The Financial Impact of Real Estate:
Five Golden Rules
Did you know?
Real estate costs
typically account
for 5-10% of
annual revenue.
Real estate is
typically one of the
largest items on
the balance sheet.
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?
Globally,
occupiers of
commercial real
estate have raised
over $240 billion
of capital from the
disposal of real
estate since 20091.
JLL has identified ‘Five Golden Rules’ that companies
should follow to ensure real estate portfolios are fully
aligned with corporate financial performance objectives.
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• Solutions: What are the real estate solutions
available to maximise shareholder value?
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JLL (Covers the period from 2009 - Q3 2014)
2 | The Financial Impact of Real Estate
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Depreciation…mark real
estate to market
3
Own versus lease?
Calculate your cost of
capital for real estate
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• Strategy: Is the real estate strategy aligned with the
financial objectives of the organisation?
Get ready for the new
lease accounting proposals
4
Raising capital?
Consider all your options
5
Outsource surplus real
estate to the experts
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Get ready for the new
lease accounting proposals
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
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
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.
What is the divergence?
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 a single classification 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 dual lease accounting 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
Type A & Type B Lease Accounting Methodology for Lessees
2
Balance sheet
Income statement
Cash flow statement
Revised proposals
Type A
Right-of-use asset
lease liability
Amortisation expense
interest expense
Principal
interest
IASB & FASB
Type B
Right-of-use asset
lease liability
Single lease espense
on a straight-line basis
Single lease
payments
FASB only
IFRS (2014), Project Update: Leases
The Financial Impact of Real Estate | 3
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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
Case study
Global technology company
Get ready for the new
lease accounting proposals
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.
Next steps…
• Calculate the impact on your balance sheet and upfront impact on
the income statement
Problem
A Global Technology Company wanted to understand and
assess the impact of accounting proposals on their European
occupational portfolio
• Develop a plan for implementation of the proposals
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
For more information on the changes to lease accounting
standards, view JLL’s latest report A Tale of Two Standards
• Assess the impact on own vs lease decisions
• Review existing lease administration and accounting systems
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
3
4
PWC/Rotterdam School of Management, (2009), Proposed lease accounting: research of impact on companies.
PWC, (2010), Making sense of a complex world.
4 | The Financial Impact of Real Estate
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Depreciation…mark real
estate to market
Unrealistic depreciation policy can stifle the business
Companies face significant write down on disposal or risk paralysis with equity locked in
redundant real estate
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.
5
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.
In practice…
What should you do?
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
Useful life
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
Residual
value
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
Company’s media plan is unaffected by the transaction.
The Financial Impact of Real Estate | 5
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Case study
Blue chip company
Problem
A 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.
Solution
JLL 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
Outcome
The 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.
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
5
Company’s media plan is unaffected by the transaction.
6 | The Financial Impact of Real Estate
Depreciation…mark real
estate to market
RULE
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3
Own versus lease?
Calculate your cost of
capital for real estate
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
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
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.
Recurring P&L costs
Assumptions table
£1.3m
Analysis term
£1.1m
10 years
Initial annual rent
£1,000,000
Rental growth pa
3.00%
Net acquisition price
£13,000,000
Depreciation term
£0.9m
30 years
VP value (in 10 years)
£8,000,000
NPV analysis
£0.7m
Lease - current accounting
£0.5m
Year 1
Source: JLL, 2014
Year 2
Year 3
Year 4
Lease - new accounting
Own
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Discount rate
8.00%
4.00%
Lease
£7.6m
£9.3m
Own
£10.1m
£8.4m
Lease
Own
Lowest NPV
The Financial Impact of Real Estate | 7
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Case study
Leasehold buy-in
Problem
The 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
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
8 | The Financial Impact of Real Estate
Own versus lease?
Calculate your cost of
capital for real estate
RULE
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4
Raising capital?
Consider all your options
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
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.
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.
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
EMEA Corporate Disposals
€20
€15
€10
€5
Volume corporate disposals
(€ billions)
€0
2008
2009
2010
2011
2012
2013
9M 2014
Source: JLL, 2014
The Financial Impact of Real Estate | 9
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Outsource surplus real
estate to the experts
Surplus real estate is a drain on most
companies – both resource and capital
Case study
Leasehold Liability Transfer
Shareholder value can be created by
dealing with it efficiently and effectively
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.
6
Henley Business School/Core Consult (2013), The Elephant in the Room
10 | The Financial Impact of Real Estate
Problem
The 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.
Solution
Advised 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.
Outcome
The 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.
JLL has disposed of several surplus lease portfolios for
Santander and BIS amongst others, with a total of £100
million in gross liabilities within an 18 month period.
Next steps…
• Mark surplus real estate to market
• Evaluate risk and assess internal resources required
• Partner with experts and market test outsourced solutions
Conclusions
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.
The Financial Impact of Real Estate | 11
Business contact
Michael Evans
Director
Corporate Solutions
+44 (0)20 7399 5575
michael.evans@eu.jll.com
Daniel Miller
Director
Corporate Solutions
+44 (0)20 7852 4003
daniel.miller@eu.jll.com
Naftali Chesner
Director
Corporate Solutions
+44 (0)20 7399 5368
naftali.chesner@eu.jll.com
Research contact
Karen Williamson
Associate Director
EMEA Research
+44 (0)20 3147 1197
karen.williamson@eu.jll.com
Tom Carroll
Director
EMEA Research
+44 (0) 203 147 1207
tom.carroll@eu.jll.com
This first featured in a guest blog for CFO World, ‘Getting real about real estate’
jll.co.uk
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