Real Estate and Capital Structure Decisions – Lease-Versus-Buy Analysis
Table of Contents
I. Introduction 3
Overview 3
The Company 3
Situational Analysis 3
II. Case Analysis 3
Considerations 3
Purchasing 4
Recommendation 5
III. Summary & Conclusions 5
IV. References 5
V. Appendix 6
I. Introduction
Overview
This case provides real estate market data for the analysis of an office lease-or-buy decision. The case demonstrates what is known as the “leasing puzzle” – the answer simply being that the two forms of financing are not cost equivalent in the presence of capital market imperfections, despite both being credit forms. The case presents two opposing anecdotes: one about a trading company that bought its office and profited hugely from this decision as the market and capital values move upwards, but then faced huge losses as the market declined; and another from a comparable trading company leasing office space, and applying its capital to grow the trading business without diversion.
The Company
Sunny Trading Company Limited is a Hong Kong based company dealing in toy trading. It rented “Grade A” office space in the Wanchai district. The office space was a gross floor area of 250 m2 with a conference room, reception area, an open space with partitions for staff, a computer server room, and a kitchen area. In 2002, the company’s lease was up for renewal. The rent was set to increase by 10 percent. An attempt to negotiate a lower rent failed, thereby, making Sunny Trading Co. consider the option of buying office space. Which option would benefit Sunny Trading Co: continue the lease or buy office space?
Situational Analysis
The anecdote presented in this case illustrates why trading companies should not take the opportunity to capitalize on a buoyant real estate market. The argument is that shareholders do not need trading companies to invest in properties for them since they can do this through their own investment portfolio activities. In principle, there is no simple answer, but the analysis provides ample
I. Introduction 3
Overview 3
The Company 3
Situational Analysis 3
II. Case Analysis 3
Considerations 3
Purchasing 4
Recommendation 5
III. Summary & Conclusions 5
IV. References 5
V. Appendix 6
I. Introduction
Overview
This case provides real estate market data for the analysis of an office lease-or-buy decision. The case demonstrates what is known as the “leasing puzzle” – the answer simply being that the two forms of financing are not cost equivalent in the presence of capital market imperfections, despite both being credit forms. The case presents two opposing anecdotes: one about a trading company that bought its office and profited hugely from this decision as the market and capital values move upwards, but then faced huge losses as the market declined; and another from a comparable trading company leasing office space, and applying its capital to grow the trading business without diversion.
The Company
Sunny Trading Company Limited is a Hong Kong based company dealing in toy trading. It rented “Grade A” office space in the Wanchai district. The office space was a gross floor area of 250 m2 with a conference room, reception area, an open space with partitions for staff, a computer server room, and a kitchen area. In 2002, the company’s lease was up for renewal. The rent was set to increase by 10 percent. An attempt to negotiate a lower rent failed, thereby, making Sunny Trading Co. consider the option of buying office space. Which option would benefit Sunny Trading Co: continue the lease or buy office space?
Situational Analysis
The anecdote presented in this case illustrates why trading companies should not take the opportunity to capitalize on a buoyant real estate market. The argument is that shareholders do not need trading companies to invest in properties for them since they can do this through their own investment portfolio activities. In principle, there is no simple answer, but the analysis provides ample
References: Pretorious, Frederick and Ho, Mary. Real Estate and Capital Structure Decisions – Lease-versus-Buy Analysis. The University of Hong Kong: Centre for Asian Business Cases, HKU253, 2003. Ross, Stephen. Westerfield, Randolph. And Jordan, Bradford. Essentials of Corporate Finance. Eighth Edition Irwin, 1996 V. Appendix For calculations, please refer to the Microsoft Excel spreadsheet and tables in the following pages.