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 multi-location 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.
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 2Lease Vs. Purchase Model Assumptions
5000 Sq. Ft. DME Example
Purchase Costs
Land and building / $600,000Percent in building / 50.00%
Building depreciation / 39 years
Cost of borrowing / 8.00%
Loan down payment / 20.00%
Mortgage loan term/ / 20 years/$4000
Monthly Payment
Annual property appreciation / 3.00%
Assess value @25%, property
tax @$10.11/C, Annual Property Tax / $15,165
Leasing Costs
Value of property / $600,000Base lease rate (*) / 8.00%
Percentage rent breakover / 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 240
Lease Payment or Purchase Option $4000
Total Payments $960,000
Taxes Saved:
Payment * Fed/State Tax Rates $384,000
After Tax Cost $576,000
Effective After Tax Loan Rate 5.12%
Present Value of After Tax Cost $212,185
Purchasing
Monthly Time Periods 240
Loan Payment $4000
Property Tax $1265
Total Payments $1,263,600
Taxes Saved:
Interest Paid $485,000
Depreciation $312,000
Total Tax Deduction $797,000
Taxes Saved $318,800
After Tax Cost $944,800
Down Payment $120,000
Total $1,064,800
Effective After Tax Loan Rate 5.12%
Present Value of After Tax Cost $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.