Journal of Corporate Real Estate Volume 7 Number 1Capturing hidden value foryour shareholdersMartin B. TrundleReceived (in...
Capturing hidden value for your shareholders                             £4bn4 that could have been reflected in           ...
Trundle         Operating assets             Claims on operating               Enterprise value           Figure 1 Creatin...
Capturing hidden value for your shareholders                             terprise value and then to look at the role      ...
Trundle          Enterprise value               Enterprise value              Enterprise value          Figure 2          ...
Capturing hidden value for your shareholders                             what the property market has to offer12          ...
Trundleation of earnings as they have little impact   and as the level of debt increases the firm’son shareholder value as ...
Capturing hidden value for your shareholders                             the business, the quality of management,       an...
Trundle                                                                                                Figure 3 A CRE     ...
Capturing hidden value for your shareholders                             some metrics in place that measure the          d...
Trundlefinancial solutions. Typical issues that will      ing less space may allow the firm toneed to be dealt with include:...
Capturing hidden value for your shareholders                             against its objectives and all the firm’s         ...
Trundle• Sign an institutional lease. These are              leaseback — how should the firm ap-  generally long and, altho...
Capturing hidden value for your shareholders                             Table 1: Pros and cons of sales and leasebacks   ...
Trundlebusiness and generate bigger returns than       can be commercially opaque; and, as thekeeping them invested in pro...
Capturing hidden value for your shareholders                             present value of their CRE obligations,          ...
Trundle       ‘Enhancing Corporate Value through                valuation uncertainty, hidden       Property Re-engineerin...
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20111018 jcre article jan 2005

  1. 1. Journal of Corporate Real Estate Volume 7 Number 1Capturing hidden value foryour shareholdersMartin B. TrundleReceived (in revised form): 28th September, 2004Donaldsons, 48 Warwick Street, London W1B 5NL, UK;Tel: 44 (0)20 7534 5000; Fax: 44 (0)20 7434 0045;e-mail: martin.trundle@donaldsons.co.ukMartin Trundle is Partner at Donaldsons where mance measurement, finance decision,he is responsible for advising occupiers on the lease versus buy, supply side.costs and benefits of managing their real estateportfolios. Martin also advises investors on howthey can add value by understanding occupiers BACKGROUNDand providing them with business driven solu- Since the publication of the first edition oftions. Prior to this he was an associate director at the Journal of Corporate Real Estate in 1998Jonathan Edwards Consulting, which he joined in the UK stock market has gone from1993 after graduating from City University Busi- ‘boom to bust’ as a result of investorness School with a first class honours degree speculation during the dot.com bubble.in Property Valuation and Finance; in 1996 he Over the same period, corporate realqualified as a Chartered Surveyor and in 2003/04 estate (CRE) executives were challengedhe completed the corporate finance programme to service demand by procuring spaceat the London Business School. on the back of very optimistic business growth assumptions. This was evident in the West End ofABSTRACT London during summer 2003, when itUntil recently, occupiers have ignored the finan- was reported that, of the 10 million squarecial benefits real estate can add to the value of feet that were on offer, around 50 pertheir firms. Corporate real estate (CRE) is now cent was in the hands of the occupiers1 ason the corporate agenda and CRE executives it was surplus to their requirements. Inare being challenged by shareholders and senior reality the situation was far worse; thesemanagement to employ best practice techniques figures applied only to space that wasto unlock the hidden value in the firm’s real actually on the market. Many occupiersestate portfolio. This paper offers a practical were (and still are) loath to classify emptydecision framework to allow this to happen and space as ‘surplus’, as the likely cost ofexplores the potential for them and for real disposing of it would then have to beestate investors to capture this value. The paper reflected as a provision in their accounts,is based on the author’s experience of advis- reducing their net worth.2ing occupiers and investors and his increasing If it is assumed that total occupancyknowledge of corporate finance principles. costs3 for this space in the West End average (say) £80 per square foot and that Journal of Corporate Real EstateKeywords: Shareholder value, firm the average unexpired lease term is ten Vol. 7 No. 1, 2005, pp. 55–71. Henry Stewart Publications,value, investment decision, perfor- years, that implies total occupancy costs of 1463–001X Page 55
  2. 2. Capturing hidden value for your shareholders £4bn4 that could have been reflected in them, ie greater than the relevant cost the market value of those firms, if they of capital. had not acquired this space in the first • Do not underestimate the cost of capi- place. tal, or the firm will make investments Although this is a simple statistic, it that destroy value. demonstrates that not enough thought • Do not overestimate the cost of capital, was given to the long-term implications or the firm will discard investments that of the real estate decisions that were being generate value. made in the 1990s. Today, CRE ex- • Do not worry about how the firm ecutives are being challenged by senior finances its investments; in a perfect management to undo what seemed value- capital market it does not matter, be- creating exercises. In fact, firms have so cause the financing decision does not much surplus space that, as the global affect the value of the firm. economy improves, some are suggesting • Return cash to shareholders rather than they are unlikely to acquire any additional undertake investments that do not earn space for some time to come. their cost of capital. The theme of the Journal’s first edi- tion was value creation, margin and Defining and creating demand management and the utilisation shareholder value of appropriate vehicles to deliver these Typically, shareholders want to maximise objectives.5 These issues are still highly the economic performance of the funds relevant in today’s economic climate and they invest, implying that firms also need must be embraced by the CRE com- to maximise their economic performance. munity if it is going to recapture the value The