You have been appointed as a consultant to Texas Bob’s BBQ shack, Inc., a restaurant chain based in Austin, Texas. The company is considering expanding into the Cincinnati market and has retained you to advise it on an appropriate real estate strategy. The standard real estate strategy when entering a new market has been to work with a local partner who will identify, purchase and retain ownership of a suitable building. Texas Bob then takes a ten-year net lease on the property. However, in this instance, because of the large fall in commercial real estate prices, Texas Bob has asked you to investigate the feasibility of purchasing a building instead of leasing one. The company has identified a suitable freestanding building of 7,750 square feet that is available to either lease or purchase. You are provided with the following information:
Option 1 – lease The property can be leased for $15 per square foot on a ten-year (net) lease. The lease includes a CPI adjustment. Over the next ten years inflation is expected to average 2.5%.
Option 2 – purchase The property can be purchased for $90 per square foot. Financing terms are based on a mortgage of 65% LTV. The interest rate is 350 basis points above ten-year Treasury Bonds (currently trading at 1.90%). The loan term would be ten years and the loan would also be amortized over a 30-year period (assume one-payment per year with interest compounding annually). Over the last thirty years commercial property prices have increased by two percent per year in Cincinnati. From the local tax assessment records, the value of improvements on the site is given as 50% of the assessed value.
The company anticipates that sales at the new location will average $57,000 per week, with the costs of goods sold expected to average 70% of the sales level. Sales are expected to grow at 6% per year. Corporate overheads are expected to increase by $8,100 a week as a result of the new restaurant (increasing by 3% per year). Fitting out the restaurant is expected to cost $350,000 regardless of whether the property is leased or purchased. Property operating expenses are calculated at $5 per square foot in the first year of occupancy rising by 3% per year. The marginal tax rate for the company is 25%, the rate of depreciation recapture is 25%, and the capital gain tax rate is 15%.
(a) What is the after-tax return to the company from opening the new restaurant assuming the building is leased?
(b) What is the after-tax return to the company from opening the new restaurant assuming the building is purchased?
(c) What is the after-tax incremental return from purchasing the restaurant rather than leasing it?
(d) Which is the preferred option based on your analysis?