the financial impact of real estate: five golden rules€¦ · 4 | the financial impact of real...

The Financial Impact of Real Estate: Five Golden Rules

2 | The Financial Impact of Real Estate

The executive focus on real estate has intensified since the global financial crisis, bringing intense scrutiny over the cost and structure of the portfolio and its impact on financial statements.

With the closer involvement of CEO’s and CFO’s, real estate is in the spotlight as companies strive to ensure the portfolio matches the business strategy. Understanding the true cost of real estate and aligning this to financial strategies is vital to maximising value for companies and shareholders.

With continued vigilance on maximising value, understanding and managing the financial impact of real estate can deliver significant operational and financial advantages. Businesses are in search of solutions to some tough questions, namely:

• Metrics: Can I quantify the financial impact of my real estate?

• Strategy: Is the real estate strategy aligned with the financial objectives of the organisation?

• Solutions: What are the real estate solutions available to maximise shareholder value?

# 1Get ready for the new lease accounting proposals

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# 2 Depreciation…mark real estate to market

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# 3 Own versus lease?Calculate your cost ofcapital for real estateRULE

# 4 Raising capital? Consider all your options

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# 5 Outsource surplus real estate to the experts

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JLL has identified ‘Five Golden Rules’ that companies should follow to ensure real estate portfolios are fully aligned with corporate financial performance objectives.

1 JLL (Covers the period from 2009 - Q3 2014)

Did you know?Globally, occupiers of commercial real estate have raised over $240 billion of capital from the disposal of real estate since 20091.

Real estate is typically one of the largest items on the balance sheet.

Real estate costs typically account for 5-10% of annual revenue.

The Financial Impact of Real Estate | 3

Whatisthedivergence?

Both the IASB and FASB support the recognition of assets and liabilities for all leases in the balance sheet, where they differ is in the treatment of leases in the income and cash flow statement:

• IASB has opted to support asingleclassification of all leases that will require the recognition of interest and amortisation for all leases recognised on balance sheet (See Type A below). This means the cost of the lease will be higher in the early years

• FASB has decided it will apply a dualleaseaccounting model that retains the distinction between finance leases and operating leases (Type A or B below). For Type B leases the cost is allocated on a straight line basis over the lease period

• This means the same lease will be accounted for differently depending on whether the lessee accounts under International Financial Reporting Standards (IFRS) or US GAAP


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exposure draft in May 2013, outlining proposals to put all leases on balance sheet.

Since then, there has been an important divergence between the IASB and FASB on one key aspect: the recognition of lease expenses in the lessees income statement. Although discussions are ongoing, with the proposals for the standard becoming clearer and its arrival closer, now is the time for organisations to prepare for the changes that are coming.

2 IFRS (2014), Project Update: Leases

New lease accounting proposals will move leases on balance sheet Debt balances will increase significantly impacting on loan covenants and gearing

The cost of leases in the early years will be higher

Reporting requirements will increase the administrative burden

Type B Right-of-use assetlease liability

Single lease espenseon a straight-line basis

Single leasepayments FASB only

Type A Right-of-use assetlease liability

Amortisation expenseinterest expense

Principalinterest IASB & FASB

Revised proposalsCash flow statementIncome statementBalance sheet

Type A & Type B Lease Accounting Methodology for Lessees

All leases create assets and liabilities. At present however, most leases are not reported on a company’s balance sheet. This leads to an inaccurate picture of the financial position of an organisation. The IASB found that for a sample of retail chains that fell into liquidation, the liabilities ranged from 7 times more to 90 times more than the debt that was reported when taking “off balance sheet” leases into account.2

In light of this, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) issued a revised


ProblemA Global Technology Company wanted to understand and assess the impact of accounting proposals on their European occupational portfolio

Solution• JLL developed a model to calculate the upfront and ongoing

impact of the proposed changes, at both a property and portfolio level

• 23 leases with annual rent of £90 million analysed, representing 66% of overall rental commitment

Outcome• 20% increase in year one P&L with £500 million increase in

balance sheet• Identified the accounting, resource and financial implications,

enabling them to respond to the proposals with their concerns and suggestions

• Review accounting for new acquisitions

Case studyGlobal technology company

Next steps…• Calculate the impact on your balance sheet and upfront impact on

the income statement

• Develop a plan for implementation of the proposals

• Assess the impact on own vs lease decisions

• Review existing lease administration and accounting systems

Formoreinformationonthechangestoleaseaccountingstandards,viewJLL’slatestreportATaleofTwoStandards

No matter what your company’s business, if you have leases, the impact of the new lease accounting proposals on your financial statements needs to be reviewed. These proposals have the potential to completely alter a company’s real estate strategy, underlining the need for expert advice.

