Niranjan Chatterjee’s Weblog

May 30, 2010

Corporate Real Estate Management: Strategies for generating maximum return from this fixed asset

Introduction

Land and buildings happens to be the most valuable item on the asset side of almost each and every corporate balance sheet and this is true irrespective of the nature and size of any particular business. Thus, it makes immense economic sense for business managers to utilize the most valuable asset in the most efficient manner so as to generate maximum possible returns as it can influence the bottom-line not only immediately but also significantly. For a proper evaluation of strategies that are adopted by business houses as they manage corporate real estate, it is necessary to briefly review the relevant economic theories as this will provide the necessary theoretical basis for passing an informed judgment.

As large amounts of value are locked in land and buildings, it is imperative that the issue be studied from three separate perspectives – business, capital market and financial – as all these different perspectives when taken together would provide a proper and balanced approach to any researcher that is trying to identify the logic that drives corporate houses to take decisions that they take when dealing with real estate at their disposal.

There will also be another rider. All the theories that would be discussed in this study will relate to those corporate houses that use the corporate real estate as a means of production and not as a stock in trade. To put it simpler terms, this study will assume that business houses do not deal in real estate but are in a different line of business and utilize the real estate under their control to further their production and distribution capacities in their chosen line of operation. In particular, the focus of this study would be more on huge retail chains that spread across continents. The reason for focusing on such global retailers is that for such businesses reaching retail customer is essential for survival and the more point-of-purchase they have at their disposal the better are they poised to improve their turnover levels. Thus, these businesses provide a very unique scenario where their survival depends on fast turnover which can only be achieved through maintenance of high value retail stores that more often than not cause large outflows in the form of interest and remind of lost opportunities in the form of notional rent that these retailers could have earned had they let out these prime business properties on rent or lease instead of utilizing these for internal use. This concept gets a fuller treatment by scholars in this field as they examine it from the point of internal rent which will be discussed in greater detail later in this paper.

Importance of Real Estate as a corporate investment option

It has been observed all over the world that corporate entities have always given real estate a special place in their balance sheets. As for example, firms in USA have on an average maintained 25% of corporate assets in the form of real estate. (Rodriguez and Sirmans 1996). The firms of UK have gone one step ahead of their US counterparts as almost 40% of their assets are held in the form of real estate. This is true for all types of firms, especially those involved in retail markets.

Another remarkable issue is that the real estate holdings of firms that deal in real estate are almost at par with those that do not deal in real estate as their main line of business. This only goes to prove that corporate entities, irrespective of their area of operation, tend to view real estate as the most viable and lucrative investment option. This could be because land never depreciates and, as an economy increase in size and activity, value of land can only appreciate. It needs no special training to understand, therefore, why business houses consider investing in land and buildings as a prudent economic decision. It should further be pointed out that the entire capital of most industrial firms in UK consists of real estate. This is very significant considering the fact that it has been the tradition among most UK and European firms to own their corporate headquarters as it possibly sent a signal of economic soundness among stakeholders and the more grandiose the headquarter, the greater has been the perceived goodwill. (Laposa and Charlton 2001)

This same trend has been observed among large companies in Asia where firms in Singapore own at least 40% of their assets in the form of real estate. The basic notion that ownership of corporate headquarters signifies greater economic muscle, that is so very common among European and UK companies, is also prevalent among Asian companies as most corporate giants prefer to own their headquarters. One must not overlook the amount of capital that gets locked in owning such massive headquarters and such ownership must be of some considerable value to these companies as they would have otherwise taken the apparently far cheaper option of leasing their headquarters. The fact that these companies still prefer to own their headquarters leads one to conclude that often such benefits cannot be quantified in monetary terms as there might be a substantial boost in their market standings and goodwill if they own their corporate headquarters. Such an increase in goodwill and consequent elevation in market standings often translate into higher turnover, greater consumer loyalty and preferential treatment by investors in money markets. As these are genuinely substantial benefits, especially to retail giants that operate in acutely competitive markets, most of these giants prefer to not only own their headquarters but also most of their retail outlets. (Liow 1999)

