As in past economic downturns, over the past several years, many organizations have come to the realization that real estate "ownership" can drain precious capital from other investment opportunities. By either restructuring or refinancing real estate commitments, an enterprise can free up capital for better purposes, lower annual operating costs, or both.
One option is the relocation of an operation that, while maintaining a quality work force, can reduce operating costs. While this is a potential long-term cost savings solution, it typically requires upfront capital; therefore, it may not be the first choice. So we look at remaining in place and look to existing real estate.
Today's tight capital and credit markets are forcing many corporations and small businesses to become creative in their search for capital to free up suddenly constrained balance sheets. In turning over every stone in the hunt for liquidity, many entities simply overlook the value of their corporate real estate assets. When an operating business, no matter how large or small, finds itself in need of low-cost capital, its real estate assets should be evaluated as a source of readily accessible quality capital. Additionally, both owned and leased real estate holdings should be analyzed for cost savings optimization.
A key issue that any organization will face when looking to restructure either owned or leased facilities will be the accounting treatment. Currently, most businesses utilize U.S. Financial Accounting Standards (FAS), which reports results according to GAAP (Generally Accepted Accounting Principals). These regulations are quite rigid in terms of how to account for real estate holdings and annual costs. Quite often, although annual cash flow savings may be achieved, the official financial reports will not show improvement or benefit to the organization. Therefore, if improved cash flow or access to fresh capital is the objective, there are several re-structuring methods available. However, if balance sheet and income statement improvement is the objective, there will be fewer choices available.
Owned Real Estate
Real estate can be a hidden asset on the balance sheet, if it has been fully paid for and depreciated. The ability to "monetize" this asset has gathered strong and renewed interest from both domestic and global enterprises during the most recent credit crunch. A sale/leaseback transaction - where a company sells its office building, plant, or other property and then leases it back from the new owner - is an alternative form of financing that some companies turn to when traditional financing, such as bank loans, is harder to obtain. Originally prevalent for manufacturing facilities, sale/leasebacks were all the rage earlier in the 2000s. They enabled companies to gain access to new capital while not incurring debt on the balance sheet.
In the current economic downturn, two issues have arisen with this option. First, while interest remains strong, actual investors are scarce; therefore, the volume of sale/leaseback transactions is way down. Real Capital Analytics has stated that single-tenant sale/leasebacks are down by 60 percent compared with the first half of 2008. Unless the real estate asset is well positioned and the company has solid credit, there will be an extremely limited market.
Second, it appears there will be a convergence of the U.S. Financial Accounting Standards (FAS) and International Accounting Standards (IAS). Once this occurs, from the standpoint of the balance sheet, there will be no difference between operating and capital leases - all leases will appear on the balance sheet. The Securities and Exchange Commission (SEC) wants the largest publicly traded U.S. companies to adopt IAS as early as next year. The commission will require all of them to do so by 2014.
A different option with owned real estate could be to place debt on a property or refinance existing debt. In the first case, we tap new capital, while in the second, we lower operating expenses. Market interest rates are historically low and may be advantageous to a company without other means of capital access. As a result of credit market instability, lenders are now looking for a minimum of 40 percent equity investment for real estate loans. Although only 60 percent of a property's value will be available for monetization, this refinancing alternative still warrants review. This strategy needs to be evaluated closely with other organizational needs for capital as it will impede critical credit capacity.
Leased Real Estate
At first glance, under leasing conditions, unless there is a pending lease expiration, there appears to be less flexibility in utilizing the property for financial strategies. A popular strategy over the last few years has been lease restructures. When there are two to four years remaining on an existing lease, the landlord can be approached for an extension of term. Typically, during the remaining term of the lease, the cash rent can be lowered by providing value to the landlord in terms of additional term. This can be utilized to decrease cash flow requirements on the property; but several issues can arise. First, while cash flow will decrease; the GAAP rent may not decrease. As accounting rules require a straight-lining of the new term, it may actually require the company to book a higher rent. In additional, the company needs to thoroughly evaluate its intention to remain in the existing property for additional years which may interfere with organizational mobility or expansion plans.
An opportunistic option could be a purchase/leaseback. This is a much more selective technique that requires all the stars to be in alignment. Primarily, this is used in a single tenancy situation where the landlord may be in the market for cash now as opposed to long-term income. The process would be to purchase the property from the owner, then execute a sale/leaseback based on the company's improved credit and a bondable lease. In effect, the company is arbitraging the difference between the cap rate and the cost of capital. Again, the stars need to be aligned; but if it works, the organization could lower operating expenses.
Current and Future Markets
The current market impacts owners and lenders just as it is impacting companies. Owners covet stabilized properties with good tenants and may not have additional capacity to be opportunistic with additional purchases. Lenders are much more cautious, requiring higher equity-to-debt ratios and much more stringent covenants with their loans. Tenants dealing with owners will not have the freedoms they once had in coming to terms on lease restructures, as their loan terms may require review and approval from the lender or lenders.
In spite of the overall trends in the financial markets, there are still groups looking to put their money into quality real estate with good companies. Pension funds, insurance companies, and private equity groups - as well as individuals - can't remain on the sidelines forever and still need to diversify their money. While today may not look like the feeding frenzy of a few years ago with low cap rates and high asset values, there will still be opportunities.
There are no single or group of strategies that will work for all companies. Just as every organization is different in its location and real estate needs, so are the financial aspects of the properties. In addition, while a certain option may match up exactly with the real estate requirements, it may be in conflict with the financial objectives of the organization. Although the next few years will see accounting treatment modified - and the "off-balance sheet" benefit disappear - sale/leaseback transactions will continue to be executed, as evidenced in the European business community, which has been operating under these standards for some time. The year 2010 will require creativity not only for short-term but long-term positioning of organizational real estate assets.
Les Cranmer and Art Wegfahrt are location and real estate consultants in the Corporate Services Practice at Studley, Inc. Collectively, they have more than 66 years of experience in advising corporations on strategy, location selection, and implementation. Contact them via the company's website, www.studley.com.