How Socially Useful is Banking

For many companies in the real estate property development, the cost of construction equipment constitute the single most largest cost that can not be factored in to the final property price. Under current economic conditions, especially with respect to the housing market, developers must search every avenue for opportunities to minimize costs and maximize returns. Property developers have three basic options for meeting construction equipment needs needs: purchase the needed equipment, lease the needed equipment, or custom hire. Custom hire may work well for certain jobs, but often does not allow the amount of control many operations require. Like purchasing, leasing allows the real estate developer to maintain control of the timeliness and quality of the work conducted on their operation. Therefore real estate developer should evaluate leasing versus purchasing based on the economic opportunities that each provides.

Under a standard lease agreement, the lessee (real estate developer) agrees to pay the lessor (bank, credit corporation, dealer, etc.) a specified amount (payment) at certain intervals over a certain length of time. Three-year leases with annual payments are very common, but any arrangement is possible. The lease will generally specify the amount of annual use permitted under the base contract. The amount needed to purchase the equipment at the end of the lease is the residual. Any and all of the components are negotiable.

Lease arrangements are based on an initial price for the equipment. As with purchases, developers should negotiate the best deal possible, then consider whether to lease or purchase based on the negotiated price. Just as a lower negotiated price lowers the costs associated with a purchase, a lower negotiated price lowers the costs associated with a lease. Once the initial price has been established, the components of the lease can be finalized.

Ideally for a real estate developer the lease agreement should be such that it fits their projects needs. It is imperative for the developer to evaluate the lease contracts for use levels above and below the expected use in order to determine the most economic level. The length of the lease should be determined by the needs of the project at hand. Consideration should be given to the length of time the equipment will be needed, the ability or desire to operate machinery past warranty, planned changes in the project (termination, expansion, etc.), and residual value.

The residual is often the confusing part of a lease. The residual is the amount owed on the equipment at the end of the lease. Generally, the lessee may purchase the equipment for the residual value. The lease will often be designed so the residual is equal to the expected appraised value of the machinery at the end of the lease. The periodic lease payments will reflect the amount of the equipment "used up" during the lease term. Therefore, additional costs associated with excessive wear (hours, miles, etc.) or abuses over and above those designated in the base lease are usually quite expensive. Of course, the residual and the lease payments reflect a lease factor or discount rate. This discount rate may or may not be consistent with the interest rate of a purchase. If the desire is to purchase the equipment after the lease period, then the lessee may try to negotiate a lower residual as a result of higher payments.

Depending on an individual's tax situation, this may be an attractive option; however, the tax man will not allow tax credits for leases if "up front" consideration is given to purchasing.

When an asset is leased, the lessee loses the tax benefits of depreciation and interest associated with purchasing. However, the real estate developer can still deduct the full amount of the lease payment from taxable income as an operating expense. Determining which alternative provides the greater tax benefit is where the decision becomes most complicated. As a precaution, be sure to consult your accountant before signing a lease. There are a variety of leases, and many ways to interpret them for tax purposes. Most tax benefits associated with leasing and purchasing occur in the future. Therefore, the net cost of each alternative should be analyzed in terms of present dollars. Net present value (NPV) techniques can be used to compare the two options. In other words, the question of whether to lease or borrow can be answered by comparing the present values of the net cash outflows of lease payments and loan payments. In a lease versus purchase decision, the option with the lowest net present value of expense should be chosen.

Getaway Real estate developers pay corporate tax at the rate of 40%. They need to purchase construction equipment to expand their business given they are still a small start up. Getaway employs the Modified Accelerated Cost Recovery System (MARCS) 150% declining balance method to compute depreciation. The construction equipments costs $1,250,000 and have a life of seven years. Getaway could either borrow and buy the equipments or lease them. Since insurance, taxes, fees and normal maintenance costs apply whether the equipment is leased or purchased, this are ignored in the analysis.

For this option, the underlying assumption is that Getaway will borrow the funds from a financial institution. The interest rate applicable is 8.75% and the financial institution requires a down payment of 25% to finance the deal. The repayment period will be for the life of the equipment-seven (7) years. Given that interest is a tax-deductable expense, it is necessary to calculate the annual interest that accrues on the borrowed money. Thus the yearly loan payment is calculated on the basis of equal loan and principal payments.

Getaway can get a lease contract for an annual payment of $208,440. This yearly payment was derived from a lease factor of 0.16675 provided by the lessor. Additionally, the terms put the lease time frame to be seven (7) years with a ten (10) percent residual at the end of the lease.

Including the down payment in the cash outflows for each loan scenario, total outlay is $1,578,120 and $1,605,470. This establishes the purchase option with the lowest cash outlay. The lease will have seven (7) payments of $208,440. Typically, the first payment is due at signing, which is assumed in this example. Also, as mentioned earlier, the lease includes a residual ($1,250,000) which is 10 percent of the entire principal of $1,250,000. Because center-pivots are used in this discussion, assume that the farmer will pay the residual and thus own the pivot at the end of the lease. Again, paying the residual is optional. If the farmer decided not to pay this, the lessor would retain ownership of the center-pivot. Thus, with the residual payment included, total cash outlay for the lease is $1,584,080.

Given the analysis, it would seem obvious that the lease would be preferable to a fully amortized loan and only $5,960 less preferable than a loan with equal principal payments. However, the final decision should be made using the net present value approach.

Net Present Value of Loan Payments

In NPV of Purchase with Equal Principal Payments table and NPV of Purchase with Equal Payments, column 2 gives the annual loan repayment from which the tax benefit of interest and depreciation should be deducted. The tax benefit, as shown in column 6, is calculated by multiplying the interest and depreciation expenses by the tax rate of 46.6 percent. By subtracting the tax benefit from the annual loan repayment, the loan repayment after tax is shown in column 7. In column 9, the present value of loan repayments has been determined, using the present value interest factor of 5 percent, to obtain a total value of $784,660 for a loan with equal principal payments and $783,852 for a loan with equal payments. As stated earlier, the decision process is:

1. If NPV lease > NPV purchase, borrow and buy the equipment.
2. If NPV lease < NPV purchase, lease the equipment.

Because the present value of the purchase expenditure $784,660 or $783,852 is lower than $793,248 (lease), the purchase option is more economical. XYZ Farms could save as much as $940 in current dollars by purchasing rather than leasing the pivots ($793,248-$783,852=$9,396).

Obviously, $9,396 is not a significant savings for this level of investment. However, this analysis has exposed some points for consideration. For example, it is easy to say that the cash expense of the lease option is $2,139 less than a fully amortized loan ($1,605,470-$1,584,080 = $21,390, Column 2 in Tables 1 & 3). One could also say it would be $596 less expensive to structure a loan with equal principal payments ($1,584,080-$1,578,120 = $5,960).

However, simply looking at the cash outlay for each alternative is only scratching the surface. Consideration must be given to the tax benefits of both leasing and purchasing. In the example, purchasing proved to be the best choice over leasing, no matter how the loan payments were structured

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