The Lease Versus Own Decision for DME Companies Complied by Mark Higley, VGM Director of Development How a DME company should be capitalized is a function of many factors, among them, profitability, plans for future growth, and the assets required to operate a business. For companies that operate multiple locations (or contemplate expansion in the near future), capital needs can be especially acute. As a DME business owner, you will need a method of comparing leasing and financing options. To come to a decision, you should have a good 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. Remember, real estate is not the basis of wealth; your company cash flow is. Should you own real estate, consider it a capital asset used by your DME business so that it can produce cash flow. A simple example (see Table 1, below) illustrates this point. A multilocation DME company decides to build two new 5000 square foot properties for $600,000 each. After a year of operation, one location achieves revenues of $750,000 and the other site achieves revenues of $1 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. Table 1 Real Estate Value Vs. Business Value 5000 Sq. Ft. DME Example Property 1 Property 2 Land and building cost (1) $600,000 $600,000 DME revenues $750,000 $1,000,000 Pre-tax cash flow (2) $36,000 $140,000 Income tax (14,400.00) (56,000.00) Net $21,600 $84,000 Business valuation (3) $151,200 $588,000 Original investment (4) $100,000 $100,000 Gain on investment (%) 51.20% 488.00% Gain on real estate Norminal Norminal (1) Assume square foot land cost @ $7, building @ $93 (2) After occupancy and overhead (3) Using a multiple of 7 (4) Investment in working capital 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 33% higher revenues in one location produce about a 275% increase in pre-tax profits. Since businesses are bought and sold based on cash flow, the value of the higher-volume DME location is potentially 4 times the value of the lower-volume location. In both cases, the value created by the cash flow far exceeds the likely appreciation of the real estate. To Lease or Own. Although the value of a DME business has little effect 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, in some cases, sale-leaseback financing. (Note: This is more common in LTC facilities and some home health agencies). This last option - which is somewhat analogous to an interest-only loan with no requirement to ever repay the principal - is not available for capital 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 only on 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 may exclude further investment in your DME business, such as showroom or warehouse 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 a Model Because real estate and business values are distinct from one another, lease versus purchase models utilize one or more factors for comparison. Perhaps the most common (and easiest) factor determines the extent of any opportunity cost brought about by owning investment property. Another compares the effective after-tax interest rate of leasing versus owning. A third can create a single number that incorporates the two previously calculated factors. Computation of the effective after-tax interest rate is somewhat complex. The methodology is included within this report for reference, but readers are urged to utilize professional services to ensure accurate analysis. Generally, the “rate” factor is less significant that the “opportunity cost” factor. A full example of estimating opportunity costs follows. Let us assume an owner desires a new DME location, and expects initial annual revenue of $750,000. Table 2 lists the starting assumptions for this model. Table 2 Lease Vs. Purchase Model Assumptions 5000 Sq. Ft. DME Example Purchase Costs Land and building $600,000 Percent in building 50.00% Building depreciation 39 years Cost of borrowing 8.00% Loan down payment 20.00% Mortgage loan term/ Monthly Payment Annual property appreciation Assess value @25%, property tax @$10.11/C, Annual Property Tax 20 years/$4000 3.00% $15,165 Leasing Costs Value of property Base lease rate (*) Percentage rent breakover $600,000 8.00% 8.00% (*) Equivalent to an initial $48,000 annual lease payment, or $4000 monthly. Equivalent cost per square foot = $9.60. Beginning sales $750,000 Sales growth rate 3.00% Marginal income tax rate 40.00% Business valuation multiple 7 Pre-tax ROI hurdle rate 40 The Opportunity Cost Analysis 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 DME operation opens a new branch, as in the example shown in Table 1. If the investment in working capital is $100,000, and the property produces a $36,000 pre-tax profit (from gross revenues of $750,000), then a 36% pre-tax return is realized. If the property achieves a revenue level of $1 million, the pre-tax return grows to 140%! Of course, these types of returns presume that the DME owner elects to lease the property and finance virtually all of the furniture, fixtures, and equipment. Many companies prefer to have some investment in the 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. This 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 2, presume that the pre-tax "hurdle rate" for new investments in the business is 40%. If the cash flow saved through property leasing ($1265 per month, or about $15,000 annually) 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 about $1 million by year 20. Assuming a valuation multiple of seven times cash flow, the business would have an additional value of $7 million at the end of year 20 as a result of the decision not to own the real estate. Table 3 Lease vs. Purchase Model Assumptions 5000 Sq. Ft. DME Example Leasing: Monthly Time Periods Lease Payment or Purchase Option Total Payments Taxes Saved: Payment * Fed/State Tax Rates After Tax Cost Effective After Tax Loan Rate Present