shareholders’ stake equates to the eroded during the 1990s. overall market value of the firm less the This paper explores the shareholder market value of the debt employed by the value-added process and how CRE affects firm. the value of the firm. It then volunteers To create shareholder value a firm needs a decision framework for CRE and offers to maximise the gap between its market some thoughts for the supply side (real value (enterprise value) and the book estate investors). value of the claims on its operating assets, by applying the decision rules set out above (see Figure 1).7 SHAREHOLDER VALUE-ADDED ANALYSIS How does CRE affect the book value Classic finance theory suggests that if of the firm’s operating assets? a firm wants to maximise shareholder The financial statements set out the value,6 it should: historic performance of the firm. The balance sheet records the book value of • Focus on the economic rather than the the firm’s assets, liabilities and shareholder accounting model of value to assess funds; the profit and loss account records capital investment decisions, as only the the firm’s annual income and expenditure; cash flows generated from them and and the cash-flow statement shows how their associated risk matter. the firm’s cash position has changed over • Remember that cash returns on all the year. The underlying problem is that investments need to be greater than the these statements record performance on cost of the funds required to deliver an accounting basis when shareholders arePage 56
  3. 3. Trundle Operating assets Claims on operating Enterprise value Figure 1 Creating (Book value) assets (Book value) (Market value) shareholder value Working Capital Equity Equity ` Net Fixed Assets Debt Debtprimarily interested in economic perfor- for example, the impact of revaluing as-mance. The accounting book value there- sets is not reflected in the profit andfore needs to be adjusted to determine the loss account, understating the firm’s cashfirm’s economic book value. The rationale profitability. It is also impossible to assessis that the capital base of the firm will from the firm’s financial statements thethen be more in line with the liquidation overall CRE occupancy costs, implyingvalue or replacement cost of the firm’s that the true picture may not be reflectedassets.8 in the accounts. This is a missed oppor- Typically, a firm’s balance sheet will not tunity; CRE is typically one of the largestbe complete, as it does not include all the operating costs for a firm. Finally, thefirm’s assets and liabilities and those that cash-flow statement is presented in such aare included are usually recorded on a way that it is very difficult to see exactlyhistorical-cost accounting basis rather than how much free cash flow9 the firm hasan economic basis. In terms of CRE, generated and the role CRE has played inoperating leases are recorded off balance this process.sheet, so they need to be capitalised andadded back to the accounting book value. How does CRE affect the marketIn other words, the economic capital value of a firm’s operating assets?employed increases, implying that if the The cash flow generated from the firm’sfirm’s CRE portfolio is out of line with operating assets and how a firm funds thesewhat it can afford this will hinder the assets form the common theme within thisfirm’s economic performance. paper, implying that CRE decisions need to The profit and loss account generally be viewed and made in this context. So itfalls short, as it is not comprehensive and is important first to explore the differentdoes not reflect the economic reality: approaches that determine the firm’s en- Page 57
  4. 4. Capturing hidden value for your shareholders terprise value and then to look at the role Stern Stewart & Co10 suggests that CRE has to play. those firms that understand the drivers of shareholder value and engage the Capital market valuation economic value process outperform those The capital markets value the that do not. These firms appreciate that shareholders’ stake on a daily basis; as a capital is not free and that investments rule, these valuations are about future need to earn their cost of capital to performance and the markets’ expecta- generate shareholder value. They use the tions of future performance. If it is term ‘market value added’ (MVA) to accepted that the market is efficient, define economic value and ‘economic market value will increase if ‘performance’ value added’ (EVA) to define economic is in excess of expectations and fall if rent. ‘performance’ is worse than expected. However, for CRE purposes this The value of the firm’s cash flow — approach is not that helpful, as the Approach 3 outcome changes on a daily basis and is Another approach is to think of the firm influenced by external matters. as a collection of investments, its en- terprise value being equal to the net The claims on the firm’s assets — present value of the cash flows generated Approach 1 from each of these investments. In other This is a more useful analysis, as the book words, the market value of the firm is the value of the claims on the firm’s operating present value of the expected cash flows assets equals the book value of those assets. generated from all the firm’s investments, These claims will be a mixture of debt and discounted back at a discount rate that equity; so, to maximise the value of its assets, reflects the business risk of those invest- the firm needs to maximise the market value ments and the risk associated with the of these funds. By minimising the actual cost financing mix used to acquire them. of these funds, while maximising the cash These three approaches are summarised flows the firm generates from the assets in Figure 2. For CRE purposes, valuing purchased with these funds, the firm will the free cash flow to the firm is the most maximise its enterprise value. useful, as it identifies the key drivers of value and the role CRE has to play. It Economic rent generated from the needs exploring. firm’s assets — Approach 2 ‘Economic value’ is the net present value Valuation process of the economic rent generated from the First, forecast the free cash flow to the firm’s assets. Economic rent is generated firm that can be generated over an ap- if the returns on these investments are propriate period, taking into account the greater than their cost of capital. If the likely growth prospects of the firm. Then economic value is added to the book determine a terminal value for the firm at value of the firm’s assets, it gives the the end of this forecast period and dis- overall market value of the firm. A firm count the cash flows and terminal value at that earns only its cost of capital will an appropriate cost of capital (discount not generate any economic value for its rate) to get to the intrinsic value of the shareholders. In other words, its enterprise firm. Finally, add the non-operational as- value will equal the economic book value sets, such as cash, to get to the firm’s of its assets. enterprise value.Page 58
