Purchase vs. Lease Analysis for a Commercial Property

Purchase vs. Lease Analysis for a Commercial Property

A client who was moving their manufacturing facility to Tampa Bay was unsure whether to purchase or lease a particular commercial property. We looked at the net present value of the comparative costs which helped clarify their decision. When deciding whether to lease or purchase a commercial property, crunching  the numbers can give another perspective on your decison.

Purchasing requires a down payment, which can be an issue for a company that needs the funds for operating capital. But purchasing also offers tax advantages and the benefit of appreciation.  When all the factors are compared, after certain number of years there is a crossover point where Purchasing often becomes less expensive than Leasing.  Discount Cash Flow Analysis is a useful tool to determine the Net Present Cost of each option. This methodology allows one to consider the future costs of Purchasing and Leasing  and to compare apples to apples.

Some factors such as prices are known, but you must take the time to sit down and write out reasonable assumptions for unknown variables in order to do this analysis. A projection is after all, a best guess.

Consider a free standing building which is being offered for sale at $800,000 or for lease at $$70,000 per year. Should you  purchase it or lease it? A discount cash flow analysis will take the following form.

1. USER ASSUMPTIONS:

Ordinary Income Tax Rate: 30%

Capital Gains Tax Rate:       15%

Cost Recovery Recapture Rate: 25%

After Tax discount Rate: 6%

2. PURCHASE ASSUMPTIONS:

Purchase Price $800,000

Acquisition Costs $5,000

Acquisition Loan Amount $600,000

Interest Rate 7%

Amortization Period 25 years

Loan Term 10  years

Payments Per Year 12

Loan Costs   $6,000

Improvement Allocation 81%

Useful Life of Improvements 39 years

Annual Growth Rate 2%

Projected EOY 10 Sales Price $975,000

Projected EOY 10 Cost of Sale 6%

3. LEASE ASSUMPTIONS:

First year payment $70,000

Escalation 5% after three years, 3% after the next three years

Lease Term 10 years

To compare the cost Purchasing vs Leasing this property, first determine the After Tax Cash Flow for each of the next 10 years for both Purchasing and Leasing scenarios. Then use Discount Cash flow Analysis to determine the Net Present Cost for each option and compare the result.

For the above example, the after tax cash flow analysis looks like this:

End of  Year  ………..         Purchase  ………………….     Lease

0 ………………………………. -$211,000 ………………….. -$49,000

1 ……………………………….. -$33,389 ……………………. -$49,000

2  ……………………………….     etc etc ……………………….. etc etc

10…………………………….  -$35,796 + $386,526 …….. -$52,994

ANALYSIS RESULTS:

ATNP COST: ……………….-$246,794 ………………….-$428,933

IRR Internal Rate or Return:  (Purchasing – Leasing) = 16.84%

The After Tax Net Present Cost of Occupancy (ATNP) to the user who purchases the property is $246,794 vs $428,933 for Leasing the property. The Internal Rate of Return in favor of Purchasing is 16.84%.

After considering the other pros and cons of purchasing vs leasing (see prior blog article) a reasonable user may prefer to purchase this property.

The usefulness of this type of analysis can be expanded to make other financial decisions regarding the property. For example, for the same property above, assume that the user does not need all the space and that can rent out a portion of the space for $1,875 per month. Using the same type of Discount Cash Flow Analysis, this additional $22,500 in annual income reduces the Net Present cost of Occupancy for the purchaser from $246,794 to $127,900. This could be a meaningful factor in the decision.

The purpose of this blog is to share information on questions that I have answered or information I have given to my commercial real estate clients in the Tampa Bay, FL area. I hope that others may find the information useful.

Steven Silverman, CCIM is the broker at Tampa Commercial Real Estate, a commercial real estate brokerage firm based in Tampa, FL. Please contact us if you are looking to purchase, sell or lease commercial property in the Tampa Bay area.

email: Steven@TampaCommercialRealEstate.com.

WebSite: www.TampaCommercialRealestate.com