Commercial Investment Real Estate is the magazine of the CCIM Institute, the leading provider of commercial real estate education. CIRE covers market trends, current developments, and business strategies within the commercial real estate field.
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Model Assumptions Income Statement Sales Annual sales growth EBITDAR* margin Real Estate Lease Cap rate Rent-to-sales ratio Annual lease escalations Real Estate Debt Loan to value Interest rate Amortization Expansion Capital Working capital/Real estate value 15.00% *Earnings before taxes, depreciation, amortization, and rent $1,500,000 2.00% 20.00% 8.50% 8.00% 1.50% 70.00% 6.00% 20 years impact of real estate fi nancing decisions on corporate valuation. T e V-Formula calculates pretax rates of return on equity, which means that the relative return comparisons are the same, irrespec- tive of the dollar values of the real estate and business. T at said, the model assumes location revenues of $1.5 million for the purposes of demonstrating the magnitude of the capitalization decisions on corporate cash reserves. T e model inputs are self-evident, perhaps with the exception of the expansion capital input. T at fi gure represents the amount of company capital that has to be invested in start-up or other costs asso- ciated with the location fi nanced. Many businesses also require capi- tal for equipment related to new locations. For simplicity, the model does not take such investments into account, nor does the model include an allowance for ongoing replacement capital expenditures. Model results were prepared for both the fi rst year and the fi ſt h year. T is is because returns on equity change over time as a result of anticipated sales and profi tability growth and as a result of changes in corporate capitalization as debt is repaid. Based on the model assumptions, corporate pretax equity rate Model Results Year 1 Pretax Equity Yields Current pretax yield on equity* Pretax cash fl ow equity yield** Sales:investment ratio Investment % funded with equity % More fi nanced Leasing multiple advantage Year 5 Pretax Equity Yields Current pretax yield on equity* Pretax cash fl ow equity yield** % More fi nanced Leasing multiple advantage Five-year cash fl ow lease advantage with growth investment 93.20% 93.20% 35.28% = $572,757 2.66x $1,693,223 *EBITDA ÷ amount of cash equity invested (which rises through debt repayment) ** (EBITDA – loan principal payments) ÷ amount of cash equity invested 34.98% 30.56% Lease 85.00% 85.00% 0.924 13.04% 26.09 = $423,529 2.24x Own 37.89% 33.85% 0.924 39.13% of return in the fi rst year is 85 percent if the location is leased. (See V-Formula sidebar for computations.) T e model results illustrate that the current pretax returns from the decision to lease real estate are more than 2.2 times greater in the fi rst year and rise to nearly 2.7 times greater by the fi ſt h year. T e magnitude of the diff erence is signifi cant and the company is immedi- ately able to conserve more than $423,000 in equity in the fi rst year. Moreover, to the extent the company can apply the equity saved to further growth, an additional two leased locations can be added. Over five years, the three combined locations would provide nearly $1.7 mil- lion in pretax equity cash fl ows over and above the cash fl ows that would be real- ized from the alternate decision to own real estate in a single location. What could be done with that extra $1.7 million? Well, aſt er taxes are paid, another five locations could be opened, which would generate even more extra cash fl ow and more opportunities to expand share- holder wealth. While 100 percent fi nancing can cre- ate a drag on cash fl ows, the drag is less than the added percentage funded because leases have lower payment constants than any other source of outside capital. Plus, since leases conserve precious corporate equity, more equity can be applied to 34 November | December | 2012 Commercial Investment Real Estate