  5. 5. Trundle Enterprise value Enterprise value Enterprise value Figure 2 (Approach 1) (Approach 2) (Approach 3) Valuation approaches to the assessment of a Book firm’s enterprise Value value operating assets Equity or NPV of capital Free cash employed flow to the firm MVA DebtFree cash flow to the firm (FCFF) property portfolio, given the direct impactFCFF is the amount of cash a firm can it will have on the extent of the FCFF.pay out to its investors after paying for all Events like using capital to buy a buildinginvestments necessary for growth. It stems or fitting out the space will also increasefrom the cash that has been generated capital expenditure and reduce FCFF. Thefrom the existing operations and the capi- higher these property costs, the lower thetal that has been invested to maintain free cash flow and (potentially) the lowerthem. It is independent of the firm’s the value of the firm, if the investment incapital structure. CRE does not allow the firm to generate There is, unfortunately, no require- economic value in the long run.ment for a firm to show this figure Another major issue within the valua-in its accounts, but it can be deduced tion is determining how the FCFF isfrom the cash-flow statement. One way is expected to grow over the period of theto take the firm’s operating profit, add analysis. Growth is a function of manyback depreciation and changes in working different variables and difficult to predict.capital and then deduct the tax on opera- From a macro point of view, understand-tions and any capital expenditure for the ing the underlying economy and theyear. industry is vital. From a micro point of In terms of deriving the FCFF some view, it is important to look at historicCRE adjustments need to be made. First, growth patterns; what the managers insidestrip out rent from the operating profit;11 the firm think; what analysts are predict-then adjust the tax calculation, as the ing; whether the firm has a competitiverental tax benefit from leasing will be lost. advantage; how much capital is beingEven though the rent paid to the landlord reinvested; and the likely returns that canis excluded, all other occupancy costs be generated from this capital.remain, implying that firms need fully to From a CRE viewpoint, understandingunderstand the real cost exposure of their growth is critical, given the nature of Page 59
  6. 6. Capturing hidden value for your shareholders what the property market has to offer12 of equity. So, in terms of CRE, there and the lead-in time to get it. This is needs to be a good match between the probably the most challenging area for average duration of all leases (as they are CRE: having too little or too much space, a fixed cost) and the firm’s business cycle. or inflexible space in terms of consuming If there is a mismatch, operational gearing or vacating it, will affect business growth will increase, driving up the cost of equity and ultimately the value of the firm. and implying that firms must finance their CRE needs with a range of different Terminal value products: a combination of long, short The terminal value is a significant part of and flexible leases. Financial gearing is a the valuation and needs to be calculated function of the level of debt within the in the year when the firm settles down to firm. The higher the debt, the greater the steady-state growth. One method is to financial risk and so the higher the return capitalise the free cash flow in that year at required by equity providers — CRE will the firm’s weighted average cost of capital affect the level of debt within the firm. (WACC), with an allowance for sus- In summary, CRE will have a direct tainable growth in the free cash flow. This impact on the extent of the firm’s cash calculation will need to reflect the long- flow, its cost of capital and ultimately its term nature and extent of the firm’s CRE enterprise value. portfolio, so it is vital to ensure there are no inefficiencies as these will increase Should CRE decisions be based upon cost, reduce the firm’s margins and reduce the impact on the firm’s cash flow or value. on its earnings? Debt providers have a prior charge on the The cost of capital firm’s assets and can use contractual In terms of valuing the FCFF and ter- agreements to protect themselves from minal value the WACC is appropriate. It transfers of wealth to the shareholders is based on the market value of the firm’s through management taking on risk- weighted average cost of debt and cost of ier investments. This suggests managers equity,13 and CRE will have a bearing on should really focus on maximising the the overall cost. market value of the firm’s equity by The cost of debt is a function of the level protecting the shareholders’ stake, as the of interest rates and the risk associated latter have only a residual claim on its with the firm paying back the debt, ie the assets. In fact this is what the shareholders level of default risk. In terms of CRE, the employ the managers to do: to maximise debt side of the WACC calculation needs the value of their stake. to include the capitalised value of all Economic performance stems from operating leases; they are classed as debt creating returns on new and existing because the lessor has a claim on the firm’s investments that are in excess of the costs assets. of capital required to deliver them. By The cost of equity is based on the extent undertaking investments that maximise of the operating and financial gearing in earnings, however, it is not immediately the firm. The higher the gearing, the obvious whether their returns are in higher the return demanded by equity excess of the cost of capital, ie are creating providers. Operational gearing is a func- value for the shareholders. tion of the fixed costs in the firm: the So, assuming the objective is to maximise higher the fixed costs, the higher the cost shareholder value why focus on the gener-Page 60
