Tips on Choosing to Lease or Buy

What is a city without a city hall or a county without a courthouse- These buildings are the icons of the local body politic; it is sometimes the buildings themselves that define the localities. They are an American tradition, symbols of representative democracy located downtown, often on Main Street. It is no longer clear, however, that building a city hall or courthouse always makes financial sense, particularly in times of fiscal uncertainty. Renting might be a more efficient move for many, local governments.

Over the last decade, localities have undergone a transformation of remarkable proportions. The term "reinventing government," now a cliche, describes a rigorous, even radical improvement approach that critically examines, rethinks, and redesigns financial and operational processes to improve efficiency and services and to lower costs. Under conditions of such rigor, even the city hall or the courthouse must come under scrutiny.

This reinvention trend, of course, was born of necessity: as funding for local governments increasingly has become uncertain, managers have developing five-year forecasts and worst-case-scenario business plans. In short, local governments have become more business-like as they make financial, operational, and investment decisions.

A simple lease- versus -buy decision is probably, not an option for new communities that include in their building plans a jail or council chamber or other facilities that are uniquely local in their functions. One rarely sees a prison up for rent. But often, such specialized facilities do not need to be sited on prime downtown real estate or located near other community activities.

The administrative office portions of city hall, on the other hand, are particularly, fungible. The customer service counter or the finance, administrative, engineering, planning, and zoning offices - these spaces are generic in nature and easily can be located in a variety of building types, whether local office complexes or converted houses. They also represent service functions most visited by residents and thus require a central location. Given the available supply of such office stock, this portion of city hall usually can be subjected fruitfully to a lease- versus -buy-buy analysis.

Of course, thousands of local governments already have made largely irreversible decisions to build their buildings, and most of these build decisions were made in a simpler era. Indeed, for the many new cities incorporating annually (20 in California during the period 1989 to 1994), the governing body's decision to build city hall might follow the same approach that probably, guided most such decisions in the past: we want a city hall; every other city in the country has a hall; we have the money in the bank (or the power to tax); so let's call the architect.

Net Present Value:

Combine the new, business sense that guides the modern manager with a public that is increasingly aware of how local governments spend tax revenues, however, and this approach becomes grossly, insufficient. Today, the investment decision must be treated as businesses treat their investment decisions. Thus, for public managers facing such decisions, two key questions immediately arise: How would a business, facing uncertainty over future revenue and expense projections, decide whether to invest in a new headquarters or factory- And does this approach work for local governments, or do different rules and circumstances apply?

Business school students are taught a relatively straightforward, three-step approach to evaluating investment decisions. First, calculate the present value of the stream of revenues that the factory will generate. Second, calculate the present value of the stream of expenditures required to build the factory. Third, subtract the first from the second, and - voila! - If the net present value (NPV) is greater than zero, then go ahead and call the architect. In real life, the analyst likely would compare the NPVs of competing projects - including the alternative of leasing instead of buying - and recommend the project with the lowest net long-term cost.

Unlike with a factory, however, a number of special issues arise when calculating the NPV for a city, hall. For instance, because local governments rarely go out of business or disincorporate, the question arises of the expected life of the building. Should it be 20 years, 30 years, or 50 years- And what annual percentage rate should be used to inflate or "discount" the cash flows over time- The choice of this discount rate is particularly important because a lower discount rate will favor projects with larger up-front expenditures (i.e., construction), while a higher discount rate will favor investments that require little cash down (i.e., renting).

Classically, economists have suggested that the discount rate should be equal to the interest rate at which the investor can borrow money. For instance, Edith Stokey and Richard Zeckhauser, in their seminal a Primer for Policy Analysis, write:
What about discount rates and municipal governments- ... The flow of costs and benefits from a proposed use of funds should be discounted at the opportunity cost of the funds.

Because local governments can borrow at tax-free rates that often are lower than the interest rates available to private firms, they currently should choose discount rates below 10 percent. These low rates suggest that local governments, compared with private businesses, will more often favor proposals to build rather than to lease.

Modified NPV:

Almost everywhere public managers currently are using the NPV approach discussed above to seek investments that give them the lowest long-term net cost. A number of economists, however, have begun to question NPV's ability, to circumscribe investment decisions accurately, particularly decisions made during periods of uncertainty.

