An interesting by-product of the work of preparing and analyzing data for corporate real estate portfolios, in anticipation of the proposed FASB changes to Lease Accounting, has been the knowledge gained about how much value is lost with the prevailing “lease first” strategy. Most large portfolio companies lease between 70% and 90% of their corporate properties. In analyzing these portfolios, a number of findings have emerged that could dramatically improve the bottom line for the corporate occupiers and their shareholders.
One Size Does Not Fit All
For most businesses, real estate is an operational necessity. Retail, logistics, manufacturing or service companies have a fundamental requirement to have space to conduct business. For over thirty years the ability to treat rent as an operating expense made leasing an excellent source of off-balance sheet financing and an accelerant to growth. More sophisticated real estate organizations are focused on locational analysis, standardizing lease terms, tenant improvements and workplace management. Very few classify the strategic importance of individual properties, and as a result apply the same length of lease and renewal options to most of their sites. Stratifying all properties into categories like Core, Strategic or Transitional can begin to allow the development of more cost effective occupancy strategies. The evaluation of ownership or longer term leases for Core properties can create material savings for the company and its shareholders.
The Flexibility Premium
In evaluating the top quartile of properties for different portfolios, an interesting trend emerged. For these largest and most expensive leased locations, the length of the remaining lease term averaged just under 3.5 years. The average length of time that the company had occupied the space was almost 16 years. This approach of maintaining short-term leases or renewal terms has some merit when accounting for organizational agility. But the premium in rent expense between short-term and long-term leases, or ownership, can range between 25% and 50%. This premium comes into effect at the initial term decision and increases significantly over the long-term as companies continue to execute a series of short-term renewals. Understanding the utility of specific properties to the business allows for the right-sizing of the financial alternatives for occupancy.
The Value of Corporate Credit
Demand from private and institutional investors for safe and reliable returns has driven significant capital towards investment in corporate leased properties. The Single Tenant Net Lease (STNL) market has seen an historical compression of yields for credit tenants. In many cases these cap rate based valuations can increase the value of the underlying property from 50% to over 100%. These value increases are rarely captured or shared by the corporate tenant. In all cases reviewed, a company’s Landlords get a significantly higher return on investment than the company’s shareholders. A major element of a strategic real estate plan is to gain all or a portion of that value for the corporate occupant.
Taking a Strategic View
Depending on industry, multi-location companies spend 5% to 15%of their gross revenue on occupancy costs. These same companies earn between 2% to 10% of revenue as net income. Base Rent makes up almost 65% of that occupancy cost. Yet companies invest significant resources in energy management initiatives or contesting real estate taxes which together account for less than 10% of the overall costs. There is a material opportunity for profit improvement from a more strategic financial view of real estate within the corporation, rather than strictly operational. This is often driven from the CFO’s perspective. Identifying and analyzing key data and metrics; stratifying core properties; evaluating alternative financial structures and leveraging the value of corporate credit all contribute to the value capture opportunity.
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