20111018 jcre article jan 2005

Journal of Corporate Real Estate Volume 7 Number 1

Capturing hidden value for
your shareholders

Martin B. Trundle
Received (in revised form): 28th September, 2004
Donaldsons, 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.uk

Martin 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 estate
portfolios. Martin also advises investors on how
they can add value by understanding occupiers BACKGROUND
and providing them with business driven solu- Since the publication of the first edition of
tions. Prior to this he was an associate director at the Journal of Corporate Real Estate in 1998
Jonathan Edwards Consulting, which he joined in the UK stock market has gone from
1993 after graduating from City University Busi- ‘boom to bust’ as a result of investor
ness 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 real
qualified as a Chartered Surveyor and in 2003/04 estate (CRE) executives were challenged
he completed the corporate finance programme to service demand by procuring space
at the London Business School. on the back of very optimistic business
growth assumptions.
This was evident in the West End of
ABSTRACT London during summer 2003, when it
Until recently, occupiers have ignored the finan- was reported that, of the 10 million square
cial benefits real estate can add to the value of feet that were on offer, around 50 per
their firms. Corporate real estate (CRE) is now cent was in the hands of the occupiers1 as
on the corporate agenda and CRE executives it was surplus to their requirements. In
are being challenged by shareholders and senior reality the situation was far worse; these
management to employ best practice techniques figures applied only to space that was
to unlock the hidden value in the firm’s real actually on the market. Many occupiers
estate portfolio. This paper offers a practical were (and still are) loath to classify empty
decision framework to allow this to happen and space as ‘surplus’, as the likely cost of
explores the potential for them and for real disposing of it would then have to be
estate 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.2
ing occupiers and investors and his increasing If it is assumed that total occupancy
knowledge of corporate finance principles. costs3 for this space in the West End
average (say) £80 per square foot and that
Journal of Corporate Real Estate
Keywords: 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

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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 are

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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 Debt

primarily interested in economic perfor- for example, the impact of revaluing as-
mance. The accounting book value there- sets is not reflected in the profit and
fore needs to be adjusted to determine the loss account, understating the firm’s cash
firm’s economic book value. The rationale profitability. It is also impossible to assess
is that the capital base of the firm will from the firm’s financial statements the
then be more in line with the liquidation overall CRE occupancy costs, implying
value or replacement cost of the firm’s that the true picture may not be reflected
assets.8 in the accounts. This is a missed oppor-
Typically, a firm’s balance sheet will not tunity; CRE is typically one of the largest
be complete, as it does not include all the operating costs for a firm. Finally, the
firm’s assets and liabilities and those that cash-flow statement is presented in such a
are included are usually recorded on a way that it is very difficult to see exactly
historical-cost accounting basis rather than how much free cash flow9 the firm has
an economic basis. In terms of CRE, generated and the role CRE has played in
operating leases are recorded off balance this process.
sheet, so they need to be capitalised and
added back to the accounting book value. How does CRE affect the market
In 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’s
firm’s CRE portfolio is out of line with operating assets and how a firm funds these
what it can afford this will hinder the assets form the common theme within this
firm’s economic performance. paper, implying that CRE decisions need to
The profit and loss account generally be viewed and made in this context. So it
falls short, as it is not comprehensive and is important first to explore the different
does not reflect the economic reality: approaches that determine the firm’s en-

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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.

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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
Debt

Free cash flow to the firm (FCFF) property portfolio, given the direct impact
FCFF 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 building
investments necessary for growth. It stems or fitting out the space will also increase
from the cash that has been generated capital expenditure and reduce FCFF. The
from the existing operations and the capi- higher these property costs, the lower the
tal that has been invested to maintain free cash flow and (potentially) the lower
them. It is independent of the firm’s the value of the firm, if the investment in
capital 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 is
from the cash-flow statement. One way is expected to grow over the period of the
to take the firm’s operating profit, add analysis. Growth is a function of many
back 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 the
year. industry is vital. From a micro point of
In terms of deriving the FCFF some view, it is important to look at historic
CRE adjustments need to be made. First, growth patterns; what the managers inside
strip 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 competitive
rental tax benefit from leasing will be lost. advantage; how much capital is being
Even though the rent paid to the landlord reinvested; and the likely returns that can
is excluded, all other occupancy costs be generated from this capital.
remain, implying that firms need fully to From a CRE viewpoint, understanding
understand the real cost exposure of their growth is critical, given the nature of

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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-