There are, of course, other more tangible reasons as to why companies prefer to invest in real estate. The most obvious benefit is, as mentioned earlier, value of land on its own appreciates over time and no investor would let go an opportunity of owning such an asset that increases in value without any form of additional investment or expenditure on the part of the owner. Moreover, real estate happens to be a ready source of funds as a prime commercial property can be disposed of without much hassle if the company is in sudden need of liquidity. Real estate also in its own way reflects the trajectory of capital growth as a firm that exhibits steady increases in real estate ownership quite obviously also enjoys equally steady increases in corporate efficiency, profit generation and profitability. (Brennan 1990)

Corporate real estate ownership thus has many dimensions and the issue needs to be analyzed from various perspectives, especially as large volumes of capital are involved in ownership and disposal decisions.

Business perspective of corporate ownership of real estate

This notion of managing and owning real estate assumes that management of real estate, like management of all other assets, has to be done in such a way that it increases overall corporate profitability and efficiency. Thus, efficiency of management of real estate will be measured with respect to how such management augments the core competence of the firm and helps in providing a competitive edge to the firm’s operations. In a sense, business perspective of measuring efficiency of managing real estate centers on the basic notion that an asset needs to be utilized to the fullest extent by a business firm in order to remain competitive and profitable. This is perhaps most relevant to firms that operate in retail sector where consumer loyalty is extremely fickle and competition is extreme.

The basic measure of real estate utilization is occupancy costs that have a direct impact on the overall cost structure of a company especially companies involved in retailing. There is a strong relation between floor productivity and overall profitability of a retailer and sometimes return per square feet of shelf space is also considered a suitable unit of measurement of efficient management of corporate real estate. Return per square feet of shelf space is measured by calculating the sales volume generated by merchandise stacked in each shelf and the larger the sales the better is the management of the shelf space. In a sense this approach is not radically different from the conventional approach of measuring economic efficiency. The only difference is that instead of directly measuring the turnover with monetary investment, shelf space is compared to the return it generates. This is a better way of measuring efficiency in managing real estate as it helps the store manager to immediately zero in on more profitable ways of managing the available shelf space probably by more accurately analyzing and correctly forecasting future consumer demand and stacking the shelves accordingly. (Gibson and Barkham 2001)

The other measure of gauging operational efficiency of real estate is through application of notional rent on all self occupied properties. It is an accepted fact that all business entities do a rent-or-buy analysis while buying a property, but once the purchase is completed, such analysis is relegated to the background and available space is generally regarded as an a free resource. This usually leads to uneconomic utilization of such a costly resource.

If notional rent is applied on internal usage of real estate, the benefits are manifold. Assuming each unit operates as a profit center, application of notional rent will automatically encourage more efficient usage of retail space as any wastage will attract a notional rent without any corresponding return. Thus, each profit center manager will actively cut down on any avoidable usage of space, more so, if their bonuses depend on the extent of cost reduction they are able to achieve.

This cost conscious approach to usage of retail space will lead to increase in overall profitability of the company that would finally lead to possible increase in dividends and consequent satisfaction of investors which in turn would go a long way towards generating goodwill of the business as a whole. It has been observed that such a system of charging notional rents is not so popular among businesses in UK and United States and whatever little practical implementation of this concept that has been done is mainly in retail sector where large multinational retail chains have on a few occasions used the concept of notional rent to create an increased state of cost awareness among departmental managers. (Nelson, Potter and Wilde 2000)

There is another school of thought that attaches a lot of importance on the geographical location of the property as retail business depends on how convenient it is for the consumers to approach the point of sale. Thus, many retailers end up having high levels of real estate holdings simply because they put up their retail outlets at all points they feel would be strategically convenient for customers to troop in. In a sense thus, retail giants have to, whether they wish to or not, invest large amounts of money in corporate real estate to ensure continued dominance in their chosen sectors. (Brounen and Eichholtz 2004)

However, some economists argue against this notion as they highlight the continued emergence of e-commerce as a viable market place. (Andersen and Rosen 2000) Though this is true to a certain extent, a virtual market place can however be more efficient in sectors dealing with high technology products where both the customers and suppliers are highly informed and are more interested in the technical specifications and characteristics of the products rather than their physical appearance. In retail sector where customers prefer to physically touch and feel the products before they make a purchase, virtual markets can never become a substitute of real retail outlets. Thus, the necessity of maintaining as many retail outlets as possible continues to be high on the agenda of retail chain owners.

