,080 $3,939 Tax rate 0.31 0.31 0.31 0.31 0.31 0.31 Tax shield $ 3,100 $ 4,278 $ 4,406 $ 4,538 $ 4,675 $1,221

Lease payment 10,000 10,300 10,609 10,927 11,255Operating expense 3,500 3,605 3,713 3,825 3,939Less tax shield (3,100) (4,278) (4,406) (4,538) (4,675) (1,221)

Annual after-tax cost of leasing $6,900 $9,522 $9,808 $10,102 $10,405 $2,718

C. Summary of the AnalysisBuying Leasing

Initial outlay $28,000 $ -0-

Present value of annual cost 31,387 40,046

Total cost $59,387 $40,046

Present value of after-tax cash flow from resale (20,772) -0-

Net cost $38,614 $40,046

©1995, Real Estate Center. All rights reserved.Director, Dr. R. Malcolm Richards; Associate Director, Gary Maler; Chief Economist, Dr. Ted C. Jones; SeniorEditor, David S. Jones; Associate Editor, Dr. Shirley E. Bovey; Assistant Editor, Kammy Senter; Art Director,Robert P. Beals II; Circulation Manager, Gary Earle; Production Assistant, Emma Kubin; Typography, Real EstateCenter; Lithography, Williamson Printing Corporation, Dallas.Advisory Committee: Don Ellis, Del Rio, chairman; Conrad Bering, Jr., Houston, vice chairman; Michael M.Beal, College Station; Patsy Bohannan, The Woodlands; Dr. Donald S. Longworth, Lubbock; Andrea Lopes Moore,Houston; John P. Schneider, Jr., Austin; Richard S. Seline, Alexandria, VA; Jack Tumlinson, Cameron; and PeteCantu, San Antonio, ex-officio representing the Texas Real Estate Commission.Tierra Grande (ISSN 1070-0234), formerly Real Estate Center Journal, is published quarterly by the Real EstateCenter at Texas A&M University, College Station, Texas 77843-2115.Subscriptions are free to real estate brokers who provide their name, address, telephone and license numbers toDepartment JS at the address given. Other subscribers, $25 per year. Views expressed are those of the authorsand do not imply endorsement by the Real Estate Center, the College of Business Administration and GraduateSchool of Business, or Texas A&M University.