The valuation of a business is influenced by how we treat the real estate component. This is especially relevant for capital-intensive businesses, where the Sales-to-Asset ratio tends to be relatively stable. As a result, when forecasting sales, it’s also possible to estimate the level of employed assets, which in turn—depending on the return on capital—allows for a better view of expected cash flows.
But imagine two identical businesses that differ only in how they access the real estate they need: one rents it, the other owns it. Two wine store chains, two multi-campus universities, or even two galvanized steel frame manufacturers…
In the example below, one business owns the land and buildings, while the other simply leases them. Due solely to this difference, Business B’s annual return on capital is 3% higher (which increases its valuation). However, B will have a lower EBIT due to rental expenses (which decreases its valuation).
Clearly, there will be a difference in valuations (often in favor of A, although the direction depends on the case). But is this difference “real”?
Is the choice to buy or lease real estate an investment decision or a strategic one? If it’s merely an investment decision, then management might change its approach over time depending on interest rates, cap rates, or even tax policy. This would make the Sales-to-Asset ratio less stable and complicate both company comparisons and long-term forecasts.
To address this issue, accounting standards changed in 2019, and companies are now required to bring leased real estate onto their balance sheets, dividing rent expenses into interest and depreciation costs. This created some structure around the problem, but it still remains—since the value of real estate on the balance sheet depends on the length of the lease agreement.
Sometimes the solution is to separate the real estate from the core business and value it independently. But this isn’t always the right approach.
One argument in favor of separation is that, unlike other specialized assets, real estate has a liquid and efficient market. It’s relatively easy to assess both absolute value and capitalization rates based on market transactions.
The counterargument is that, in some cases, real estate has strategic importance. For example, a tire manufacturer’s warehouses might be located close to automobile plants, giving the company a competitive edge and making that real estate uniquely valuable. In such cases, the asset is more specific and less aligned with the general market.