Value of After Tax Cost 240 $4000 $960,000 $384,000 $576,000 5.12% $212,185 Purchasing Monthly Time Periods Loan Payment Property Tax Total Payments Taxes Saved: Interest Paid Depreciation Total Tax Deduction Taxes Saved After Tax Cost Down Payment Total Effective After Tax Loan Rate Present Value of After Tax Cost 240 $4000 $1265 $1,263,600 $485,000 $312,000 $797,000 $318,800 $944,800 $120,000 $1,064,800 5.12% $392,248 The next step is to use net present value analysis. The added terminal business value from the investment of the cash flow savings through leases is discounted at the 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. Prior to taking into account any after-tax interest rate differential (see next section), this demonstrates that the decision to lease currently has a net present value $180,083 over the decision to own. Coupled with the large cash-flow reinvestment factor (approximating $7 million in increased business valuation), leasing likely represents the best means of property financing. 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. The Comparative Interest Rate Analysis 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. (Again, due to complexity, a detailed example of this analysis is not included within this report.) 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; it 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 September 19, 2001, was 6.00%, roughly 3.5% above the 30-day Treasury bill rate. A 20-year lease with a base rent of 8.5% 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. The example model includes an 8% borrowing and 8% base lease rate. (Note: The use of the term “base lease rate” may be relatively uncommon to potential lessees in the commercial real estate market. Rather, the interested party would likely examine the cost of the lease in a “cost per square foot” basis and compare this cost to other properties. While it is acknowledged the negotiation process of the amount of the cost per square foot lease payment generally is dependent upon “the market” for similar properties, for analysis purposes the base lease rate can and should be determined. In this example, presume the land and the 5000 square foot building has an equal $600,000 value. 8% of this estimated value equals $48,000, or a presumed monthly payment of $4000 and an equivalent cost per square foot of $9.60.) Appreciation vs. Escalation - 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. Real Estate Ownership. To determine the effective after-tax cash flows for a commercial real estate mortgage, you will need to 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. The example model uses a 20-year amortization schedule. Depreciation Schedule - Depreciation time frames for real estate have become progressively longer. 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 example 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 example model uses a tax rate of 40%, which includes federal, state, and local income taxes. (Note: The current nominal federal tax rate for corporations is 35%. Several states, such as Texas, have no state corporate income tax.) 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 - Many models use a sales participation escalation feature, computed to be the amount at which 8% of sales exceeds the base rent. Such a "natural breakover" is reasonable within medical equipment sales. 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 Without detail of the computations, the rate comparison for the model indicated that the lease has a higher after-tax interest rate than the mortgage (6.4% versus 5.12%). However, a few modifications of the input assumptions would change the rate comparison. Such changes are detailed below. Appreciation-The model presumed a 3% appreciation annually on both the land and the building. If the appreciation were only on the land (50% of the investment), appreciation could 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 sales level of $750 thousand, 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 $750,000, the base lease rate is fixed for the lease term. The landlord has therefore assumed the risks of low sales levels. Length of Lease-If reviewed over a 10-year period, 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. Deriving a Single Index A complete lease versus purchase analysis determines a single number that incorporates both the after-tax interest rate differential as well as the opportunity cost of property ownership. As indicated in the previous section, this is effected through net present value analysis. In the example model the effective after-tax loan rate is 5.12%. By calculating a net present value of the lease streams at the same after-tax rate, a net loan advantage was computed at about $29,000. As previously shown, the net present value of the “opportunity cost” was approximately $180,000. Adding the two costs together demonstrates that the decision to lease has a net present value of about $151,000 (and, additional business valuation of up to $7 million in year 20) over the decision to own and thus 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: Real estate leases tend to lower fixed costs because there is no required down payment or amortization of loan principal. Lowering fixed costs reduces overall business risks. Leasing properties passes on the risks of value losses to a third party. If the lease also happens to include a purchase option, a sale/leaseback tenant has essentially cashed out at an accepted sales price and has a call option to repurchase the property at a future date. The risks of devaluation in the interim have been avoided. A tenant purchase option may effectively enable the tenant to reprice the cost of occupancy. 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 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 the business owners.