These changes will have a significant impact on a range of companies across industries. One survey found that for retail companies, the reported debt balances could increase by 213% on average.3 The telecoms industry will also be impacted. A study of 125 listed telecoms companies reported that the debt to equity ratio would increase by more than 10% for more than half of companies and more than 25% for at least a quarter of these companies.4

Organisations need to consider the impact on current transactions and future strategies. It may make leases with fixed rental uplifts less popular since this significantly increases the minimum lease commitment. Similarly, shorter leases will become more attractive and whether to own rather than lease will become a more frequent question at board level.

Finally, organisations need to prepare the systems for information collection and analysis which will support the reporting requirements of the proposed changes.

3 PWC/Rotterdam School of Management, (2009), Proposed lease accounting: research of impact on companies.4 PWC, (2010), Making sense of a complex world.


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http://www.jll.co.uk/united-kingdom/en-gb/research/211/a-tale-of-two-standards



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Unrealistic depreciation policy can stifle the business Companies face significant write down on disposal or risk paralysis with equity locked in

redundant real estate

5 Company’s media plan is unaffected by the transaction.

Inpractice… Whatshouldyoudo?

Cost Companies often allow an assets cost base to grow. The cost of owner occupied assets is normally higher due to the bespoke nature of buildings which may be added to over time without any existing costs being de-recognised.

• Avoid bespoke costs • Derecognise “old” costs

Usefullife Companies typically depreciate their buildings over 30 - 40 years. However they would never sign a lease for that long. The useful lives of buildings tend to be no longer than 25 years before they require significant refurbishment.

• Review useful lives of each building

Residualvalue

Companies often consider the value of their properties based on their own occupation and overestimate the residual value.

• Ensure the residual value reflects vacant possession value

Often when a property comes to the end of its useful life and needs to be sold companies are faced with a net book value that is well in excess of the real market value. This can result in an unwelcome hit to the income statement and substantially lower cash receipts than expected – an unpalatable message to deliver to the CFO.

What can be done? Staying put and doing nothing is one option, but it means putting up with redundant real estate that could damage the wider business.

The problem typically arises due to an inadequate depreciation policy. The combination of overinflated cost bases, excessive useful lives and residual values that bear little relation to the market mean that the depreciation of real estate assets is often understated and net book values are overstated in the accounts.

Depreciation typically allocates on a straight line basis the cost of an asset less its residual value over the asset’s useful life. The table below summarises the most common issues and what can be done to correct the depreciation policy.

Solutions have been developed which potentially enable asset write downs to be avoided. By trading real estate for trade credits which can be used as part payment for other services, one asset can be swapped for another at no cost. Successful in the US, this concept is beginning to emerge in Europe.


Next steps…• Plan ahead – reassess the depreciation policy on all assets before it

becomes a problem• Explore swapping assets for trade credits to avoid write downs• Sell asset(s) on a short term sale and leaseback to match the net

book value• Accelerate depreciation over a shorter period prior to an exit

ProblemA Company holds a freehold property at a net book value which is in excess of its market value. Disposal would result in an instant P&L loss upon sale. However, holding costs continue to run and equity remains locked in.

SolutionJLL working in partnership with a trade credits specialist has developed an innovative asset swap that mitigates a loss on property assets and creates cash savings. The transaction involves swapping a real estate asset for Media Trade Credits at up to full net book value. Media Trade Credits can create savings on existing media purchases.5

OutcomeThe write off on disposal of an asset can be mitigated by swapping the asset for trade credits. In addition, this generates a cash saving on future media spend by offsetting the trade credits.

Case studyBlue chip company


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5 Company’s media plan is unaffected by the transaction.


When a company owns an asset it may be funded by debt or equity or a combination of both – and the cost of capital can be calculated depending on that mix. When a company has a lease the new lease accounting proposals recognise that a lease is the provision of financing in return for the right to use an asset. So what’s the cost?

The cost of leasing is essentially calculated using the discount rate the lessor is charging the lessee. This rate is effectively the landlord’s internal rate of return (IRR), not something that most lessees consider, but now is the time to do so.