  7. 7. Trundleation of earnings as they have little impact and as the level of debt increases the firm’son shareholder value as it is an economic cost of equity adjusts, so that the overallconcept. Earnings are derived from ac- cost of capital remains constant. Thuscounting records that do not reflect the only the real cash flows the firm generatesreality, earnings can be manipulated as firms from its assets and their associated businesscan use different accounting methods to risk actually drive value, suggesting that inrecord performance, earnings ignore the a perfect market it really does not matterfuture capital investment (working capital whether a firm uses debt or equity toand capital expenditure) required to main- finance its activities.tain a firm’s cash flow and earnings do not It could therefore be argued that it doestake into account the impact of the time not matter whether a firm owns (equity)value of money. or leases (debt) its CRE, as only the However, in practice occupiers do base absolute quantum of space, total cost oftheir property decisions on their earnings using the space, productivity of the spaceimpact, as this is how senior management and associated efficiency of the portfoliotypically make their decisions. For ex- matter, not how the space is financed.ample, a firm with a large CRE portfolio In practice, however, debt (leases) givescan usually generate significant cash the firm a tax advantage but places addi-benefits by reconfiguring the portfolio, tional financial risk on it. As the level ofusing space more efficiently and disposing debt increases so does the financial risk,of surplus space. There will be upfront potentially increasing financial distress andcash costs associated with these benefits, eroding the tax benefit of the debt. Thisbut the cash returns (the savings) that can suggests that firms should strive for abe generated are usually in excess of the specific mix (ie an optimal capital struc-cost of the capital needed to release the ture) if they want to maximise the valuesavings. However, given the negative of the cash they generate. This is whyimpact these decisions have on the firm’s some firms spend a considerable amountimmediate earnings, CRE teams are loath of time managing the trade-off betweento recommend them to senior manage- the level of debt they use, their creditment even though they make good ratings and the financial flexibility theyeconomic sense.14 In other words, there is need to achieve their strategic goals.hidden value in the portfolio not reflected Recent research suggests that firms thatin the firm’s enterprise value. use leases (debt) to finance their CRE Experience also suggests that firms with needs outperform those with a largea significant freehold base are more likely freehold (equity) base,17 and firms shouldto make a major CRE decision during a aim for an optimum level of leasing toperiod of financial distress.15 However, finance their CRE requirements if theyswapping the equity (freeholds) tied up in want to add value ie increase the value ofthe estate for debt (leaseholds) may not the firm.18actually add any value.16 However, alternative research19 that has looked at a range of UK structuredIs there an appropriate debt–equity sale-and-leaseback CRE transactions sug-mix for a firm to use to finance its gests that increased firm value cannot beCRE portfolio? guaranteed simply by swapping the wayClassic corporate finance theory suggests firms finance their CRE requirements.that in a perfect market a firm’s enterprise This research also concluded that thevalue is independent of its finance mix market views the operational efficiency of Page 61
  8. 8. Capturing hidden value for your shareholders the business, the quality of management, analytical techniques that complement the the overall performance of the sector and shareholder value drivers set out above. the use the funds raised from the From a CRE viewpoint, the discounted transaction are put to as having a cash-flow technique is useful. Typically, significant role to play. In other words, though, as CRE departments and property issues that have a direct impact on the advisers are not well equipped with these cash a firm can generate are just as skills, they stand a limited chance of being important. able to demonstrate to senior management In summary, as it is not clear what where the hidden value is, even though this the appropriate mix of leaseholds and is exactly what the shareholders want them freeholds should be, occupiers must focus to do. their attention on the issues that drive A connected problem is that, as the occupancy costs and identify property property market is geared to selling solutions that have a direct impact on the finance solutions, there is a big incentive firm’s ability to maximise its cash flow. to get a deal done. Thus for the uninformed occupier these financial solu- What lessons can be learnt? tions can actually transfer more value to the financier than to the end user. • CRE is embedded within the It is vital first to work out what the shareholder value-added process be- firm has and what it is costing; identify cause it affects a firm’s economic book what it wants; monitor the portfolio; value, its cash flows, its cost of capital highlight the opportunities; and engage and ultimately its enterprise value. with senior management, before sourcing • CRE needs to be managed in a rigorous an appropriate financial solution, because and structured way in order to generate what is being financed is far more impor- shareholder value. tant than how it is being financed. As a • CRE decisions must be measured starting point, the firm should be marking against the shareholder value drivers its portfolio to market on a regular basis identified in this paper. by assessing the net present cost of all • CRE needs to be financed with the of its CRE obligations, so it can then aim of releasing additional value while manage down this cost in the context of preserving the value released from a the firm’s overall objectives. sound operational property strategy. A summary of the above points appears in Figure 3. IS THERE A SUITABLE The CRE investment decision DECISION FRAMEWORK? Typically, CRE decisions are intertwined Once again classic finance theory can with much bigger decisions within the help, as it encourages firms to think of firm, such as expansion, contraction and making two decisions — first the in- relocation or (say) a merger, acquisition or vestment and then the finance decision. consolidation exercise. Firms apply capital It suggests value can only be generated budgeting techniques to assess these deci- by making a sound investment decision, sions, so CRE decisions must be assessed rather than merely employing a smart on an identical basis. This means that it financing solution. is important to analyse and engineer a To achieve this, firms require good busi- property solution that participates in the ness and financial skills and need to utilise economics of the bigger business decisionPage 62
