Leasing or selling, which is better?

Question

We purchased a warehouse building 3 years ago for our use. Because our business expanded, we moved to a bigger location. We decided to put our smaller warehouse for sale or lease. Whichever was the better deal or came first, we were going to take it. After the property sat for 6 months, we got a quite a few showings for lease. Finally, last week we got a company interested in our property and they offer us either they can buy it outright or lease for 5 years with an option to buy. The interested company already owns another building a block away from ours and needs extra space. They are a subsidiary of Berkshire Hathaway. The term is 5 yr with a 3% increase from year 2 on with a buyout at 5 years with another 5 year option to rent if they do not exercise the option or return the building. Should I sell the property now or lease to them and take the chance that they will not exercise the option at the end of 5 years?

thanks for any input.

Jeff Kehl · Answer

@Ivan Leung when I have a choice like that I'm not clear about I like to run the numbers both ways in a financial model and let the higher IRR win. Part of the problem with doing that is you have to somewhat predict the future. As an example, you have to decide what the property will be worth in 5 years and if they will exercise the option or not. But you can make some intelligent guesses about some of that.

Just very simplisticly, if you look at the lease you're getting $120k on a $650k investment. That works out to about an 18% return. And it's pretty much guaranteed for 5 years with a great tenant so little risk. The 3% bumps I would just discount with a 3% inflation assumption. Then you get $1.5 million if they exercise the option or market price if not. What will the market price for this property be in 5 years? To determine that look at supply and demand. From what you said it sounds like it won't drop a whole lot so assume it's $1m-$1.5 million. So in 5 years add another $350-$850k profit. That's a terrific IRR which I think you will have trouble matching with anything you 1031 into.

On the other hand let's say you sell and 1031 the $1.2 million into one or more nnn leased properties. To be safe let's say you find very high quality investments like a starbucks, walgreens, or panera in great locations. Doing that you will be lucky to get a 6 cap. That's $72k per year which is a terrible return and probably not quite as safe as keeping the property. And what do you have in 5 years? If interest rates have risen (which they probably will have) you're looking at selling them at a higher cap and you don't even have your $1.2k back.

Because you're a commercial broker I would also model a 3rd scenario. Can you go out and find more under-valued properties like this or do you have friends who can? If you can find higher IRR deals or invest with friends that can then you might be better off doing that.

If I lost you on the financial analysis, let me offer a trite saying, a bird in the hand is worth two in the bush ...

Ivan Leung · Answer

Thanks, Dave, for very insightful input.  Good points being made and need to be considered.  Because the market is at a high point over the last few years and I'm not a real estate investor, but rather a speculator,  I can't envision any 1031 where I can make that kind of return.  In our area, $1.2 doesn't get you much.  Right now, I am getting a good return on the investment and the market is too unpredictable for the 5 year future.  So I guess I am taking the gamble.

Ronald Rohde · Answer

I would sell. It sounds like you already have another active business, until you want to be full-time in the real estate business, there are better passive investments.

Aaron K. · Answer

I think it will depend on the return you get vs the return you could get if you sold and invested somewhere else, but if it were me I'd probably rent it because I don't see Berkshire Hathaway going out of business anytime soon.

Joel Owens · Answer

In NNN 5 year lease STNL just is not worth much for resale. You have the income stream for primary term but not for long so has little value.

Most NNN stand alone tenants have 10 as a minimum to 25 year primary term leases depending on who it is.

If the goal is to sell in a few years and 1031 then getting a longer term lease if a single tenant generally gives the best cap rate value for resale.

As the primary lease term winds down the cap rate tends to rise because lenders do not count the option periods. So it is important to analyze rental increases in the primary term to account for some inflation and blending the cap rate up when you sell. You at least want close to a break even scenario.

The tenant with a short term lease and an option is trying to buy ultimate flexibility. You have to also look at any early termination rights and out clauses in the lease as well as subleasing language. You want as a landlord to control who a sublease would be allowed to and under what condition the current tenants guarantee goes down or goes away if at all. For example stating the tenant subleasing has to have a net worth equal or great er XX,etc,etc.

