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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(Sales :investmentooperatingprofit margin – percentage financed interest rate – annual capitalia nvestments) × Percentage of eq Using Model Assumptions 2 04 s e uity = Current pretax return on equity The V-Formula g (92.40%× 20.00%–86.96%×8.% 13.% 50 ) = 85.% 00 (slSalea s: investment ×EBITDAR margin – debt funded portionc Equity funded portion × ap rate) t Pretr ax equity = rate of return growth, which can reduce corporate risk and add to corporate cash fl ows through greater location diversity. In today's credit markets, leasing real estate will almost always be preferable to real estate ownership. T e principal determinant of the relative desirability of leasing versus owning is the percentage of fi nancing and the loan terms available from debt providers. T e 2010 passage of the Dodd-Frank Act and the added lending constraints imposed on banks by the Basel Accords have combined to make the extension of real estate credit restrictive for the foreseeable future. In this current light, where debt providers are generally limited to advancing between 60 percent and 80 percent of project cost, leasing is not simply a debt substitute, but a debt and equity substitute, because the landlord provides 100 percent of the real estate capital. As a result, real estate leasing allows business leaders to avoid the costly options of infusing added equity capital or constraining corporate growth. A Wise Investment? T e preceding analysis overlooks the question of whether corporate real estate ownership is a wise investment for companies to make. However, the answer is fairly clear: Real estate investing tends to be nowhere near as lucrative as corporate investing. T is is the basic reason why companies that own their real estate tend to post lower equity returns and create less shareholder value; strong business rates of return are depressed by the lower rates of return from real estate investing. In the previous model example, the fi ve-year average returns from corporate investing (assuming locations are leased) would actually be more than seven times those for the landlord who owns the leased locations. T e implication for companies having surplus cash fl ow is that investing in real estate will tend to lower returns and erode CCIM.com shareholder wealth. As a result, the corporate valuations of businesses having surplus cash fl ows tend to be better supported by paying out the cash in dividends or by buying in shares, rather than by directing free cash fl ows to real estate investments. One look at a cross-section of public companies laden with real estate will bear this point out. For closely held LLC or Subchapter S companies, shareholders may desire to direct their surplus free cash fl ow into real estate ownership in lieu of other personal passive investments, which is fi ne. Here, the catch to watch out for is trapped equity. On one hand, it is always smart to undertake long-term real estate debt so as to avoid fl oating rate risks and lock in spreads. On the other hand, long-term loans can be subject to severe prepayment restrictions, as well as restrictions on assignment or assumability. Such restrictions can, at the least, lower property valuations and, at the worst, limit the potential to freely sell real estate. Real estate leasing is just one of many tools that are at the disposal of corporate leaders to minimize corporate costs of capital. As dem- onstrated above, the advantages of this tool include: • an ability to conserve equity capital that can be directed into growth; • an ability to lock into a wealth-creating capital structure for a long time; and • a lower payment constant compared to other external capital alternatives. Combined, the three advantages of leasing spell a lower cost of cor- porate capital. T e result is greater shareholder value created through capital effi ciency. Christopher H. Volk is chief executive offi cer of STORE Capital, which specializes in single-tenant sale-leaseback transactions. Contact him at cvolk@storecapital.com. November | December | 2012 35