Led by Princeton's Avanash Dixit and MIT's Robert Pindyck, these economists have proposed that investment opportunities should be thought of as options, that is, as rights but not obligations to take some future action. Whereas the NPV approach assumes that investment decisions are now-or-never propositions, Dixit and Pindyck suggest that this approach simply does not describe the world in which businesses - or by extension, local governments - operate.

In fact, new communities facing office space decisions have a much broader, even a virtually infinite range of options available to them, including:

- Build the traditional city hall or courthouse now, with council chambers, jail, emergency operating centers, etc.
- Sale the money now and build later, when the market environment is more favorable.
- Build now, but build a generic building that can be sold later if operating expenses become overwhelming or if the local government has to downsize.
- Build a large, generic building now, and sublease nonmunicipal space to tenants.
- Build a generic building later, when cash flows are more stable.
- Rent forever.

According to Dixit and Pindyck, when a local government chooses to build rather than to lease, it effectively gives lip its option of waiting for new information that might affect decision makers' thinking about the desirability or timing of the investment. Thus, the simple NPV rule must be modified. Instead of being merely, positive, the expected savings generated by the building must exceed the cost of the project by an amount equal to the value of keeping the option alive. That is, the value of having the option to build later is worth something and should be acknowledged in the NPV calculations.

Value Options:

Common sense suggests that the greater the uncertainty about the economic or political environment, the greater will be the value of the options. Simply, put, if a locality exists in an uncertain economic environment, then its decision makers should value more highly the option to wait and keep the opportunity alive. And because now, more than ever before, localities do indeed operate in an atmosphere of financial uncertainty the "options approach" suggests that they should factor this uncertainty, into their decisions about building city halls or country courthouses.

The same suggestion holds true for communities in high-growth regions and communities with such rapidly changing indices as demographics or tax structures. Likewise, if a local government can identify fluid situations that might cause it to rethink a go-ahead decision (e.g., a potential reduction in sales tax receipts due to recession, a forecasted decline in property taxes, or anticipated cuts in funding received from state agencies), and then the option to wait and avoid these eventualities should be considered seriously and valued explicitly.

The Decision:

Each city or county must incorporate a multitude of financial and political variables into its decision, and there will, of course, be circumstances in which a locality has little choice other than to build. One thinks immediately of those places that must incorporate special facilities (jail, council chambers, or emergency operating center) that are not otherwise available on the local rental market or cannot be located remotely. The decision to construct the general offices portion of a building, however, ultimately reduces a local government's flexibility and should therefore, whenever possible, be considered separately. The go-ahead decision for such facilities should be made more hesitantly and subjected to stiffer hurdles than simply that of the cost of capital - particularly during times of financial or political upheaval.

Lafayette's Approach:

The city of Lafayette, California, has been wrestling with the question of whether to build or rent city offices for many of its 26 years. The city's staff has occupied rented space since incorporation. After rental costs had increased nearly fivefold in just over 10 years, Lafayette's city council directed staff to prepare a lease- versus -buy analysis using calculations based on net present value (NPV).

The staff analysis assumed a 30-year building life and indicated that when the discount rate was assumed to be 7 percent or below, it made financial sense to build or purchase the building. When the discount rate was assumed to be higher than 7 percent, however, the analysis suggested that the city should continue to rent space. Because the city's cost of capital is currently about 6 percent, the NPV analysis Suggested, by, however thin a margin, that Lafayette should build its city hall.

Given the uncertain climate in which Lafayette operates (i.e., flat sales tax growth, threats from the state to reduce funding to cities, a virtual absence of new residential development, and continued vacancies on key downtown parcels), the council ultimately. Decided that it valued the option of waiting for a better option) to come along. Specifically, councilmember's remarked that "now is not the right time" and that "it sends the wrong signal during this period of uncertainty."

Councilmember Don Tatzin may have summed it tip best when he said, "In order for me to vote to build, the NPV analysis has to indicate a clear win for the city. Otherwise, I'm inclined to wait for other options to unfold. And as it currently stands, this is not a big win."