Question

Describe in depth one strategy that companies and organizations can use to generate cash flows from leasing. Provide an example--real, or hypothetical, of a company would choose to use this opportunity. What are the risks vs. possible returns in a leasing cash flow?

Answer 1

Repurchasing Strategies :

In the routine course of business, companies sign leases for existing warehouse, office, retail, or industrial properties. Since many of these scenarios require leasing entire buildings, companies should attempt to negotiate for the right to purchase the properties. This provides companies with another opportunity to generate cash while decreasing operating costs.

Various types of repurchasing options are available. The first right of refusal option is exercised when a landlord chooses to sell a property and permits an offer from the tenant. The tenant has the first option to buy the property at the offered price and normally has 15 days to respond to the offer. If the tenant decides to purchase the property, they usually have another 60 to 90 days to close the transaction.

Another approach is the first right of market option in which a landlord selling a property offers the tenant the right to purchase the property at the price upon which it is being marketed. This might result in a negotiated purchase price without broker involvement. If the tenant refuses to purchase the property at the set price, the landlord has no further obligation to the tenant.

The tenant also could negotiate into its lease a purchase option at fair market value and the right to negotiate the method of determining that amount.

It would be advantageous for a company to negotiate an option to purchase the building and then sell the option to an investor while simultaneously executing a long-term triple net lease. In many cases, companies could make 20 percent to 100 percent of their investment using this strategy.

Some landlords are not amenable to any option to purchase their properties, but it is worth pursuing since repurchase options are excellent ways to make money and reduce operating costs at the same time.

Cash flows generated from the collected income (rent) less operating expenses and debt service are most properties' primary return source. These are predictable to the extent that rents are known and expenses are controlled through pass-through provisions.

A second return source for taxable entities is the tax shelter and postponement generated from non-cash depreciation deductions. Depreciation taken during the holding period results in recapture at the time of the sale, but the recapture is at a lower tax rate. The return is highly predictable as long as tax rates remain stable.

Equity buildup from reducing the mortgage loan principal (if financing is used and if the debt service includes principal repayment as part of the typical level amortization payment) is another predictable return source, especially if the interest rate is fixed. Interest-only loans do not involve equity buildup from this action.

Appreciation or depreciation from a property's change in value is the least predictable return for most investments, and thus, one of the greatest risk sources.

Each of these returns has a certain degree of predictability; if the return flow is more predictable, the return source is less risky. Tax deductions and equity buildup returns are highly predictable. Cash-flow returns are somewhat predictable based on known leases and tenant reliability, but they become less predictable over time. Returns from value changes are the least predictable, thus much of real estate investment risk comes from changes in price and long-term cash flows.