A comment I often hear from commercial tenants is that they're sick and tired of flushing
money down the toilet.
This frustration arises when they have nothing to show at the end of their lease, so they
feel all they did was pay their landlord's mortgage.
But people may be surprised to hear that many companies intentionally lease instead of owning.
I'm going to use Amazon to illustrate this as they lease the vast majority of the warehouse
space they occupy. With over $33 billion in cash on hand, it's not a matter of them not
being able to afford to purchase either.
Instead, it's a financial strategy that is shared with numerous other savvy companies,
and in this video I'm going to share with you why these companies don't feel like they're
flushing money down the toilet.
Let's start by looking at this from a company's perspective. If management was considering
purchasing a property, they would certainly create a projection on how they thought that
asset would perform.
This would likely include building out a proforma for some period of time into the future. After
accounting for all the cash flows and an estimate for a sale price, they would then calculate
the internal rate of return, or IRR. That might sound complex, but it's really just
the annualized return over a period of time. I did a video explaining IRR in more detail
if you want to check it out.
Interestingly, there was a recent study done which showed commercial real estate investment
properties averaged 9.4% yearly returns going back several years. Naturally returns for
each individual property could be higher or lower depending on local market conditions
and what period of time the property was owned, but for the sake of this argument let's assume
the rate of return for investing in real estate is nice round 10%.
A prudent company will not just consider what this projected return will be, but they also
factor in what the opportunity costs are of making that decision.
In other words, could the company make a higher return by picking from all the other investment
alternatives available to them?
There's essentially an endless amount of options to choose from. They could invest in machinery,
equipment; they could start a new division or product line; expand into a new market
or even acquire another company. In Amazon's case, they could have earned 10%, give or
take, investing in real estate, but instead their remarkable growth has been fueled in
large part by their pursuit of much higher returns.
It's a rhetorical question, but if you're a shareholder of Amazon, would you want them
owning their own real estate or continue on the same path that's made them one of the
largest companies in the world?
Unless it's a very mature business with few other avenues to deploy capital, purchasing
a building will typically rank quite low on the list from an IRR perspective. Even in
many business transactions, purchasers of a business will often model a sale & leaseback
of the building to unlock that capital so it can be deployed to more fruitful alternatives
that provide a better IRR.
There are other considerations as well. For example, what happens if the real estate market
takes a downtown? At the end of a lease a company might not have anything to show, but
surely this is better than being forced to sell at a loss. All things being equal, it
will also be much easier for a company to move from one leased property to another than
it would be to work through the sales process. Being nimble and flexible is of huge importance,
particularly when a company is unsure of what their needs will be in the medium to long
term.
I can speak anecdotally to this as well as I've helped clients expand into larger spaces
with their current buildings. Landlords are always open to allowing expansion within their
own portfolios, and most of the time this happens without any penalties. This benefit
does not exist whatsoever if the company owns their own property.
At this point you might think I'm opposed to owning real estate, but as I've mentioned
in other videos on my channel, I've actually got the majority of my net worth directly
invested in industrial real estate.
And I think there are entirely valid reasons on why a company would choose to own their
property.
But real quick before I get to that, if you're getting any value from this video I would
greatly appreciate you tapping that like button.
Back to why it may make sense to own versus leasing.
For one, real estate has historically provided very steady returns, particularly when stretched
over a long period of time. In some hot markets it's conceivable that the appreciation in
the real estate actually outperforms other investments.
It shouldn't be lost on anyone that large fortunes have been made investing in real
estate.
Even beyond financial measures, owning can also offer more stability. When a company
leases they are somewhat at the mercy of the landlord, so if the landlord decides to sell
the building or lease to another tenant, it might mean that the company is forced to move
when their lease comes up. Then of course there is the possibility of rents dramatically
increasing. Owning will naturally safeguard against those risks.
The main point is that there's a lot that goes into the decision making process on whether
to lease or to own. And the fact that many companies intentionally lease instead of owning
means there are tremendous opportunities for investors looking to provide them with the
physical real estate.
Check out this video if you want to learn more about investing in industrial real estate.
And if you're an investor, professional or company looking to better understand the industry,
my entire channel is devoted exclusively to industrial real estate, so please consider
subscribing if you want to follow along.
Thanks for watching, catch you in the next video!