With Christmas approaching, and with partridges ensconced in pear trees, it’s time to reflect on last year and make resolutions for the New Year. So I thought I would take this opportunity to reflect on some of the themes that have emerged from my blogs and columns over the last 12 months and signpost some areas for consideration next year.
The underlying theme of these blogs is the importance of property, not just as a strategic asset but, in its impact on the financial statements. It is often one of the largest items in the balance sheet – and that’s even before all leases come on to the balance sheet – as well as typically being the second highest cost after staff costs in the profit and loss account.
The numbers in the accounts are the aggregate result of maybe tens, hundreds or even thousands of individual business and property decisions and transactions. They are also the result of accounting policy and strategic decisions about the resource for and approach to property – and maybe now is the time to review those polices and strategies and make some new resolutions.
1. Don’t depreciate buildings over more than 30 years
Why do so many companies depreciate their properties over terms of 30, 40 and even up to 50 years – when they would never consider taking a lease that long? Corporates would typically never contemplate taking leases for greater than 20 years because of uncertainties around the business and the useful life of the building.
It’s a topic that I covered in It’s the depreciation policy stupid (May 2013). Using a shorter useful life for a property may result in an unwelcome increase to the annual depreciation charge on property but it will be more realistic and accord with IAS 16. More importantly it should avoid the problem of a net book value considerably in excess of the market value when the building is vacated – which is much more unwelcome.
2. Get ready for the new lease accounting proposals
The changes are coming; so collect the data on all of your leases and assess the impact on your balance sheet and gearing ratios. The proposed changes are described in Ballooning Balance Sheets (July 2013) It’s also worth preparing the systems for information collection and analysis which will support the reporting requirements of the proposed changes. You may also want to review major property transactions and the impact on the balance sheet and P&L treatment and whether that might change an own versus lease decision or the transaction structure.
3. Calculate the cost of capital for property – and decide whether you should own or lease
All property whether owned or leased is a capital commitment and the new lease accounting proposals should make corporates think about exactly what the cost of that lease commitment is i.e. “the rate the lessor is charging the lessee”. It’s effectively the landlord’s internal rate of return – it may be 8 to 10 percent over the course of the lease – maybe more.
How does this compare to the cost of ownership? For some cash rich corporates 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 12 to 15 percent rates of return. These rates should be considered carefully in evaluating whether to own or lease and build into the financial decision making model.
4. Raising capital from real estate? Consider all of the options
There has been a significant increase in interest in sale and leasebacks recently from corporates – which is hardly surprising given the surge in capital values across all asset classes and geographies. With a “wall of money” desperate for good quality product – your bricks and mortar could be its home! The traditional sale and leaseback is one way of doing this – but it is a fairly blunt instrument for “BBB” covenants or better.
In which case, it is worth considering other capital raising options such as strip income, fixed income or an Opco/Propco model. They are all described in more detail in my in-depth column Raising Capital from Real Estate (December 2012) and they may offer benefits in terms of higher values achieved and different levels of control and flexibility.
5. Outsource surplus property to the experts
The first resolution for surplus property should be to mark it to market – whether it’s onerous leases [under IAS37] or taking an impairment of freehold property. Surplus properties are at the bottom of the list of priorities for most corporates – they devote limited resource and capital to them and the decision making process for disposal is far too slow.
The most effective solution for most corporates is to outsource to the experts. A new marketplace has emerged of lease liability specialists who take over entire portfolios of surplus lease properties -which are usually vacant – at a price comparable to a reasonable provision number for the leases. These specialists have often worked through these portfolios to get them entirely off risk within 12 to 24 months. Corporates could never do that by themselves – even with help from agents.
Difficult surplus assets deserve the same treatment – one option is to take advantage of rising land values and dispose of the site now. What about a change of use to a pop up shopping mall or a hotel – check out Old Dogs, New Tricks (March 2013) for some innovative ideas.
Alternatively “partner” with an entrepreneurial asset manager on an incentivised fee basis to deliver an added value of the site that doesn’t drain your capital and resource. One route may be for them to make the most of the governments real squeeze on local authorities to address the housing problem and get sites consented.
But beware the corporate real estate team may not like the sound of “outsourcing surplus property to the experts”- they may feel like turkeys voting for Christmas!