For companies seeking new office premises, manufacturing plants or distribution centres, during the procurement process the ‘own versus lease’ debate usually arises. Rodney Timm addresses the eternal question.
The issue is often phrased around why the company should commit to paying high occupancy and rental costs to a developer or investor rather than own its operating premises and facilities at a lesser total cost. This debate is particularly relevant for companies with a relatively low cost of capital.
Considerations in this decision can be complex and multifaceted. But at a basic level the ‘own versus lease’ decision can usually be assessed by analysing five key aspects: the strategic advantage of the property or location, the extent to which the facility is specialised, the likely duration of occupancy, the management of risk of ownership and the availability of capital to fund the property.
In certain industries the competitive advantage provided by a particular location or facility is fundamental to the continue a success of the business. Examples may include facilities such as breweries, universities and transport modal centres. These facilities are usually regarded as strategic to the core business with a strong bias to ownership and are seldom leased.
However, the imperative of ownership because of strategic advantage may be more difficult to argue for users of more generic premises in which specific locations may not be that critical to ongoing success. Hence with accountants, lawyers and consultants, leased tenure is usually the primary occupancy approach.
In contrast many retailers, particularly supermarkets, rely on the monopoly of locations to maintain their market share and use a range of tactics to keep competitors out of their trade areas. Securing existing and future strategic locations to protect trade areas often results in direct site acquisitions, but, with a strong need to recycle capital, these retailers usually resort to long sale- and-leaseback strategies. This process, if managed appropriately, can effectively control locations with ongoing ‘tenant-friendly’ options to renew.
The next tenure indicator to consider is in understanding the specialised nature of the asset required to support the operations of the business. Generally, property developers and investors avoid placing their capital in highly specialised assets because of the alternative use and residual value risks.
Property investors assess the occupancy risk of their properties by reviewing the availability of alternative occupiers for the property at lease expiry or potential default by the incumbent tenant. If they determine that the specialised nature of the facility will result in limited or no market demand without significant modifications, this risk will be managed via rental premiums.
In the investment cash flow analysis, investors will significantly discount the residual value of the facility at the end of the tenancy period to reflect the inherent risks of finding an alternative tenant for the type of specialised property. In addition, capital budget allowances will be included to potentially modify the property to a more generic use.
The net impact of this financial modelling is that the required rental for specialised properties by investors will likely be relatively high compared to alternative arrangements in owning and financing the capital cost internally. In some cases, with highly specialised properties, it may not be possible to find a developer or investor to finance the property in any form of arrangement.
In general, the shorter the period of required occupancy, the more likely that the optimal tenure decision will tend to be lease arrangements. In the ever-increasing uncertainty of the business operating environments, corporate agility and flexible financial commitments are becoming essential – even if a premium is to be paid to obtain such flexibility.
At the extreme, the serviced office model can be a solution for companies needing temporary or flexible office arrangements – but this solution usually attracts a large rental premium. Alternatively, the leasing strategy may include multiple short lease arrangements accepting the requirement for frequent and costly relocations.
The cautionary note in portfolio planning is not to attempt to make the entire corporate portfolio flexible, as this will be expensive. The right approach is to realise that there will always likely be the need for a core head office and support group accommodation and the lease duration for this space should be managed and procured differently.
Author: Rodney Timm, director of Property Beyond.