The initial yield on an asset may be 6-7% however the landlord’s prospective IRR may be nearer 8-10% or even higher. Companies need to consider whether this rate is lower than the cost of owning a property and funding it themselves. For some cash rich organisations

Funding a business efficiently is a core financial objective Property is a major capital commitment and should be carefully considered as part of the

overall capital structure


£0.5m

£0.7m

£0.9m

£1.1m

£1.3m

Year 10Year 9Year 8Year 7Year 6Year 5Year 4Year 3Year 2Year 1

Lease - current accounting Lease - new accountingOwn

RecurringP&Lcosts

Source: JLL, 2014

AssumptionstableAnalysis term 10 yearsInitial annual rent £1,000,000Rental growth pa 3.00%Net acquisition price £13,000,000Depreciation term 30 yearsVP value (in 10 years) £8,000,000

NPVanalysis

Discount rate 8.00% 4.00%Lease £7.6m £9.3m Own £10.1m £8.4m Lowest NPV Lease Own

or those with ready access to debt - this cost may be very low. But for other companies who are not in that position - the cost of ownership may be higher if there are other opportunities to invest their capital which could deliver higher rates of return. The key is to understand your own cost of capital and evaluate whether to own or lease. Many companies develop own vs lease strategies and taking into account prevailing financial markets, carry out analysis with key criteria to enable decision making.

JLL has a proprietary ‘own vs lease’ model which provides a cash flow and income statement analysis to enable clients to navigate through the decision making minefield and develop the business case. This allows companies to evaluate ‘own vs lease’ options from both an economic appraisal and financial statement standpoint, to arrive at the right solution.


Next steps…• Calculate the ‘true’ cost of ownership• Determine the total return that landlords are charging on

lease properties• Assess the true cost of owning versus leasing and choose the

best option• Develop an own vs lease strategy and financial model alongside

key stakeholders

ProblemThe new corporate owners of a substantial UK roadside trade operator inherited an almost wholly leasehold portfolio. The owner had an extremely low cost of capital and available cash.

Solution• JLL devised a feasibility study on all sites and proposed a

value enhancing acquisition programme. This identified those sites where EBITDA performance would be increased most significantly and sites where there was uncertainty around the landlords’ future intentions for the site

• Financial analysis of own vs lease decisions was carried out for each site identifying the maximum feasible purchase price

Outcome• 20 individual units were acquired from an initial target list in

the order of 80 units• With an aggregate purchase price of c. £25 million, EBITDA

was improved by £2 million per annum• A fortunate by-product was that £5 million of onerous lease

provisions were also released• Additionally the client now owns the freehold asset and

operational certainty is secured

Case studyLeasehold buy-in



Should you be raising capital from your real estate? Globally, occupiers of commercial real estate have raised over $240 billion of capital from

the disposal of real estate since 2009

# 4 Raising capital? Consider all your options

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Some companies choose to sell their property and leaseback; as an alternative source of capital to equity and debt, at a relatively low cost, with the additional benefit that currently, before the lease accounting proposals come in, it can be structured off balance sheet.

While selling the family silver to fund the business is not for everyone, the recent surge in capital values and the sheer weight of money targeting real estate means occupiers should rigorously evaluate all the options. Conditions for raising capital from real estate are compelling. Across Europe, the market is experiencing some of the best conditions for over six years. The first nine months of 2014 saw €129 billion of direct real estate investment volumes traded, a 26% increase compared to the equivalent period in 2013. Looking at 2013 and 2014 combined, corporates disposed of €23.8 billion, reflecting an 8% share of the market. With the opportunity to raise cash, potentially make a profit and keep the funding off balance sheet – for the moment – disposing of real estate could be a viable route to raising capital.

Next steps…• Identify core assets and overall business objectives• Price for alternative capital raising structures• Assess impact of lease accounting proposals• Decide on the strategy to go to market

€0

€5

€10

€15

€20

2008 2009 2010 2011 2012 2013 9M 2014

Volume corporate disposals(€ billions)

EMEACorporateDisposals

Source: JLL, 2014

Many companies, particularly food retailers, have actively recycled capital from core properties in their portfolio to satisfy their wider business objectives. Demand from investors has fuelled innovation and there are now a whole range of options beyond the traditional sale and leaseback that enable companies to raise capital from their real estate. Alternative capital raising options include strip income, fixed income or Opco/Propco models. These will be explored in more detail in a subsequent report but may offer benefits in terms of higher values achieved and different levels of control and flexibility.


# 5 Outsource surplus real estate to the experts

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Redundant real estate is not just a problem for individual organisations; it faces the whole real estate industry. The question is how to recycle real estate into productive use. Whether its redundant manufacturing sites or 1970’s office blocks that don’t meet modern business needs, a lot of assets are at risk of becoming obsolete.