  9. 9. Trundle Figure 3 A CRE CRE investment decision CRE finance decision decision framework Establish clear objectives Assess finance options Record what the business has Deliver value for money Agree and analyse the options Implement a financial solution Assess what the business wants Lease (debt) versus buy (equity) analysis Deliver best value Debt finance Achieve affordability targets – Operating lease Measure performance – Finance lease – Value metrics – Hybrid eg PFI, REPS – Productivity metrics Equity finance – Operational metrics – Own – JV Maximise generation of Minimise impact on the firm’s free cash flow the firm’s cost of capitaland matches key business and real estate as it is vital that the firm works outissues such as: exactly what it wants, why it wants it, where it wants it and how long it wants• Cost it for, given the potential to destroy value• Flexibility by sourcing and then financing the wrong• Image real estate solution. Unfortunately, the• Location natural instinct is to negotiate the best• Layout ‘property’ deal without rigorously assess-• Duration. ing the need and the potential of the investment that is about to be financed;The aim here is to search for a real estate hence the excessive amount of occupiersolution that is in line with all the firm’s surplus space on the market.objectives and affordability metrics, to There is also a real risk that any benefitsensure the real estate is adding as much derived from the finance decision couldvalue as possible by not acting as a drain be quickly eroded, if the investment deci-on the firm’s cash flow. On the surface, sion is not in line with the duration ofthis seems relatively simple, but in reality the business need. In other words, onlyit is a very interactive and sometimes when all the business issues have beenfrustrating process, given all the informa- worked through and a CRE plan articu-tion that needs to be included in the lated should the alternative finance routesanalysis. It also assumes the firm knows be progressed.exactly how much space it has, where itis and what its existing portfolio is costing Performance measurementand has appropriate performance measures So how do you know if the portfolio isin place to measure alternative solutions adding or destroying value, how well it isby. As a rule, it does not. performing and where the hidden oppor- This approach must not be sidestepped, tunities lie? This boils down to having Page 63
  10. 10. Capturing hidden value for your shareholders some metrics in place that measure the dividual investment the minimum return portfolio against the value drivers set out should be based upon the business and above — for example: finance risk of that investment. Invest- ments with a higher risk than the average • Value metrics assess how the portfolio is risk in the firm will need to generate affecting the value drivers within the returns greater than its WACC. firm: for example, identify the firm’s Various techniques can be used to CRE cost of capital and compare it to assess the best CRE investment deci- the firm’s overall cost of capital; identify sion, but as a rule discounted cash- all the CRE occupancy costs as a per- flow techniques are best, as they take centage of the free cash flow the firm into account the time value of money, generates; capitalise the value of the risk and associated cash flows: that is, CRE’s debt and equity and measure it they encourage the firm to look at the against the firm’s enterprise value; and, shareholder value drivers. finally, understand the CRE element within the firm’s credit rating, if it has Some FAQs one. Occupiers are regularly confronted by • Productivity metrics assess how efficiently questions like: the firm is using its real estate: for example, identify total cash occupancy • The firm has a lease expiry — or has costs and compare them to the firm’s outgrown its existing facility — and turnover and operating profit. wants to assess the potential to relocate • Operational metrics assess what is actually the business and the value that could be driving the real cost of CRE and where added. the inefficiencies could lie: for example, • The firm has too much space; if it total occupancy cost per square foot, consolidated the portfolio, how much total occupancy cost per person, square value would this add? feet per person, surplus space to total • The firm wants to dispose of its surplus space and net present cost of surplus space; how does it get best value? space. • The firm’s business is constantly chang- ing and it wants to explore the need Firms that take the time to undertake for some occupational flexibility; how regular value, productivity and operational much does it need and how much can audits will have a much better under- it afford to pay for it? standing of how well their portfolios are performing and stand a far better chance These are CRE investment decisions, and of capturing the hidden value within the process set out above is ideal for them. dealing with them. Assessing the CRE investment decision An example — Relocating the business Investments must earn a return that is If the firm needs to relocate, the key to greater than an acceptable rate of return success is in identifying the most ap- given their underlying risk. So, if the propriate solution in terms of costs, affor- whole firm is being valued, the mini- dability, risk and best fit. The correct mum return should be based upon the solution will be one driven by the needs business and financial risk in the firm, of the business, not by the property ie the WACC. When assessing an in- market: that is, not by the providers ofPage 64
  11. 11. Trundlefinancial solutions. Typical issues that will ing less space may allow the firm toneed to be dealt with include: finance a more prestigious location. Generic modelling assumptions are• What are the firm’s objectives? made to evaluate the total occupancy cost• What are the constraints? of each option and measured against the• What are the options? base case. Occupancy costs typically cover• Which option provides best economic rent, rates, service charges, all other value? running costs, capital expenditure and• What are the financial and operational relocation costs. These can also be risks? benchmarked against external indices. A• What about the qualitative issues? range of rental and cost growth assumptions are identified, to enable moreFirst, it is important fully to understand accurate analysis of the likely exposurethe drivers behind the move and map with each location.out the objectives and constraints. An appropriate discount rate (usuallySecondly, agree the options to be the firm’s WACC) is selected and a dis-analysed, in order to identify the one that counted cash flow is completed for all thebest meets these objectives. A methodical options, to identify which one gives thebriefing process should be undertaken to best economic value. Comparison of theensure that alternative ways of working actual capital costs incurred for each op-and layout options are explored, to tion and of the ongoing flow of revenuecapture opportunities and improve ef- costs provides further important manage-ficiency and effectiveness. All relevant ment information.data (including exit costs) should be It may also be important to accountcollated; where assumptions on future for the potential movement in some ofcosts are required, these need to be fully the variables over the duration of thesupported by market research and in- analysis. Market-based assumptions suchdustry standards. as estimated rental values, rental