Eric Von Berg - Newmark Realty Capital - 595 Market Street, Suite 2550, San Francisco, CA 94105 - for loan quote: 415 956 9922

December 22, 2010

A wind blows against rental property.

Facebook is rumored to be trying to buy Sun Microsystems' 2.5 million square foot campus in East Menlo Park from Oracle. But the burning question among Bay Area commercial real estate circles is, why are companies building and buying campuses, instead of leasing some of the 40 million square feet of vacant space in Silicon Valley, even at historically attractive rental rates?
If you were to ask one of these campus builders or buyers, you might hear two answers, the business manager’s answer and the finance department’s answer.
Business Manager's more than ever, the lifeblood of high-tech is attracting young talent that will create your next product, service or killer app. The 20 and 30-somethings do not want the suburban experience that was so comfortable for the baby-boom generation. No, the gold standard today is to grow your company in downtown Palo Alto with its youthful energy, restaurants, shopping and clubs. If you are too big for downtown Palo Alto, a company can build a campus to create its own amenity-rich experience, ala the Google campus in Mountain View.
Financial Manager's answer... the lease versus own scenario is going through a radical shift – making ownership more attractive.

Lease versus own going through radical shift?

Two fundamentals are changing. First, interest rates are so low that they are distorting the market. Companies can finance a purchase of a building with cash, (which is earning below 1% at the bank), debt (which is amazingly cheap; in September Microsoft sold 5-year bonds at 1.625%.) or equity (Facebook has a 165 P/E ratio = equals a cost of capital of 0.6%. Apple, Google, eBay have P/E ratios in the low to mid 20’s; still a relatively cheap 4% to 5% cost of equity capital.).
Even during these distressed times, no landlord will willingly accept a return of 2% to 5% for their office or R&D building. So owning is cheaper.
Second, The FASB and the IASB are moving to eliminate operating lease accounting entirely. And (at the risk of stating the obvious) if all leases are treated as capital leases then one of the main reasons for leasing versus buying disappears. The rule change also requires all probable rental increases for the base term and likely extension options be brought forward using straight-line accounting. Under the new rule, occupancy charges will be significantly more than the rent actually paid in the early years of a lease. So owning will look cheaper still, once this rule takes effect.
This accounting change would be retroactive to all leases. So, even though the elimination of operating leases is not yet required, companies should make decisions today as if this rule change is in effect. See the attached slide set from Deloitte explaining this pending change to FASB 13.

In a nutshell, the model may be changing from build-to-lease to build-to-sell; we'll watch how this plays out..