However, one must discount the fact that internet has permeated every sphere of our existence and with further development of technology it might quite be possible that virtual markets will soon overtake real markets in generation of retail sales revenue. Giant retailers are aware of such a possibility and are preparing themselves to shift their overdependence on ownership of real estate to outsourcing and leasing occupancy in accordance to their changing requirements. It is perhaps needless to emphasize that such a flexible approach will allow these retailers to free huge amounts of capital that they might use to further develop their businesses in manners and ways they deem fit. It would also make them more flexible as regards their line of business and make these companies more financially stable with larger levels of liquidity.

Capital market perspective of corporate ownership of real estate

Corporate managers across the entire cross-section of commercial world are under tremendous pressure to continually increase shareholders’ wealth and, real estate, being a substantial part of asset portfolio of most retailers, has a serious impact on how efficiently managers are able to actually increase the net worth of shareholders. There are basically two ways in which real estate affects the valuation of a firm.

The first and more obvious way is by influencing occupancy cost which happens to be one of the most important constituents of the total cost of operation of retailers. Now, profit is the excess of revenue over cost and, if a substantial component of the total cost, i.e. occupancy cost, can be controlled, profit would, through simple arithmetic, increase. Occupancy cost, however, depends almost entirely on efficient management of corporate real estate. Thus the profitability and attractiveness of a corporation (especially those engaged in retail chains) depends to large extent on how efficiently the real estate owned by it is managed.

Owned real estate also affects the valuation of a firm in another way. Presence of high proportion of real estate among the asset portfolio also implies the requirement of a comparatively higher volume debt to finance the operations of a business. Now, presence of high quantum of debt implies a higher capital gearing that automatically leads to a higher leverage of any fluctuations of a company’s annual returns. This is by itself a risky affair as during times of economic prosperity the shareholders would enjoy substantial increases in their net worth while during less favorable times their net worth would erode drastically. Investors and shareholders would rather not opt for such a risky proposition and hence would avoid companies having high cost of capital caused due to high levels of real estate ownership.

However, most balance sheets carry figures of real estate that were purchased decades ago and reflect values that are vastly lower than their current market worth. Thus, real estate is considered by many potential investors and shareholders as latent assets and if due to any reason the share prices do not reflect the actual market value of owned real estate, both shareholders and the businesses have the opportunity of arbitrage either in shares of such companies or in real estate owned by them. (Louargand 1999)  

Financial perspective of corporate ownership of real estate

Due to huge volumes of capital involved, ownership of real estate has a direct bearing on several very important financial parameters as cost of equity, cost of debt and debt capacity of a non-real-estate firm. Real estate ownership can also significantly affect a firm’s credit facility and hence influence its overall operating economics. Thus it requires some analysis as to how best a firm should manage its real estate ownership so that it has the most beneficial financial impact on its operations.

A glance at any corporate balance sheet reveals that the asset side of a balance sheet consists of corporate real estate, other fixed assets and current assets that also include cash and marketable securities. Thus, the limited capital that each company has its disposal has to be judiciously distributed among competing demands and corporate real estate can deserve proper funding if and only if it provides more, or, at least, equal returns as the other competing alternatives are expected to provide. This, however, is a strict notion of how a firm should design its asset portfolio and in reality the actual asset structure of a firm depends largely on its size and nature of business rather than on academic calculations of notional returns from each type of investment.