voids, A financial model should then be used rent-free periods and rental growth willto analyse all options to find the best change. Monte Carlo simulation can beeconomic solution, the key decision tool used here to provide an analysis of eachat this stage. It could be to ‘do noth- option in greater depth, in order to iden-ing’. Accounting analysis to determine the tify which option has the greatest risk, asprofit and loss impact, and a risk assess- the cheapest location may be exposedment for each option can also be under- to more risk, ie higher future rentaltaken. The model will demonstrate where growth.savings can be made, the cost associated The results are then combined with thewith delivering these savings and how qualitative review of each option andchanges in the information available affect shared with management, to allow thethe project’s affordability. It will also iden- latter to make an informed decision. Oncetify where the sensitivities lie and allow a decision has been made (which can takethe firm to identify what needs to be done a considerable period of time) the firmto make each option work. will be in pole position to approach the For example, the analysis will allow the property market to procure the best finan-firm to identify what it can afford and cial solution. By mapping out what itwhat the trade-off could be — procuring wants, it will be able to measure thea smart workplace solution and consum- impact and cost of each financial solution Page 65
  12. 12. Capturing hidden value for your shareholders against its objectives and all the firm’s operational purposes are more straightfor- requirements. At that stage, the firm may ward: they are treated as an asset and actually find that an expensive solution recorded in the balance sheet at cost, the meets the business need better. building element being depreciated over an appropriate period. However, they can The CRE finance decision be funded by either debt or equity, so The aim is to employ a method of finance they also affect the nature of the firm’s that best matches all the firm’s objectives. capital structure, its risk and (potentially) In terms of CRE, this boils down to its value. either leasing or buying real estate. In terms of the actual cost of each route, it is important to look at the Lease versus buy decision underlying occupancy costs, associated tax Leases come in two forms — operating or benefits, risk and the transaction and finance lease — and SSAP 21 (Statement information costs of each option and if of Standard Accounting Practice) states possible to appraise all the potential that an operating lease is anything other financing routes.22 However, there may than a finance lease. be situations where cost is not the driving With an operating lease, the lessee ac- factor. For example, ownership may be quires use of the asset for a period less than best if the asset is so specialised it is of its economic life, and the present value of strategic importance to the firm. the rent due should be less than 90 per cent of the asset’s fair value. With a finance lease, Some typical finance routes the lessee acquires all the benefits of using the asset for a greater part of its life and takes • Buy land and build a facility. This is a on substantially all of the risks associated high risk, as typically it is not the firm’s with ownership. In other words, a finance core business. Also the purchase price lease is similar to ownership, but legal title for the land typically reflects the nature remains with the lessor. In accounting of the requirement rather than market terms, all finance leases are recorded on the value: ie the occupier ends up paying an balance sheet and all operating leases are off over-inflated price. Finally, the occupier balance sheet.20 needs to ensure that it builds a facility Irrespective of how a lease is recorded where the specification is in line with in the firm’s financial statements, however, what the market would typically spend; shareholders view all leases as debt, as they otherwise, on exit it is likely to recoup are a prior claim on the firm’s assets. a poor return on the capital outlay. If it In fact, a recent study by the Cor- tried to sublet surplus space at a market poration of London21 highlighted research rent, the rental return on capital in- that suggested shareholders take all leases vested would also be very poor. into account when assessing their required • Buy a completed building. As a rule, returns. In any event, the credit rating property owners are reluctant to sell; if houses include off-balance sheet finance they do, it is usually at a premium and when determining their ratings, implying the price may not truly reflect the that there may be no financial benefit underlying fundamentals in the market. for firms that strive for off-balance sheet Once again it is important to weigh up transactions such as sale and leasebacks or the pros and cons of buying a facility outsourcing deals. with a specification that is out of line Freehold properties used by the firm for with the market norm.Page 66
  13. 13. Trundle• Sign an institutional lease. These are leaseback — how should the firm ap- generally long and, although they are praise this and should it accept it? getting shorter, they are typically not • The firm has a lease expiry and has very flexible. More flexible structures are been approached to take space else- available from serviced-office providers, where in return for significant upfront but as a rule these are expensive and not cash benefits — does this provide best in favourable locations, and their pricing value and is it good value for money? policy is not very transparent. The more • The firm has a break option it its lease traditional landlords will also offer break and has been offered a sum to waive it options, but they come at a price. — should this be accepted? Typically, occupiers use serviced-office • Should the firm outsource its CRE space to get their business up and running requirements? or to complement the overall portfolio; or feel they should have a break option These are all CRE finance decisions, but but in practice never use it, as it falls in at the firm can deal with them only if it an inappropriate time. has gone through the CRE investment• Undertake a sale and leaseback. These process. It will then be able to measure come in different forms, from the tradi- the real benefit of what is on offer and tional sale and leaseback on a single demonstrate to senior management that asset to specific structured deals on a the opportunity makes good economic bundle of assets or the more complex sense. CRE outsourcing transactions that fold For example, it is pointless accepting a in associated property services. Typi- lump sum to waive a break option if the cally, the driver is that the firm views building is unlikely to fit the business them as an