Lease Versus Own for a 10-Year Occupancy
An engineering firm needs 40,000 SF for at least 10 years. Option A is a lease of 40,000 SF at $22.00/SF NNN with 3% annual escalations, a 10-year term, four months of free rent and a $35/SF tenant improvement allowance from the landlord. Option B is the purchase of a 45,000 SF building for $7,200,000, financing 60% at 6.50% on a 25-year amortization; the firm would occupy 40,000 SF and lease the remaining 5,000 SF at $14.00/SF NNN, though that space may sit vacant for a full year. The firm's required return on equity is 12%. Operating expenses, taxes and insurance are comparable per occupied square foot in either case and can be ignored for the comparison. The firm expects building values in this market to grow about 2.5% per year.
1. Compute the net effective rent of the lease and the present value of the lease's occupancy cost over 10 years.
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Gross lease economics
- Year-1 rent = 40,000 × $22.00 = $880,000.
- Total base rent, 3% escalations, 10 years = $880,000 × [(1.03^10 − 1)/0.03] = $880,000 × 11.4639 = $10,088,200.
- Less free rent (4 months of year-1 rent): ($293,300).
- Less TI allowance: 40,000 × $35 = ($1,400,000).
- Net rent over the term = $8,394,900, or $20.99/SF/yr - the free rent and TI only trim about $1.00/SF from the face rate.
Present value at 12%
- Growing annuity-due factor for 10 years at 3% growth, discounted at 12%: Σ(1.03/1.12)^t for t = 0…9 = 7.06 per $1 of year-1 rent.
- PV of rent = $880,000 × 7.06 = $6,212,800.
- Less free rent at t = 0: ($293,300); less TI at t = 0: ($1,400,000).
- PV cost of leasing ≈ $4,519,500.
Note that the undiscounted net effective rent understates the cost of the lease because the escalations push real dollars into later years - but the discount rate offsets most of that.
2. Compute the present value of owning, including the residual value, and determine which option is cheaper.
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Capital and debt
- Equity = 40% × $7,200,000 = $2,880,000.
- Loan = $4,320,000; monthly payment factor at 6.50%, 300 months = 0.0067518, so annual debt service = $350,000.
Annual cost
- Year 1: debt service $350,000 + non-recoverable owner costs (say $25,000) = $375,000; the 5,000 SF sits empty.
- Years 2–10: $375,000 − rental income of 5,000 × $14 = $70,000 → $305,000.
Present value of the cost stream at 12%
- Year 1: $375,000 ÷ 1.12 = $334,800.
- Years 2–10: $305,000 × (5.3282 ÷ 1.12) = $305,000 × 4.7573 = $1,451,000.
- Total PV of operating cost = $1,785,800; plus equity of $2,880,000 = $4,665,800 of outflows.
Residual value at year 10
- Value = $7,200,000 × 1.025^10 = $9,216,600; less 3% selling costs = $8,940,100.
- Loan balance after 10 years ≈ $3,348,000, so exit equity = $5,592,100; PV = $5,592,100 ÷ 3.1058 = $1,800,400.
Net PV cost of owning = $4,665,800 − $1,800,400 ≈ $2,865,400.
Owning is cheaper by roughly $1.65 million in present value. The result is robust: even if the 5,000 SF never leases and value stays flat, owning still beats the lease.
3. The landlord counters with $19.50/SF and a $25/SF TI allowance. Does that change the decision, and what non-financial factors would you weigh?
Read the worked answer
Recompute the lease
- Year-1 rent = 40,000 × $19.50 = $780,000; PV of rent = $780,000 × 7.06 = $5,506,800.
- Less free rent ($260,000) and TI (40,000 × $25 = $1,000,000).
- PV cost = $4,246,800 - still about $1.38 million above owning.
Break-even lease rate: solve 7.06R − 0.3333R − $1,400,000 = $2,865,400 → 6.73R = $4,265,400 → R ≈ $634,000, or $15.85/SF NNN. The landlord would have to cut rent roughly 28% from $22.00 to make leasing competitive - which tells you the answered question is not price, it is capital.
Non-financial factors to weigh
- Capital availability: the $2,880,000 of equity plus the risk that the second 5,000 SF never leases. If that capital is the firm's growth engine, a 12% hurdle may understate its true value inside the business.
- Excess space: 12.5% more area than needed is a bet on headcount growth; if the firm shrinks, it owns an under-used asset.
- Balance-sheet risk: debt service is fixed and the loan must be refinanced; a lease shifts residual and refinance risk to the landlord.
- Flexibility at year 10: owning gives an option on staying or expanding cheaply; leasing gives an exit.
- Taxes: ownership generates depreciation and interest deductions that a straight NNN lease does not, which widens the ownership advantage if the firm is a profitable taxpayer.
Conclusion: recommend buying if the growth capital is genuinely not needed elsewhere and the 5,000 SF can be pre-leased before closing; otherwise, negotiate a shorter lease with two 5-year options and a smaller TI package to preserve flexibility.