Lease -vs- Buy

I promised to write a post dealing with a question that comes up from time-to-time in corporate real estate practice – whether to lease or buy property.  Over the years I’ve heard many different “theories”, most of which are simply opinions that do not benefit from the support of either a rational methodology or a sufficient number of pertinent facts.  Which is how a lot of bad real estate decisions tend to get made.

There are two types of factors that a business needs to consider in a lease-versus-buy decision.  The first are quantitative criteria – chief among them metrics that relate to the company’s internal rate of return from core operations.  The second are qualitative criteria – things like the importance of highway visibility or the weight that should be given to LEED ratings.

Once identified and calculated, these metrics can be plotted into a decision matrix that will inform your decision:

In many instances, the answer will likely be to lease.  The core return that most businesses realize will generally exceed the return that can be generated through the ownership of real property.  In some instances, however, the returns from property ownership – when coupled with other strategic business criteria – will indicate that ownership is the most favorable choice.

All of this said, there are a number of common mistakes made when making a lease-or-buy real estate decision.  One is to significantly overestimate the rate of appreciation or end value of the property.  As we’ve seen most recently, property values do not always move upward.  Another is to underestimate the need for ongoing capital contributions over the period of ownership – and, as importantly, to make budgetary provisions for capital reserves to cover the replacement of roofs, mechanical systems, parking lots, and other property components.

The important thing to realize is that there are many factors – and many implications – to consider.  Shifting capital from high yield core operations to low yield – and illiquid – real estate can markedly impact earnings and retard growth.  Other parameters – like the efficiency of the local real estate market and the availability of tax and financing incentives – might create a strong argument for ownership.

It’s essential to carefully consider all of the factors in a rational and objective context.

Buy Low

In a survey of over 1,500 global business leaders reported last month, McKinsey & Company found that their top strategic priority (selected by 45% of the respondents) was to cut operational costs.  This is not a harbinger of impending growth and prosperity for commercial property developers and investors.  Cutting costs is more likely to involve reducing a company’s property footprint than increasing it.

It also suggests the kinds of strategic and tactical issues logistics and supply chain professionals are apt to face in the months ahead.  Cut operational costs.  Do more with less.  Increase throughput.  Reduce cycle times.  Get more done faster, with fewer errors, for less money.

Is there a pony in there?  I’d like to think so.  There may actually be a happy confluence of events for many supply chain managers today:

-    Property owners need to stabilize their portfolios today.  With debts maturing over they next few years – and with unfavorable loan-to-value ratios and other fundamentals - they are willing trade lease extensions for lower rents and concessions like free rent (typically, you can roll back your base rent and obtain 3 to 5 months of free rent on a 5 year term).

- For the same reasons, property owners are also interested in trading leases for cash.  If you now rent a building and have the means to purchase it, your landlord may be happy to convert your lease in to an agreement of purchase and sale.

- Commercial banks will make mortgage loans to owner/occupants, but not to investors.  If your business has a healthy balance sheet you can take advantage of the current lending environment to buy property you are now renting.

So, if you are facing pressures to cut costs, you may be able to use the current conditions in the commercial real estate market to your advantage.

Improving Your Balance

Real estate-related costs represent one of the top three or four expenses on the income statements of over 80% of US businesses.  When times get tough, they are an easy target - a low hanging fruit just begging to be picked.  However, the picking is often done in a ham-handed way - typically through staff reductions, outsourcing, or counterproductive edicts that, at the end of the day, only trigger the Law of Unintended Consequences.

There are two common mistakes that organizations make when trying to improve the efficiency of their real estate operations - both having to do with the degree to which planning and decision making are centralized and controlled.  Over-centralization results in a stultifying "command and control" environment.  Under-centralization results in organizational and financial chaos.

A few years ago a consumer products company had developed a new product they were sure would quickly become a category killer.  They hired a national sales manager to manage the roll-out - and gave him carte blanche authority over the process.  Rather than approaching the roll-out in an incremental way, he floored the pedal and opted for a ballistic launch.  The net result was the procurement of bunch of leased sales offices in most major cities in North America.  Eighteen months later (after the product had fizzled), there were a whole bunch of sales offices that needed to be sublet for the balance of their terms.

