Most companies lease their industrial facilities because it’s easier, faster, and requires less capital. The common corporate mantra is: If the yield on the capital (to purchase) doesn’t meet our investment “hurdle rate” we are going to lease. In other words, the return from the property must meet or exceed a company’s double-digit return requirements, otherwise owning can’t be the right decision.
Bottom line, this is only one element of a much more complicated financial and operating decision…a decision with long term implications. Changes in industrial real estate market conditions, overall financing costs and new accounting regulations suggest owning an industrial facility deserves greater consideration than ever before.
Real Estate Market Conditions
- Pre-COVID 19 labor availability was highly constrained and more costly in large industrial markets like Atlanta, Dallas, Chicago, and Los Angeles, as well as 2nd tier markets like Nashville, Indianapolis, and Charlotte. The best labor availability and lowest costs are in ex-urban and rural areas where most real estate investors don’t go; and where there are few, if any, available buildings.
- Leasing costs increased substantially during the robust economic expansion since the Great Recession. The supply of quality properties has also diminished, adding leverage for an owner/landlord to raise prices.
- Industrial property landlords are increasingly institutional investors (REIT’s, Insurance Companies, and Investment Banks) who impose less-than-favorable lease terms and conditions on their tenants. These include punitive lease documents, requirements for the tenant to pay common area maintenance and property management fees, including payments into sinking funds to repair and replace paved areas and roofs. It is also customary to see compounding annual rental escalations of 3 to 5%.
- Larger warehouse operations (300,000 sq. ft. and up) almost always include sophisticated material handling equipment (MHE) that is very expensive, sometimes exceeding the value of the building. Relocating this equipment is difficult and costly, which leads to longer lease terms, commonly ten (10) years or longer, including options to renew. Occupancy of the same building for ten years or more almost guarantees the cost of ownership is less than leasing. (This ALDI Food Distribution Center is a great example.)
Financing Costs & Incentives
- Borrowing costs are at the lowest levels in decades. Established industrial companies can qualify for loans to acquire real estate at very attractive rates (currently 4% to 7%) depending on the credit worthiness of the company and the location and character of the property. Yes, financing requires equity contributions of 20-25% of a property’s value, but under all circumstances it is a good time to finance owned real estate.
- A net present value (NPV) comparison of owning versus leasing an industrial facility (which includes an estimate of sale proceeds to an owner at the end of building occupancy), often results in total out-of-pocket ownership costs that are a fraction of leasing costs, sometimes as little as half the cost to lease. The favorability of ownership will increase, if rents continue to climb and borrowing costs decline.
- The COVID-19 pandemic and recently passed CARES Act established a number of potential financing and grant programs for domestic industrial projects, especially favorable to reshoring overseas manufacturing. While it’s not certain at this time, it appears a company-owned facility will ensure the CARES benefits accrue to the company, rather than their landlord.
Accounting Regulations
- The Financial Accounting Standards Board (FASB) issued new lease accounting requirements in 2016, which require occupiers to report leases on their balance sheets. The requirement is in effect today for public companies and applies to private companies January 1, 2021.
- Generally, these new accounting requirements for leases negatively impact a company’s financial statement by increasing debt-to-equity ratios and lowering borrowing capacity, as well as reducing working capital and return on assets.
The Bottom Line
Ownership of industrial facilities is not always the right occupancy scenario, especially for young companies with modest net worth, limited borrowing capacity, and an uncertain occupancy horizon. However, for established and well-capitalized businesses, there are numerous reasons to carefully consider owning rather than leasing the next industrial facility.