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ation of earnings as they have little impact and as the level of debt increases the firm’s
on shareholder value as it is an economic cost of equity adjusts, so that the overall
concept. Earnings are derived from ac- cost of capital remains constant. Thus
counting records that do not reflect the only the real cash flows the firm generates
reality, earnings can be manipulated as firms from its assets and their associated business
can use different accounting methods to risk actually drive value, suggesting that in
record performance, earnings ignore the a perfect market it really does not matter
future capital investment (working capital whether a firm uses debt or equity to
and 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 does
take 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 of
their property decisions on their earnings using the space, productivity of the space
impact, as this is how senior management and associated efficiency of the portfolio
typically 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) gives
can 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 of
using space more efficiently and disposing debt increases so does the financial risk,
of surplus space. There will be upfront potentially increasing financial distress and
cash costs associated with these benefits, eroding the tax benefit of the debt. This
but the cash returns (the savings) that can suggests that firms should strive for a
be 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 value
savings. However, given the negative of the cash they generate. This is why
impact these decisions have on the firm’s some firms spend a considerable amount
immediate earnings, CRE teams are loath of time managing the trade-off between
to recommend them to senior manage- the level of debt they use, their credit
ment even though they make good ratings and the financial flexibility they
economic 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 that
in the firm’s enterprise value. use leases (debt) to finance their CRE
Experience also suggests that firms with needs outperform those with a large
a significant freehold base are more likely freehold (equity) base,17 and firms should
to make a major CRE decision during a aim for an optimum level of leasing to
period of financial distress.15 However, finance their CRE requirements if they
swapping the equity (freeholds) tied up in want to add value ie increase the value of
the estate for debt (leaseholds) may not the firm.18
actually add any value.16 However, alternative research19 that has
looked at a range of UK structured
Is 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 be
CRE portfolio? guaranteed simply by swapping the way
Classic corporate finance theory suggests firms finance their CRE requirements.
that in a perfect market a firm’s enterprise This research also concluded that the
value is independent of its finance mix market views the operational efficiency of

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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 decision

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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 capital

and matches key business and real estate as it is vital that the firm works out
issues 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 occupier
solution 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 benefits
ensure the real estate is adding as much derived from the finance decision could
value 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 of
this seems relatively simple, but in reality the business need. In other words, only
it is a very interactive and sometimes when all the business issues have been
frustrating 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 routes
analysis. It also assumes the firm knows be progressed.
exactly how much space it has, where it
is and what its existing portfolio is costing Performance measurement
and has appropriate performance measures So how do you know if the portfolio is
in place to measure alternative solutions adding or destroying value, how well it is
by. 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

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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 of

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financial solutions. Typical issues that will ing less space may allow the firm to
need 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 more
First, it is important fully to understand accurate analysis of the likely exposure
the drivers behind the move and map with each location.
out the objectives and constraints. An appropriate discount rate (usually
Secondly, 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 the
best meets these objectives. A methodical options, to identify which one gives the
briefing process should be undertaken to best economic value. Comparison of the
ensure 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 revenue
capture 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 account
collated; where assumptions on future for the potential movement in some of
costs are required, these need to be fully the variables over the duration of the
supported by market research and in- analysis. Market-based assumptions such
dustry standards. as estimated rental values, rental voids,
A financial model should then be used rent-free periods and rental growth will
to analyse all options to find the best change. Monte Carlo simulation can be
economic solution, the key decision tool used here to provide an analysis of each
at 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, as
profit and loss impact, and a risk assess- the cheapest location may be exposed
ment for each option can also be under- to more risk, ie higher future rental
taken. The model will demonstrate where growth.
savings can be made, the cost associated The results are then combined with the
with delivering these savings and how qualitative review of each option and
changes in the information available affect shared with management, to allow the
the project’s affordability. It will also iden- latter to make an informed decision. Once
tify where the sensitivities lie and allow a decision has been made (which can take
the firm to identify what needs to be done a considerable period of time) the firm
to 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 it
what the trade-off could be — procuring wants, it will be able to measure the
a smart workplace solution and consum- impact and cost of each financial solution

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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.

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• 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 whether
Assessing the CRE finance decision the method of finance actually adds any
Once 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 as
this is a financing decision, it should be if value can be released only by making a
treated as a lease versus borrow (buy) sound investment CRE decision.
decision and the firm’s after-tax cost of debt
is the appropriate discount rate to use. An example — A sale and leaseback
An investor offers to buy an occupier’s
FAQs freehold premises in return for signing
Occupiers are regularly faced with such a lease — as a rule, the longer the lease
opportunities 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

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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 the

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Trundle

business and generate bigger returns than can be commercially opaque; and, as the
keeping them invested in property. This, contract unfolds, they can actually be
however, ignores the extent of the risk quite restrictive and not very user-friendly
associated with the potential business when trying to manage an occupier’s
investment; as property is a low-risk evolving business needs.
investment, lower returns are required to Experience also suggests that occupiers
add value. actually require financial solutions that
relieve them of having to deal with a
non-core activity and that when they
OPPORTUNITIES FOR THE follow the principles set out in this paper
SUPPLY SIDE (REAL ESTATE they soon appreciate that they can actually
INVESTORS) afford to pay more for a service that better
Occupiers are becoming more aware that fits their need.
their real estate can improve their perfor- So there is a significant opportunity for
mance, so here lies a significant oppor- the supply side, as long as it is prepared to
tunity 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 a
in a coherent, transparent manner and function of the future cash it can generate
capture 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 more
needs to think about offering occupiers bespoke solutions.
(their clients) products that allow them
to consume space more efficiently and
finance 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 appraisal
New real estate models have emerged to process into an investment and a finance
try and capture these opportunities (eg decision stand a much better chance of
outsourcing), but they can often be too capturing the hidden value in their
prescriptive; they require the occupier to portfolios and satisfying the needs of
commit to a very long contract; they their shareholders. By understanding the

Page 69


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)

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‘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.

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20111018 jcre article jan 2005

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