(The rule of thumb for subletting is that it will cost you 50% of the obligation remaining on the lease - keep that in mind the next time you become irrationally exuberant over the portents for a new facility that is scaled to accommodate a lot of projected growth.)

The flip side was a company that imposed rigid guidelines on its field managers - essentially neutering them in all things having to do with real estate and forcing almost every decision to be controlled by a central bureaucracy of facility apparatchiks.  The manager of a significant manufacturing line had back orders in a holding pattern that reached past the moon.

But getting the kind of facility relief he needed was an exercise akin to moving a mountain with a teaspoon.  His authority was constrained by an arbitrary dollar amount (the corporate wonks only got involved if this threshold was exceeded) - and the solution he needed was a multiple of that amount.  Being somewhat of a "don't ask for permission - beg for forgiveness" kinda guy, he found a facility that would accommodate his operational needs and then structured a transaction that broke the acquisition into components that each fell within his budgetary limits.  Fortunately, things worked out. His quarterly numbers soared and a few years later he was appointed CEO of the whole organization.

There's also a middle path to enlightenment.  A large global distributor of industrial products wanted to improve the way real estate decisions were taken without upsetting their very effective entrepreneurial culture.  Their legal and accounting department needed more input and oversight (for, among other things compliance purposes) - but they wanted to keep their local and regional managers actively engaged and invested in all real estate decisions.

The solution was to develop a comprehensive database containing all pertinent facility information - a process informed by realistic metrics and regulated by transparency, so that all of the stakeholders had all of the pertinent facts - and the tools required to support the process.  The net result was more order, greater efficiency, significant reductions in opex, and happier managers and shareholders.   

Picking Through the Wreckage

With a few notable exceptions (like Noriel Roubini, “Dr. Doom”), most economic forecasters seemed surprised when the collapsing housing market overwhelmed financial institutions and sent the global economy into recession in 2008.

This is surprising.

The housing market has historically followed a cyclical pattern that can be readily discerned and, within reasonable limitations, anticipated.  And its significance as a major driver of the economy has been well understood for decades.

The commercial real estate market also follows a foreseeable pattern – one which tends to lag months behind the direction of the overall economy.  As a consequence of this interval, the commercial real estate market hasn’t yet reset itself and, in some fundamentals ways, is still sorting itself out.

Peter Linneman (of the University of Pennsylvania’s Wharton School), one of the real estate industry’s true luminaries, recently gave an insightful interview (the transcript of which you can find here) that frames a cautionary guide for the road ahead.

The most significant uncertainty in the commercial real estate market’s future is the huge number of commercial mortgages that will roll over in the next few years.  The Real Estate Roundtable, a policy advocacy group representing a variety of interest in the real estate industry, estimates that, by 2012, $1.8 trillion of commercial mortgages will come due for refinancing.

But refinancing is, in many cases, going to be a difficult proposition.  Real Capital Analytics estimates that $1.3 trillion of equity – represented primarily by properties purchased at the apex of the last market cycle – has already been wiped out.  In other words, the table is set for another market adjustment that could have profound repercussions for the economy.

What does this mean for you?

First, it is essential to conduct some extra due diligence on properties that you now lease or are considering.  Specifically, you need to know if the property – and its owner – are financially viable.  Properties that get into trouble with lenders often suffer from reductions in service, maintenance, and management.

Second, if you are now leasing – or considering leasing – do a thorough lease versus own analysis.  Although it rarely makes a lot of sense for a business to own its facilities (more about this in a future post), the benefits of buying near the bottom of a cycle may be compelling.  Just be careful.  Projections based on irrational exuberance are apt to be grist for problems down the road.  If you buy, have a plan to sell that is keyed to clear metrics and milestones.

Third, think outside the docks.  There’s a lot of stimulus money – an expanded array of incentives – that will not likely be around forever.  You may be able to use the trough in property values as a way of addressing emerging issues – like cap and trade.  A number of states have developed aggressive alternative energy programs that can make facilities carbon neutral – or even carbon negative.  Buy low.  Use the programs to fund green improvements.  Reap the rewards immediately (lower operating costs) and down the road (higher value).