Analysis: Consider Discount Rates When Weighing Lease versus Own
Occupiers requiring commercial real estate space for operations face a variety of decisions. Lease? Own? Sale/leaseback? In addition to determining space requirements and location, Colliers’ Director of Financial Analytics Marilynne Clark suggested in a recent article that tenants also examine discount rates when comparing occupancy options.
In general finance, the discount rate is defined as a percentage rate used to measure future cash flow value in terms of today’s dollars. Clark, who is based in Colliers’ Houston office, added that any occupier discount rate analysis should include “the risk associated with the cash flows, the type of company, the company’s industry and the occupier’s cost of capital.”
Though brokers or advisors will present an assumed discount rate as a starting point, Clark said that the occupiers need to delve more deeply into the topic. For instance:
Non-corporate tenants might focus on opportunity costs to evaluate occupancy options. In this case, the tenant would examine alternative uses for funds, and potential returns on those uses (like reinvesting in the business).
Corporate entities might typically use a weighted cost of capital (WACC) to determine a discount rate. WACC calculates a company’s cost of capital by determining the percentage of debt and equity for each capital category. Along these lines, they might use a borrowing rate (for lower-risk cash flows) or cost of equity capital (for higher-risk cash flows). However, WACC “is not a simple calculation, and there are various approaches to calculating it,” Clark wrote.
She used a lease-versus-own analysis as an example. In this case, a borrowing rate could be used for lease payments, and the cost of equity capital used for the asset’s sale. Clark also outlined a sublease situation, in which an occupier’s lease payments are discounted at the cost of debt. Meanwhile, the sublease income would be discounted at the cost of equity capital. “My preferred approach is to be extremely conservative when it comes to disposition or sublease assumptions, so that a higher discount rate isn’t warranted,” Clark added.
Also important in deciding lease versus own is a hold period. “The longer you own a property (and pay no rent) rather than leasing, the more that option becomes compelling,” Clark said. She also pointed out that evaluations should also include analysis of an after-tax basis.
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