“Real estate is a big part of your company’s capital structure, and whenever you’re using capital, you’ve got to consider the different sources, costs, uses and returns of that capital,” says Jay Johnson, senior advisor and first vice president of the CB Richard Ellis Strategic Advisory Group.
Smart Business talked to Johnson about the importance of fitting your real estate into your overall corporate financial strategy.
Is real estate part of a company’s bottom line?
Absolutely, but not just in terms of rent, depreciation, principal, interest, or the associated tax consequences. Real estate is also a use of capital that impacts a company’s credit capacity, capital cost, and overall returns.
Is real estate simply a financial issue?
No. Operational needs should be the primary driver of real estate decisions, but once facility type, size, location and timing have been determined, the next decision is strictly financial - how to pay for or finance the cost of the property. Owning and leasing are the two basic structures, but there are a number of variations, and some are more financially efficient than others in terms of their impact to a company’s balance sheet, credit capacity and earnings.
Is it better to own or lease facilities?
The superiority of one structure over another depends on the company’s financial condition, local space availability, and the capital markets. A fundamental consideration is the company’s cost of capital - debt and equity - compared to the return expectations of real estate investors. A company with a capital cost that exceeds real estate market returns would tend to favor leasing over owning since it should be able to achieve a higher return by investing in its core business rather than in real estate. The opposite would tend to be true if the company had a capital cost below real estate market returns. In either case, when companies acquire or use real estate, they should ask themselves where are the dollars coming from, what are they costing, and what are they not funding if they are being spent on facilities?
How does leasing impact the cost of capital?
A lease does not require upfront investment like the purchase or construction of a new facility would. Accounting rules distinguish between “operating” and “capital” leases with only the latter being on balance sheet. Regardless of the accounting characterization, rating agencies and most banks consider the implied capitalization of a company’s lease held assets when evaluating the company’s ability to repay debt, which impacts its credit rating and thus the cost of obtaining new debt as well as the interest rate on existing variable-rate debt.
Are there tax advantages to owning versus leasing?
Facility owners can deduct annual cost depreciation of buildings and related improvements - but not land - from taxable income. Land value, however, is often reflected in the rent for leased facilities and in any debt on owned property. Both rent and interest payments are fully deductible, but rent typically exceeds the interest component of debt serviced and thereby offers a potentially larger deduction.
How do stock and bond investors view corporate real estate?
The general view of Wall Street is that corporations should invest in their core business. Some companies may say that owning corporate facilities allows them to participate in the real estate market and provides some investment diversification. There is some truth to this, but securities investors tend to prefer to individually balance risk within their investment portfolios, which is why conglomerate stocks tend to under perform those of more focused firms. If an investor wants some of the risk and return characteristics of real estate, they can choose to participate in a limited partnership or buy REIT shares.
Do these principles hold for current facilities as well as planned new space?
Yes. Currently owned space can be sold and leased back in order to redeploy capital back into the core business. If a company decides to move toward facilities ownership, it would usually be less costly to wait until current leases expire.
Jay Johnson is senior advisor and first vice president of the CB Richard Ellis Strategic Advisory Group. He can be reached at (404) 504-5936 or firstname.lastname@example.org.