ALL-CASH ALTERNATIVE

If the corporation elects the all-cash alternative, it will be using up funds it could otherwise invest in its primary business. Consequently, if the company can earn 15% to 25% on the money (i.e., its investment opportunity rate), and decides to purchase a $10 million warehouse facility for all cash, the annual cost to the company of the warehouse is $1,500,000 (15% of $10 million).

Unlike most real estate calculations, there are, in this case, two absolutes. First, as long as the company's cost of borrowing is less than its investment opportunity rate, it should never invest all of its cash in real estate.

Second, if the company can get a higher rate of return by investing its cash in the real estate, then it should reevaluate its current business returns, make a greater investment in real estate or reassess its management decisions.

If a company has the liquidity and the desire to fund the cost of its real estate with its own cash, the company's tax benefits are limited to depreciation of the building, and improvements.

Since $7 million is the cost of the depreciable assets (i.e., the building and other improvements), the amount of the annual depreciation will be $179,487 ($7 million divided by thirty-nine years). At the company's tax rate of 40%, the value of the annual depreciation deduction is $71,795 ($179,487 multiplied by 40% tax rate).

DIRECT FINANCING ALTERNATIVE

Under this alternative, the company would own the real estate, and would finance most of the cost through mortgage debt.

Typically, the amount of the mortgage debt will not exceed 80% of the property value, or $8 million in the case of the $10 million property. The company must provide the $2 million balance in cash.

Assume that the company's investment opportunity rate is 15%. In that case, the cost to the company for using its cash will be equal to its 15% investment opportunity rate. Therefore, if the company invests $2 million of its own funds, its annual expense under this alternative will be (a) $300,000 (15% of $2 million) plus (b) the cost of the mortgage debt.

This alternative has one decided advantage - ownership. At maturity, when the mortgage is fully paid off, the company will be the "free and clear" owner of the property. The value of ownership depends upon the company's estimate of what the property will be worth at the time the mortgage matures - for example, after twenty years. If the company projects the property will increase in value, this alternative becomes more attractive. If it projects a decline, then this alternative begins to lose its allure. In making a projection of future value, the company should keep two things in mind:

1. Twenty years is a long time. In real estate it is often the equivalent of several cycles.
2. No matter what the estimated value is after twenty years, its current or present value is dramatically less. For example: $1.00 received in twenty years (assuming a 10% discount rate) is worth about $0.15.

This alternative has the following disadvantages:

1. Depending upon the actual value of the property after twenty years, the cost of funds to the company will probably be higher than under the leasing alternatives, particularly when the tax benefits of leasing versus owning are taken into account. Further elaboration follows shortly.
2. The mortgage will be shown as long-term debt on the company's balance sheet.
3. To the extent the amount of the mortgage ($8 million in this example) is less than 100% of the cost of the property, the company will have to invest its own cash (or $2 million in this example).
4. Although the company will be able to deduct interest and depreciation for federal income tax purposes, the tax benefits arising from the rent reductions under the lease alternative will generally exceed those from interest and depreciation. Under the leasing alternative, 100% of the rent is deductible, including the amounts allocable to the land and to the return of "principal" of the lessor's investment. By contrast, under the mortgage alternative, any debt service payments made by the company and applied to the principal are not deductible, and depreciation can only be taken for the building and improvements and not for the land portion of the property.

TRADITIONAL REAL ESTATE LEASE ALTERNATIVE

Under this alternative, the company will lease the property rather than purchase it. The lessor will be an independent third party, and the term of the lease will usually be for the period over which the company requires the use of the real estate, generally fifteen to twenty-five years.

In the typical real estate leasing transaction, the lessor will be responsible for many, if not most, of the obligations of ownership. These obligations include maintenance and repair, real estate taxes, utilities, and insurance, although the company may be required to reimburse the lessor for some of these expenses. In the event of a minor casualty or condemnation, the rent will abate or be reduced. If there is a major casualty or condemnation, the company will ordinarily have the right to terminate the lease.

The advantages of this alternative are common to all leasing arrangements, in particular:

1. In a properly structured transaction, the lease will be an off-balance sheet obligation of the company and will not have to be shown as debt or a long-term liability on its financial statements.
2. The company will, for federal income tax purposes, be able to deduct the rent payments in full.

But there are several disadvantages to be considered:

1. As with most of the leasing alternatives, the company will not own the property at the end of the lease term. The third party lessor will be the owner, even though the company's rent payments will have substantially repaid all of the lessor's investment with interest (including any debt financing that may have been obtained by the lessor).
2. As compared to the two other leasing alternatives to be discussed below, the rental cost will be high, and frequently, materially higher than under a bond lease. There are two reasons:
   
   
   The lessor will be assuming material real estate risks, including casualty and condemnation. In return, it will demand compensation in the form of higher rents.
   The lessor will be obtaining real estate mortgage financing. Unlike a bond net lease transaction, this type of financing will not be based upon the credit rating of the company. Therefore, the mortgage rate will ordinarily be higher than the bond rate. This higher cost will be passed on to the company through higher rents.
   
