BY Barry Hardwick, CCIM
Lease or own is a question business owners often ask themselves. The questions go something like this:
It is not unusual for a client to reach out to us, especially towards the end of their lease, to explore their options and get answers to these questions. We recently did this analysis for a medical office client. The client is a young, growing and very successful medical practice. We represented them when they signed their first lease seven years ago. During this time, they have built a thriving medical practice and are poised for growth over the next couple of decades. They have outgrown their existing space (4,100 sq ft). To grow the practice, they need another 1,500 to 2,500 square feet. Their options: expand in their current location and continue to lease, relocate to another medical office building, purchase land and construct a new building, or buy an existing building and renovate it.
First, to do this it takes a team. The team will include the real estate broker, the client’s bank, their CPA, an attorney, and an architect/contractor. It starts with the real estate broker, the banker and CPA: the real estate broker provides a picture of the market, and the banker/CPA determines the debt the practice can afford and the equity that will be required. Other team members are added as we work through the process.
Step 1. Get the data. All the data.
Effective decisions require good and complete information. First, they must know their physical and operational requirements, and location preference. How many treatment rooms do they need? Will there be a procedure room? How many patients will be in the waiting room at any given time? What rooms are needed for staff, administrators, and business employees? How much parking is required? Are there special electrical, imaging or HVAC requirements? What is the geographic location of the patients? Do they want to be close to the hospital and other medical providers, or is the practice better situated in a neighborhood retail location? Once the practice knows its requirements and geographic location, what does the real estate market look like in that neighborhood: is there land and/or a building to purchase? Are there lease options other than their current location? Finally, the practice will need to know what they can afford, how much, and under what terms their bank will loan money for the project.
As identified, there is a lot of work to be done for the practice to make a well-informed decision. If a data point is missing or wrong, it can lead to incorrect assumptions, expensive change of plans halfway through the project, and/or the project ultimately not working. Having the data clearly identifies the objective versus the subjective and it tends to take the process from emotion/frustration-driven decision-making to a clear and logical well thought out process when analyzing the project.
Step 2. Rule out the Unfeasible
For this client, developing a new building was quickly ruled out as a possibility. In the client’s submarket, there is no vacant land. To develop, you must purchase an existing building and tear it down. The land value for an acre is $3-$5M dollars, with additional costs for tearing down the existing structure(s), plus the cost of building a modern 5,000-6,000 square foot medical office building in today’s construction environment, it simply does not make economic sense.
Step 3. Structure an Apples-to-Apples Financial Model
Now that you have the data and ruled out the unfeasible, the remaining options for the client were to 1) look for a building they can buy and renovate, 2) extend their current lease, or 3) look for other lease options in the submarket. The client made the decision that if they continue to lease, they want to stay at their current location on the hospital campus. The decision was to extend and expand their current building or acquire and renovate an existing one. We found a building close to their current location that checks most of the boxes the client identified as being necessary to purchase a property.
Using the analysis tools from CCIM, we created a comparative 10-year analysis for leasing versus owning a property.
What are realistic assumptions if the tenant is going to sign a new 10-year lease at their existing location? We include lease price, operating expenses, improvement cost, what the landlord will contribute to improve the space, and what the tenant will likely have to contribute to improve the space. In addition, we included anticipated tax savings (at the physician’s marginal tax rate) in that rent is a deductible business expense. Although the tenant believes they would like to expand in the future, they decided not to include that expansion in the initial analysis. These expenses were then broken down into before and after-tax costs and entered into an Excel worksheet showing the anticipated cost, tax savings, and cashflow over the 10-year holding period. Below is a table showing the results.
Before Tax After Tax
Total Cost to Lease over the 10-Year Term $1,906,985 $127,2530
Average Annual Cost over the 10-Year Term $190,698 $127,523
Average Annual Cost PSF over the 10-Year Term $46.58 psf $31.08 psf
With the lease analysis completed, we pulled together assumptions for the building they identified to purchase. This included anticipated purchase price, closing cost, financing cost, renovation cost, moving cost, as well as the ongoing operating and maintenance cost of occupying the building over the 10-year term. Their lender provided loan information about the equity required, loan terms, interest rates, amortization period and debt coverage ratios. The CPA provided estimates for depreciation and cost recovery, and a contractor was able to give us general estimates for renovation cost. The last piece of information required for a ten-year “own” analysis is to project the asset’s value 10 years from now. For our analysis, we chose to grow the asset’s value at 3% per year. Said another way, we projected the building to sell at 30% more than the anticipated purchase price. With all the above information, we were able to provide a true cost of occupancy, before and after-tax, over the 10-year hold period. The results are on the table below.
Before Tax After Tax
Total Cost to Own over the 10-Year Term (note 1) $2,719,040 $1,543,010
Average Annual Cost over the 10-Year Term $271,904 $153,301
Average Annual Cost PSF over the 10-Year Term $41.83 psf $23.74 psf
Note that the table above does not include the initial equity and sale of the asset at the end of the term. The difference between the before and after-tax cost is the favorable tax treatment of ownership which includes the deductibility of interest, depreciation and cost recovery. When you factor in the initial equity ($412,473) and the gain from the sale of the property ($968,311), the cost are as follows:
Before Tax After Tax
Total Cost to Own over the 10-Year Term $3,131,513 $987,172
Average Annual Cost over the 10-Year Term $313,151 $98,717
Average Annual Cost PSF over the 10-Year Term $48.17 psf $15.19 psf
Step 4. Review and Assess
Each property, each lease, each acquisition has its own unique characteristics that can make or break the deal. There are advantages and disadvantages to both leasing and owning.
Some of the advantages of leasing are:
Some of the disadvantages of leasing include:
Some of the advantages to owning include:
Some of the disadvantages of ownership include:
The analysis for our client showed that buying the property has a significant discount to leasing over 10 years, but there are other significant considerations to be considered. First, the practice will have to write a check up front for $400,000 plus dollars as their initial equity payment. The true cash flow out of their pocket, annually before tax savings are applied, is going to be about $80,000 more per year with ownership versus leasing. However, this number will be significantly reduced each year with the tax savings when filing their annual income tax return. Renovation costs and overseeing the construction will have to be managed. Relocation to the new building will have to be planned and managed. While the new building meets a lot of their criteria, moving off the hospital campus is a big consideration, not the least of which is unlimited parking at the hospital. The overall economy and interest rates are a concern, though the clients believe strongly in their practice’s relevance and resilience, and in the Nashville market overall.
There are significant upsides of buying this particular property as well. The size of the space accommodates their current and future growth needs which would correlate with increased revenue. If they stay in their current space there is no guarantee they will be able to expand. When they do expand, it is likely they will have to relocate to another floor in the building. With the purchase they will have an asset in 10 years with a value of approximately a million dollars. Another favorable factor is the space they are looking at is a condominium unit in a 3-story office building that a medical group previously occupied. As such, it only needs cosmetic work, not the $150-200 psf that goes into building new medical space. They will also be able to stay in the current submarket close to their patient base.
As the client considers next steps, they now can make a rational financial decision as to what is best for their practice. My third-grade teacher said everything in the world comes down to math. I have seen that play out professionally my entire career. When we, as brokers, provide good information to our clients, in an understandable format, they can make good decisions regarding their business. Rod Santomassimo says “it is our job as brokers to take the complex and make it simple.” The lease versus own analysis does that.
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