Should I Lease or Buy?
The Science of Asset Risk Strategy, Part 1

By Chris Steele, President Real Estate Line of Business, TranSystems

Companies have become increasingly, and sometimes painfully, aware of what it means to have exposure to the real estate markets. Many companies assume that by leasing instead of buying operational real estate — offices, manufacturing plants, and distribution centers — they effectively remove all risk of exposure to the real estate markets. Since they do not own real estate, they believe that they’re not in the real estate business per se.

Companies may argue that they don’t want to own because they may be stuck with a vacant facility at a time when real estate values are depressed. However, they fail to take into consideration the opposite situation — that a lease may come up for renewal at a time of escalated rents.

While there are reasons for leasing instead of purchasing, the lessor is still acutely exposed to the real estate markets and may have less control of when that exposure will take place. The inherent exposure to the real estate markets is reason enough for companies to have a coherent strategy for how they control their real estate holdings — lease, buy, some combination, or another form altogether.

The Individual Asset

Nominally, the decision to lease or buy any one real estate asset should be determined on the following basic criteria:

Strategic Role of the Facility. How critical is the facility to the company’s core business?

Size of the Space Requirement. How large is the space, and how much of the overall company’s operating portfolio does this represent?

Amount of Financial Commitment. How much of a financial commitment does the deal represent? (Note: This should be determined on both an annual all-in and a total lifetime cost basis.)

Method/Form of Control. Will we manage the asset (and the portfolio) ourselves, or will we be outsourcing this function? Do we feel that we can manage more effectively than an outside provider, or is this distinctly outside of our core capability?

Cost and Sources of Capital — both Indicated and Implied. How will we finance both the deal itself and any improvements (real estate and equipment) to the facility? (Note: Even leases carry an implied cost of capital.)

Balance Sheet and P&L Impacts. How will this asset look to our investors? How will it look on our balance sheet, and how will it impact the overall financial performance of the company?

Long-term Need for the Facility. Based upon the broadest range of outcomes, what is the shortest length of time for which we may need this facility? What is the longest?
Flexibility and Timing. From what we know about the markets, what is the outlook for real estate values when we get to the end of our need (or lease) for the facility? Having a lease means that we have a set point at which we re-enter this market. Having an owned asset means that we have some discretion in when we re-enter this market, but we may have to carry a non-performing or underperforming asset for a period of time to wait for more optimal conditions.

Opportunity Cost. On what else might we spend the capital or run-rate expense? Is it better for us to lock in an occupancy cost through asset purchase or to make other investments in our business? Will a near-term cost advantage through lease mean operating difficulties in the future?

The Portfolio

Of course, depending on the individual company’s situation and goals, the best plan probably involves some mix of leasing and asset ownership. The company should develop a strategy for asset control or ownership at the entity level, and then use this as guidance when examining any particular asset. One possible strategy might include ownership of a few essential assets, which the company has determined they need for core control. Another might be leases of varying terms to spread risk of market exposure over time.

For example:

The company at the left has managed to develop a portfolio that can accommodate between 500,000 square feet and 1.2 million square feet, spreading exposure to the real estate markets over a ten-year period. Key facilities (1 and 2) are essential to the business and will be for the foreseeable future. The company has appropriate capital, and it is cheaper than what is available through a developer (in the form of rent), so they have purchased these facilities. Facilities 3, 4, and 5 have a somewhat more uncertain future, and moreover, they may not represent an appropriate return on investment for the company. These have been leased, and the terms are staggered somewhat so that the company is spared the risk of all of its leases coming due at the same time.

This example does not take location and other factors into account, but it serves to display the overall concept.

We have only covered the basics here. Other options, such as total asset outsourcing, sale-leaseback, and joint ventures, exist and serve to provide even finer levels of balance for risk and control.

Setting forth a complete strategy that anticipates change is critical, especially in times like the present. Real estate decisions that made sense, even just a short while ago, have become untenable due to the wild fluctuation in fuel costs. Next month, we’ll take a look at some strategies for integrating real estate and logistics planning more completely.