The other important financial aspect of real estate management is a firm has to opt for a mix of debt and securities in order to raise the fund necessary for acquisition of real estate. This will have significant impact on the firm’s financial leverage and cost of capital but at the same time it will provide flexibility in capital structure as a firm owning more real estate can opt for larger volumes of debt as it can offer real estate as secured collaterals for other loans. Thus taking a loan to procure real estate allows a firm the opportunity of raising more loans by hypothecating such real estate but it would be imprudent to overlook the risk inherent in high levels of financial leverage as any problem in liquidating the hypothecated asset (which might very well happen in times of economic downturn) to meet debt servicing expenses might lead to bankruptcy and consequent liquidation of a firm. Thus, a firm must be extremely careful and cautious while deciding upon the desired debt component in its capital structure while opting for real estate acquisitions. (Manning and Roulac 2001)

The other important aspect that is to be borne in mind is that any acquisition of real estate is bound to have an adverse impact on the existing cash flow patterns of an enterprise. This is so because while any acquisition of real estate invariably entails a substantial cash outflow any form investment in real estate is essentially a long term decision that starts yielding favorable results only in the long run. So, there will most certainly be a gap in the cash flow cycle of any company that goes for real estate acquisition. Unless proper attention is being paid towards the means of financing any real estate acquisition, there might be a serious mismatch between inflow of funds and future outflows associated with other corporate obligations.

However, most firms prefer to view corporate real estate as a source of liquidity and more often than not also as a source of windfall gain. Such gains are reaped by firms during times of economic upswing when prices of real estate tend to soar much above expected levels. It is during such times that firms tend to dispose off their real estate holdings at prices much higher than acquisition prices and earn substantial profits. Disposals also have taken other forms instead of direct sales and one of the most popular forms of real estate disposal by corporate entities is through sales-and-leasebacks (SLB) that has been opted for by many retailers to generate substantial cash. This surplus cash has mostly been used finance either business expansion or capital acquisition or, to provide additional working capital to the business or to strengthen the balance sheet by recognizing undervalued properties. Thus, in brief it might be concluded that by disposing the real estate owned by them and again leasing them back for use in business has allowed many corporate houses to unlock the value that was frozen in such owned properties and increase their competitive advantage with respect to competitors that did not have the advantage of ownership of real estate. And, this entire maneuvering could be done by these corporations without hampering their day to day operations even for a single day.

There are other benefits of SLB that are availed of by many retail chains. The first economic benefit is property leases are so-called “off balance sheet” and are not shown as long term liability in lessee’s accounts. Thus, the return on capital employed improves without any additional effort by the lessee company.

The other benefit, though not so pronounced, is that rent is a fully deductible expenditure and the lessee company can get tax benefits that otherwise would not be available if owned premises are used in carrying out business. Further, the rather vague concept of notional rent that is so frequently cited in academic discussions can be done away with and managers can be made directly responsible for the rent costs incurred by their departments. It will become easier to convince departmental managers about the need to rationalize on usage of office, workshop and showroom space. (Lasfer 2003)

Quite predictably, many US and UK retailers have availed of this opportunity of strengthening their balance sheets and increasing their liquidity with big names as Germany’s Metro Group AG, UK’s Tesco and France’s Carrefour SA being forerunners in this brigade. (Louko 2004)

However, one should also not lose sight of some of the drawbacks of SLB arrangement that has become a highly favored option of most giant retailers of Europe and the United States. Though there is no doubt that sale of real estate would generate substantial cash inflow in short term it will also saddle the company with long term cash outflows in the form of lease rentals. Thus, if the funds generated through estate disposal are not invested in productive avenues, the company might end up being a loser in the long run.

Analysis of corporate real estate management by Tesco in light of latest theories

All through the current analysis, emphasis has been placed on how retail giants in general should and in, some cases, have actually responded to issues relating to corporate real estate management. Attention will now be specifically focused on corporate decisions made by Tesco, a retail giant, with regard to management of huge corporate real estate in the form of its ubiquitous retail outlets.