The first rule for surplus real estate should be to mark it to market - whether it’s an onerous lease provision or taking an impairment of freehold property. Companies typically devote limited resource and capital to surplus real estate and often the decision making process for disposal is painfully slow. A recent report indicated that in the UK alone, surplus lease liabilities are estimated to be worth up to £74 billion.6 The most effective solution for companies is to outsource to the experts. Internal real estate teams may not like the sound of this but with resources often insufficient to adequately serve their operational portfolio, companies barely have the time to think about their surplus real estate.

For surplus leases, a new marketplace has emerged of lease liability specialists capable of taking over entire portfolios of surplus lease properties - which are usually vacant - at a price comparable to a reasonable provision number as would be calculated under IAS 37. These specialists work through these portfolios to get them entirely off risk within 12 to 24 months, something most organisations would struggle to do themselves.

Difficult surplus assets deserve the same attention - one option is to take advantage of rising land values and the greater appetite for risk in the investment world and dispose now. Another is to think about how best to reposition assets via the conversion and recycling of redundant real estate.

Bundling surplus assets is another way to efficiently deal with surplus real estate. As with lease liabilities a number of organisations are willing to partner with companies to enable them to take advantage of the best market conditions for disposing of surplus real estate since 2007.

Surplus real estate is a drain on most companies – both resource and capital Shareholder value can be created by

dealing with it efficiently and effectively

Next steps…• Mark surplus real estate to market• Evaluate risk and assess internal resources required• Partner with experts and market test outsourced solutions

ProblemThe Department for Business Innovation and Skills (BIS) identified a number of empty or near vacant leasehold properties. As part of a Government drive to reduce costs there was a need to generate real estate liability savings.

SolutionAdvised by JLL, BIS transferred more than 308,000 sq. ft. of surplus real estate to a specialist Leasehold Liability Transfer Partner. The properties will be managed and disposed of as quickly as possible and at minimal cost to BIS.

OutcomeThe transfer is expected to deliver a 40% reduction to future lease liability costs, representing a potential saving in excess of £10m over the remaining life of the leases.

JLLhasdisposedofseveralsurplusleaseportfoliosforSantanderandBISamongstothers,withatotalof£100millioningrossliabilitieswithinan18monthperiod.

Case studyLeasehold Liability Transfer

6 Henley Business School/Core Consult (2013), The Elephant in the Room


It is time that occupiers of commercial real estate get realistic about the measurement of the real estate portfolio in the financial statements. Organisations need to ensure depreciation policies are appropriate, surplus property is marked to market properly and the true cost of ownership and of leases is understood.

Armed with this information it is then possible for companies to develop plans to transform the portfolio into one that more closely aligns with business and financial objectives. This enables strategies for own versus leasing, surplus properties and owned properties to be developed.

There are a number of innovative solutions that the market is providing to enable organisations to deal with problems quickly, rather than struggling to do it themselves with limited resource and capital.

• Impaired assets can now potentially be solved by swapping the asset at its book value for trade credits

• A range of options exist to raise capital from property at the most effective cost of capital

• Onerous leases can be packaged up and disposed of in one transaction via Lease Liability Transfers

Furthermore financial models have been developed to enable the analysis of these complex problems with simple and easily understood outputs that can convince Senior Management of the business case. Companies who proactively seek to address these issues and partner with expert advisers are likely to deliver operational and financial benefits.

With the IASB expected to issue a new leases standard in 2015 there will be an increased focus from Senior Management on Real Estate. Now is time to be pro-active and take forward solutions that can transform the portfolio not just for now but in the future. Just follow the five golden rules.

Conclusions

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© COPYRIGHT JONES LANG LASALLE 2014. This publication is the sole property of Jones Lang LaSalle IP, Inc. and must not be copied, reproduced or transmitted in any form or by any means, either in whole or in part, without the prior written consent of Jones Lang LaSalle IP, Inc. The information contained in this publication has been obtained from sources generally regarded to be reliable. However, no representation is made, or warranty given, in respect of the accuracy of this information. We would like to be informed of any inaccuracies so that we may correct them. Jones Lang LaSalle does not accept any liability in negligence or otherwise for any loss or damage suffered by any party resulting from reliance on this publication.

This first featured in a guest blog for CFO World, ‘Getting real about real estate’

jll.co.uk

MichaelEvansDirector Corporate Solutions+44 (0)20 7399 [email protected]

DanielMillerDirectorCorporate Solutions+44 (0)20 7852 [email protected]

NaftaliChesnerDirectorCorporate Solutions+44 (0)20 7399 [email protected]

KarenWilliamsonAssociate DirectorEMEA Research+44 (0)20 3147 [email protected]

TomCarrollDirectorEMEA Research+44 (0) 203 147 [email protected]

http://jll.co.uk

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