All commercial real estate occupiers should carefully consider the discount rate which is utilized in comparing their occupancy options, particularly when comparing leasing to owning, or negotiating a sale/leaseback and weighing that against continuing to own. Your commercial real estate advisor/broker will likely begin with some kind of assumed discount rate to provide some numbers for your review, but the appropriate discount rate should ultimately be determined by the decision maker and his or her finance department.
When choosing a discount rate for occupier analysis, one should consider the risk associated with the cash flows, the type of company, the company’s industry and the occupier’s cost of capital. Corporate and non-corporate (individuals, partnerships, or sole proprietorships) have different considerations in selecting a discount rate.
Non-corporate occupiers typically use their opportunity cost to evaluate their occupancy options. A non-corporate user considers the alternative uses for the funds and the returns on those alternative uses. An obvious alternative is to invest it in their business.
Corporate entities typically use their weighted average cost of capital (WACC), which can also be called the “hurdle” or “threshold” rate, or they may choose to use their borrowing rate (for lower risk cash flows) and their cost of equity capital (for higher risk cash flows).
The weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital, in which each category of capital is proportionately weighted by the percentage of debt and percentage of equity. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation. Unfortunately, it is not a simple calculation, and there are various approaches to calculating it. For example, one could use the “historic” approach, which uses the existing debt-to-equity ratio and existing after-tax cost of capital, or one could use the “marginal” approach, which uses the existing debt-to-equity ratio and the projected after-tax cost of new capital. This underscores that a company’s WACC is not static, so it can change over time. Nevertheless, using the company’s WACC as a guideline is what I see most commonly used by corporate occupiers.
The alternative approach, using their borrowing rate (for lower risk cash flows) and their cost of capital (for higher risk cash flows), is, in my experience, used less frequently. For example, in a lease vs own analysis, the borrowing rate may be used for lease payments, while the cost of equity capital is used for the assumed disposition of the asset. Or, in a sublease analysis, the occupier’s lease payments are discounted at the cost of debt while the sublease income is discounted at the cost of equity capital (sublease income has more risk, so it is discounted at a higher rate). 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.
As you can see, selecting the appropriate discount rate is not simple and should be carefully considered by the occupier’s decision maker or financial team. The selection of the appropriate discount rate is typically not critical when comparing lease options. As the rate gets higher, the differences between one option and another get further apart, but the ranking of the costs don’t typically change. Here is a typical graph of the present value costs of lease options with a range of discount rates.
However, when evaluating lease vs own or a sale/leaseback vs continue to own, the selection of a discount rate is more critical, as which option costs less can change with the discount rate used. To illustrate this, let’s consider the following after-tax analysis example and graph of a range of discount rates.
An occupier is considering buying or leasing a 20,000 square foot building. For the lease, the net rents would be $25.00/SF, increasing 3% per year. Building operating expenses are $10.00/SF. Buildout of the space would cost $50.00/SF, but the landlord would provide a Tenant Improvement Allowance of $30.00/SF and would amortize an additional $10.00/SF over the term of the lease at 8% interest.
If the occupier buys the building, they could purchase it for $10 million, spend $50.00/SF for retrofit (an additional $1 million cost), put $0.10/SF in a reserve for structural repairs each year, and finance the building at 80% of cost at 5.50% on a 20-year amortization. We are assuming the building’s value appreciates, and they are able to sell the building in 10 years for 120% of their original investment (including the retrofit), or $13.22 million.
In this scenario, the occupier breaks even between owning and leasing at a discount rate of 7.87%. If the appropriate discount rate is above 7.87%, it is cheaper to lease than to own. If the discount rate is below 7.87%, it is cheaper to own the building than to lease it. The reason the slope of the two curves is different is that a higher discount rate has a bigger impact on the $13.2 million income from the disposition in 10 years.
In addition to the discount rate, the selection of a hold period is critical to lease vs own analysis. The longer you own a property (and pay no rent), rather than leasing, the more that option becomes compelling. This is the reason that you want to “duration-match”. In other words, if feasible, you should own the building which is occupied by your stable, long-term business groups and lease the space which is occupied by contract services or those business groups that may expand or contract quickly. Own vs lease evaluations should also be considered on an after-tax basis, as the tax impact can impact which option is cheaper.
The above example illustrates why the selection of a discount rate in occupier analysis should be carefully considered and not selected randomly. While the impact on lease comparisons is not significant, the impact on lease vs own or sale/leaseback vs continue to own is significant, potentially changing the outcome of which option is better from a financial perspective.