alternative method of raising need for the length of the new lease, as funds to reinvest, or that the firm is the exit cost will eventually erode the in financial difficulty and needs the upfront cash benefit. In other words, any cash. In other words, it is treated as perceived financial benefit can be eroded a purely financial decision when in fact by making a poor investment decision. It it should be seen as an opportunity to is also dangerous to compare one financial match the CRE to the business need. solution with another — they all need to Some interesting pros and cons are set be compared to the firm’s existing situa- out in Table 1. tion and its overall objectives. So, as this paper has questioned whetherAssessing the CRE finance decision the method of finance actually adds anyOnce again, the discounted cash-flow tech- value, firms should go back to first prin-nique is best. It is important to note that, as ciples and appraise these opportunities asthis is a financing decision, it should be if value can be released only by making atreated as a lease versus borrow (buy) sound investment CRE decision.decision and the firm’s after-tax cost of debtis the appropriate discount rate to use. An example — A sale and leaseback An investor offers to buy an occupier’sFAQs freehold premises in return for signingOccupiers are regularly faced with such a lease — as a rule, the longer the leaseopportunities as: and the greater the certainty of the income stream, the higher will be the• A property investor is offering a sale and sum offered by the investor. On the Page 67
  14. 14. Capturing hidden value for your shareholders Table 1: Pros and cons of sales and leasebacks Pros Cons • They allow the firm to raise 100 per cent of the • They actually displace the firm’s debt capacity, value of the property, rather than be based on a and traditional sale and leasebacks are typically loan-to-value equation. more expensive than raising asset-backed debt. • In accounting terms the operating lease is off- • They leave the occupier exposed, if it wants to balance sheet, improving accounting measures of exit prior to expiry of the lease or to stay beyond return (eg ROCE). the renewal date. • The market value of owned CRE may not be • There is a risk that eventually transactions of this truly reflected in the market value of the firm’s type will have to be recorded on the balance equity;23 S&Ls provide an opportunity to take sheet and so the perceived accounting benefit will advantage of this pricing anomaly. be lost. • Evidence from the USA suggests that these • Evidence suggests that shareholders take into transactions can increase the market value of account off-balance sheet finance when assessing the firm; they identify the true CRE costs, their equity returns, so the off-balance sheet which historically firms have not monitored, so argument has little weight.25 In any event, credit shareholders treat them as a positive step in trying rating houses include them in calculating their to create value.24 ratings. • If the property meets the firm’s business objec- • Outsourcing leases requires occupiers to have a tives and recycling generates a return that is strong covenant and be prepared to commit to a greater than the return generated from the owned 20-30-year contract. They are also by definition property and greater than underlying cost of the part of a very long and expensive signing-on firm’s capital, it is a prudent exercise. Doing it process requiring the firm to commit significant increases the real cash flow of the firm and resources to ensure it gets what it wants. consequently its value. • The capital raised must be invested in value- creating investments: ie the returns are in excess of the associated cost of capital. surface this can be very attractive, if the if the leaseback does not match the occupier needs some cash or wants to business need there will be hidden costs reinvest the proceeds in the business and (such as exit costs prior to the lease sees it as a cheap method of raising expiry) that need to be factored in and finance. However, as this type of transac- appraised. Also, if the rent is above tion is similar to the firm actually raising market26 the occupier will be exposed if debt secured on the freehold premises, it wants to dispose of some or all of the it should be analysed as such and all the space at a later date. hidden costs included. After the analysis has taken place the The occupier must be fully aware of real cost of the sale and leaseback can be the terms of the leaseback and ask compared with retention of the premises whether it fits the need. Does the business on a discounted cash-flow basis and bor- want some financial flexibility? What rowing the cash. What may have looked about having several leases (short and like cheap finance may actually be very long)? What about the real occupancy expensive and inflexible and not actually costs over the length of the lease? In other give the business what it wants. words, stand back and go through the Another argument often floated in investment process; on the surface the favour of this method of financing is that transaction may look very attractive, but the funds raised can be reinvested in thePage 68
  15. 15. Trundlebusiness and generate bigger returns than can be commercially opaque; and, as thekeeping them invested in property. This, contract unfolds, they can actually behowever, ignores the extent of the risk quite restrictive and not very user-friendlyassociated with the potential business when trying to manage an occupier’sinvestment; as property is a low-risk evolving business needs.investment, lower returns are required to Experience also suggests that occupiersadd value. actually require financial solutions that relieve them of having to deal with a non-core activity and that when theyOPPORTUNITIES FOR THE follow the principles set out in this paperSUPPLY SIDE (REAL ESTATE they soon appreciate that they can actuallyINVESTORS) afford to pay more for a service that betterOccupiers are becoming more aware that fits their need.their real estate can improve their perfor- So there is a significant opportunity formance, so here lies a significant oppor- the supply side, as long as it is prepared totunity for the supply side. Understand be more rigorous in its approach. Ul-what the occupier wants, satisfy demand timately, the value of a building is ain a coherent, transparent manner and function of the future cash it can generatecapture some of this hidden value yet to and the risk associated with that cash.be reflected in their portfolios, rather than Therefore, by definition, in order to max-chase the market, play the yield curve and imise this cash flow, minimise the as-hope this adds value. sociated risk and maximise value, suppliers To capture this value the supply side need to start offering occupiers moreneeds to think about offering occupiers bespoke solutions.