3. The company will be restricted in how it uses and operates the property. In particular, there will be serious constraints on any changes or improvements the company may want to make to the property. This alternative is rarely a sensible choice for the company. The rent cost is simply too high. The real estate risks being avoided are de minimus and can often be insured against at a relatively low cost. But, the cost to the company of passing these risks along to the lessor (as traditional as this practice may be in orthodox real estate circles) is prohibitively high and is not commensurate with the dangers being avoided or deflected by the company.

BOND NET LEASE ALTERNATIVE

Under this alternative, the company will have complete freedom of use of the property. In return, the company will assume all of the real estate risks and obligations of ownership. There will be no abatement of rent in the event of casualty or condemnation, with one exception: If there is a major casualty or condemnation, the company will have the option to terminate the lease. However, if the company does not exercise that option, and the insurance proceeds or condemnation award are not sufficient to pay off the balance of the lessor's investment with interest, then the company will be required to make a final payment to the lessor equal to the deficiency. The advantages of this alternative are the following:

1. The rents will reflect the credit standing of the company. In the case of an investment grade company, this will often result in below market rents. The lease constant or rental constant will be calculated by using the lessee's direct borrowing rate and amortizing the lessor's investment in the property over the life of the lease. For example, in the case of a $100 million property, 8% borrowing rate amortized over twenty-five years equals a lease constant of 9.27%. This formula is the same formula that is used when a corporate borrower uses corporate bonds as a financing vehicle. The corporation pays interest on the bonds at an 8% rate and as a book keeping function has to internally amortize the future payment of principal to the bondholders at maturity. Example, 8% interest, principal payment twenty years, debt constant 9.27%.
2. The rent structure can be very flexible, including flat rents, CPI increases and rental options.

TAX IMPLICATIONS

Determining the tax implications of anything is usually confusing, and with real estate it is often more so. The tax impact of a real estate transaction can vary materially depending upon the financing approach that is taken.
When the net lease alternative is mentioned, the immediate thinking is the accounting treatment and the effect on a company's balance sheet. Too often, however, the after-tax benefits of net leasing are overlooked, even though they can provide a company with greater savings than other forms of asset-based financing. If a company leases a property, it can deduct 100% of the lease payments against its taxable income. As a result, leasing almost always results in a lower after-tax cost for the company than any alternative form of financing.

In order to illustrate the point, following is a comparison of the tax benefits of three basic forms of real estate financing: 100% cash equity investment, mortgage financing and net leasing. Making the assumptions listed below, it is evident that leasing provides distinct benefits over the other two forms of financing.

ASSUMPTIONS

MORTGAGE FINANCING ALTERNATIVE

Under the mortgage financing alternative, the company will look to a third party source to fund most of the cost of the property. Mortgage financing is usually around 80% of cost, with the company putting up 20% equity. However, for illustrative purposes, assume that the company can obtain 100% mortgage financing (or $10 million) at an interest rate of 8.5% and 100% amortization over twenty years. The annual debt service under the mortgage will be $1,056,710, or a mortgage constant of 10.56%.

The interest portion of the debt service will be deductible, but the principal payment will not.

In addition, the company will be able to deduct depreciation at the annual rate of $179,487 (as calculated under the description of the all-cash alternative). Therefore, the value of the total annual deductions under this alternative and the after-tax cost to the company are as follows:

LEASING ALTERNATIVE

Under the leasing alternative, assume the annual rent will be $1,056,710 - the same as debt service on the mortgage financing. However, unlike debt service on the mortgage, 100% of the rent payments are deductible. At a 40% tax rate, the value of the annual rent deduction is $422,684 ($1,056,710 multiplied by 40%), and the after-tax cost of the rent each year is $634,026, as shown below:

COMPARISON OF TAX BENEFITS

The annual tax benefit from the all-cash alternative is only $71,794.87, (i.e., 40% of $179,487). This is one of many reasons why it is not a sensible economic alternative for the company.

This leaves the mortgage and lease alternatives, which are compared below (assuming annual debt service and annual rent of $1,056,710):

CONCLUSION

If it is true that one picture is worth a thousand words, then the chart set forth above should be adequate to make the case for leasing. The reason is simple. The rent deductions under leasing will almost always be greater than the interest and depreciation deductions under mortgage financing. There may be circumstances under which the company should own instead of lease a property. But, if it is a question of tax benefits, leasing is the clear choice for the company.