The retail space has become increasingly crowded with superstore chains vying for consumer loyalty by providing continually more attractive discounts and other freebies that are tossed at consumers at some pretext or the other. Given such a stiflingly competitive atmosphere it has become imperative for Tesco to become economically more efficient simply to survive. The situation has become even more critical given the widespread global meltdown that plagued Europe and United States like it had never done since the days of Great Depression in 1929. So, one the one hand extreme competition from equally efficient and resourceful competitors and, on the other a drastic reduction in purchasing power of retail consumers, together with a tendency to consume less as a panic reaction to the dwindling incomes and vanishing jobs, has made the task of Tesco extremely difficult. The criticality of the situation can be understood when one realizes that Tesco has to continue offering massive discounts and freebies (that obviously cost the company) while facing the prospect of declining revenue. It becomes almost impossible to survive for a long period under such circumstances and Tesco is, predictably, in dire need of substantial injection of finances.

Tesco had a property portfolio in 2006 that consisted of an overwhelming majority (almost 85%) of assets as freehold premises. As discussed in detail in this essay, SLB is a very attractive option for companies to raise fund without disturbing their routine operations. Tesco had decided to reduce 15% of its freehold property by converting it to a 50:50 joint venture SLB structure within a span of five years.

This decision of Tesco whereby it planned to raise £5 billion is the most timely and prudent decision that could have possibly taken by its management. As such, customers thronging the retail outlets of Tesco would not feel any change in the operations of the superstore giant while at the same time the company would be able to mop up £5 billion in free funds that it can use for strengthening its capital base or liquidity position as the case may be. This free fund would be most useful in these trying times as maintaining liquidity in times of economic downturn becomes one of the top priorities of players in retail sector. Tesco cannot afford to let its shelves go empty without being sure of how long it might take for the inventory to be sold out. It implies, in economic terms, that the company has to keep on increasing its investment in working capital without being quite sure about the duration of the working capital cycle.

Thus, the management of Tesco has taken the right step in freeing value locked in its substantial holdings of real estate. It is also up to the management to decide if there is any necessity of improving the material handling process or storage facilities or upgrading tools and equipments used in its various stores. If such a need is felt, then some part of the fund raised through SLB agreements may also be used for that purpose as such expenditure is basically of a capital nature and would improve levels of productivity and efficiency of the organization as a whole.

References

Andersen, Arthur, and Rosen. eReal Estate: A Virtual Certainty. Chicago, IL.: Arthur Andersen, 2000.

Brennan, M.J. “Latent assets.” Journal of Finance, Vol.45 No.3, 1990: 709-29.

Brounen, D., and P. Eichholtz. “Development involvement and property share performance: international evidence.” The Journal of Real Estate Finance and Economics, Vol. 29 No.1, 2004: 79-97.

Gibson, V., and R. Barkham. “Corporate real estate management in the retail sector: investigation of current strategy and structure.” Journal of Real Estate Research, Vol. 22, Nos 1/2, 2001: 107-27.

Laposa, S., and M. Charlton. “European versus US corporations: a comparison of property holdings .” Journal of Corporate Real Estate, Vol. 4 No. 1, 2001: 34-47.

Lasfer, Meziane. “Driving Shareholder Value Corporate Real Estate – Freehold vs Leasehold.” http://www.donaldsons.co.uk. 2003. http://www.donaldsons.co.uk (accessed May 21, 2010).

Liow, K.H. “Corporate investment and ownership of real estate in Singapore – some empirical evidence.” Journal of Corporate Real Estate, Vol. 1 No. 4, 1999: 329-42.

Louargand, M. “Real estate’s influence on enterprise value.” Journal of Corporate Real Estate, No.3, 1999: 254-61.

Louko, A. “Corporate real estate disposal: impact on performance ratios.” International Journal of Strategic Property Management, Vol. 8 No. 3, 2004: 131-47.

Manning, C., and S.E. Roulac. “Lessons from the past and future direction for corporate real estate research.” Journal of Real Estate Research, Vol. 22 Nos 1/2, 2001: 7-57.

Nelson, T. R., T. Potter, and H. H. Wilde. “Real Estate Assets on Corporate Balance Sheets.” Journal of Corporate Real Estate, Vol. 2, No. 1, 2000: 29-40.

Rodriguez, M., and C.F. Sirmans. “Managing corporate real estate: evidence from the capital markets.” Journal of Real Estate Literature, Vol. 4, 1996: 13-33.

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