(their clients) products that allow themto consume space more efficiently andfinance it appropriately, for example: CONCLUSIONS The underlying objective for a firm is• Offer spatially driven solutions that to maximise the market value of the match demand shareholders’ stake; CRE is embedded in• Price these solutions in a way that fits the shareholder value-added process, and the occupier’s objectives so has a significant role to play.• Manage and price the risk associated CRE executives need to appreciate that with real estate, rather than passing it on they are managing the firm’s portfolio on to the occupier behalf of the firm’s shareholders who want• Offer more flexible and transparent to maximise the economic performance financial packages of the funds they invest. So, by definition,• Offer services aimed at actually retain- shareholders want the firm to treat its ing occupiers CRE strategically, as it is an integral part• Be innovative and adapt to occupiers’ of maximising the market value of their needs stake. Firms that split their CRE appraisalNew real estate models have emerged to process into an investment and a financetry and capture these opportunities (eg decision stand a much better chance ofoutsourcing), but they can often be too capturing the hidden value in theirprescriptive; they require the occupier to portfolios and satisfying the needs ofcommit to a very long contract; they their shareholders. By understanding the Page 69
  16. 16. Capturing hidden value for your shareholders present value of their CRE obligations, Properties and Capital Markets’, Journal measuring performance on a regular basis of Corporate Real Estate, Vol. 1, No. 1, and anticipating demand, firms will ensure pp. 5–7. the portfolio is in line with what they can (6) Brealey, R. and Myers, S. (2003) (7th afford. They will also be in pole position edn) ‘Principles of Corporate Finance’ McGraw Hill; Rappaport, A. (1998) to procure the most appropriate method ‘Creating Shareholder Value: A Guide of finance for all their CRE needs and be for Managers and Investors’, Free able to demonstrate the real value they Press. have added. (7) For the outsider analyst it is very Firms that follow the theme of this difficult to determine the economic paper will also gain a significant ad- book value of a firm’s operating assets, vantage over their competitors and will be so the accounting book value is a more likely to enhance their relative per- useful proxy. formance. So they should invest time (8) Milbourn, T. (1998) ‘EVA’s Charm as a to explain their CRE strategy to their Performance Measure’, in Bickerstaffe, shareholders and the capital markets, so G. (ed) Mastering Finance’, FT Pitman any value released is reflected in the Publishing. (9) ‘Free cash flow’ is defined as the market value of the firm’s equity. amount of cash available to compensate The challenge for the supply side is to the providers of debt and equity to the gain better understanding of what the firm; it is a key driver of firm value. occupier wants and to start to offer be- (10) Stern Stewart & Co is a global business spoke financial solutions that allow the consulting firm. occupier to preserve the value released (11) In economic terms, the rental element from a sound operational CRE strategy. of any lease is classed as debt and needs In that way the supply side will also to be treated as such. The rent is capture value yet to be reflected in their classified as interest and placed ‘below portfolios. the FCFF line’, as FCFF is assessed prior to the firm’s financing needs. Martin Brandon Trundle (12) Flexible leases are now more common, but typically there is a mismatch between what occupiers want and what REFERENCES is on offer. (1) FPDSavills Central London Office (13) See Myers and Rappaport, ref. 6 above. review and outlook, summer 2003. (14) Depreciated cost of the upfront expense (2) See Accounting Standard FRS12: and fixed-asset write-offs will have a Provisions, Contingent Liabilities and negative impact on earnings in the year Contingent Assets. the decision is made, and the savings (3) Estimated rent, rates, service charge and generated in that year are unlikely to all other cash costs such as repair, erode this accounting cost. maintenance, security and utilities. This (15) In December 2001 BT outsourced its sum excludes the upfront capital cost operational real estate portfolio (owned) incurred in fitting out the space and to Telereal for a sum of £2.38bn to the associated accounting fixed-asset reduce its debt. write-off on exit. (16) Devaney, S. and Lizieri, C. (2004) ‘Sale (4) Ignoring the time value of money; and Leaseback, Asset Outsourcing and corporation tax benefits; and time to Capital Markets’, Journal of Corporate dispose of the space. Real Estate, Vol. 6, No. 2, pp. 118–132. (5) Chekijian, C. (1998) ‘Corporate (17) Land Securities Trillium (2001)Page 70
  17. 17. Trundle ‘Enhancing Corporate Value through valuation uncertainty, hidden Property Re-engineering’, in-house management costs and illiquidity: see publication. Barkham, R. and Ward, C. (1999)(18) Lasfer, M. (2003) ‘Driving Shareholder ‘Investor Sentiment and Noise Traders: Value — Corporate Real Estate — Discount to Net Asset Value in Listed Freehold versus Leasehold’, sponsored Property Companies in the UK’, Journal by Donaldsons Research. of Real Estate Research, Vol. 18, pp.(19) See ref. 16 above. 291–312. This is also the main reason(20) It is likely that a new International why a significant number of property Accounting Standard will be firms have gone private over the last introduced, requiring all leases to be three years. shown in the balance sheet. (24) Rodriguez, M. and Sirmans, C. (1996)(21) Lizieri, C., Ward, C. and Palmer, S. ‘Managing Corporate Real Estate — (2001) ‘Financial Innovations in Evidence from the Capital Markets’, Property Markets’, Market Research, Journal of Real Estate Literature, Vol. 4, Corporation of London in association pp. 13–33. with RICS Foundation. (25) Beattie, V., Goodacre, A. and(22) Schallheim, J. (1994) ‘Lease or Buy: Thompson, S. (2000) ‘Recognition Principles of Sound Decision-making’ versus Disclosure: An Investigation of Harvard Business School Press, Boston, the Impact on Equity Risk using UK MA. Operating Lease Disclosure’, Journal of(23) Capital markets apply a large discount Business Finance and Accounting, Vol. 27, to those property investment firms that Nos. 9–10, November–December, pp. hold assets within a corporate structure; 1185–1224. it has been suggested that for property (26) Indexed rents are common in locations investment firms this discount could where the expectation of rental growth average 25 per cent in the longer term. is low, so occupiers should treat them It is due to contingent capital gains tax, with caution. Page 71

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