Look for personal guarantee as well as corporate. If corporate only look to see if they are trying to set up one business under an LLC etc. for the lease.

I see it a lot where a flyer mentions Berkshire or some other company and then you drill down and find no personal guarantee on the lease and corp guarantee is just  a few stores or a single store. Those guarantees tend to be worthless as the business simply bankrupts the remote llc's and keeps carrying on with their other assets. Remember you as the owner want ultra security and the tenant is trying to do the opposite. It can really affect you for resale the terms that are in the lease because once the tenant signs it is very hard to get them to change anything that is not advantageous to them. Generally you have to give up something of value like taking 10% rent increase in options and making it 5% etc to get  a tenant concession on something else.

If you have a building that is more than one tenant and many multiples then 3,5,10 year leases are common. It is a different product and risk profile then a single tenant building. Single tenant goes out you are paying the mortgage,taxes, and everything else until refilled. If you have a commercial 10 tenant building then even if one goes out you likely depending on how much size they made up in the building will still have enough break even occupancy to service the debt or still cash flow even.

John Franklin · Answer

IMO - What you need to know first is what is the market rent for the space?  I'd much rather lease the building to them (a high credit tenant)  and then sell it with the tenant in place.  Only problem is the proposed lease limits the upside value (that increases the cap rate at sale to investor) with the set purchase option in 5 years.

Don't give away your ability to participate in future appreciation.  Get a smart tenant rep who can craft a lease that protects your upside. for instance, you give an option to sell at the stated price or market value, less $50,000, which ever is higher.

Great tenant, bad terms.

Dave Foster · Answer

@Ivan Leung, Certainly the proposed lease is advantageous.  That option to purchase I suspect.  An option unless there's real hard money behind it is really just a comfort play.  And the purchase price they're wiling to write into the option represents what - 0.5% appreciation over 5 years?  I'd sure be willing to give an option for that kind of term especially if the consideration was small.  It almost feels to me that the handsome rent is really a cover to get a cheap option.  I'm not sure it's worth keeping for the appreciation visioned in the option.

So the decision comes down to cash flow from a 5 year lease vs a sale.  And what position you'll be in 5 years.

A 1031 exchange would allow you to shelter the approx $60K of depreciation and 500K gain.  But to buy what?  The debt free aspect makes for some intriguing options.

I'd be basing my decision on a comparison of the value of a 5 year NNN lease and tenant with 3% escalators vs what you could buy on the market and the quality of lease and tenant. Stand those up against your long game.

Ivan Leung · Answer

Thanks for all the input and advice.  I would like to give some further details so that I can make a decision.  The building I bought 3.5 years ago, I purchased for $650,000.  Since then, the market has rallied.  We put it for sale for $1.2 million.  The lease is $120,000 NNN.  When we put in the market 6 months ago, there was no action.  No one made an offer.  Now, we got this offer and the prospective client is willing to lease for 5 years, 3% increase yearly starting year 2 and also an option to buy at end of 5 years for $1.5 million.  We feel the market is very hot but by next year or so, it may level off.  The buyer is willing to give us a full price offer of $1.2 (our asking price now).  Meanwhile, if we take the sales offer, we have to do a 1031 exchange right now.  The building is free and clear so bottom line.... should we take the money and run?  Or sit on it and collect the income and hope market continues and they buyout at the end of 5 years?

Thanks so much!

Kegan Russell · Answer

Talk to a quality commercial broker.  It really depends on the market, but here in MI Industrial CRE is at a peak.  Many small-medium sized businesses prefer to buy, which causes some pretty lofty sales prices.  Just had a client turn down $550,000 to net less than $3,800 a month which took him months longer to lease versus selling.  Had multiple offers to buy, very few wanted to lease. He had an emotional attachment to the building, but the whole office can't believe he didn't want to sell.

Leasing or selling, which is better?

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