Your corporate real estate assets: do you know what's under the covers?

Today, successful corporations are examining every component of their operations to capitalize upon market opportunities and ensure that their operations are as efficient and effective as possible. One key aspect often overlooked in this analysis is the real estate operations of the enterprise. Oftentimes those now overseeing this area may believe that there is no opportunity to change or alter the costs associated with this aspect of the corporation: There is an opportunity to change the cost structure and add value through the corporate real estate department!

Over the past few years many corporations have focused attention upon their real estate operations in order to more closely align themselves with customers and employees. In the process many have concluded that real estate is not one of their core competencies and have outsourced the area to a third party service provider while others have concluded that they do have the expertise to manage their real estate assets. While both paths are being pursued, it is crucial that the company's real estate assets be proactively managed. During this active management process, the following areas are being addressed:

Strategic Plan - Do the real estate assets support the Company's plan? Is flexibility provided to adjust to changing market conditions?

Facility costs - How does our company compare with its peers and what is the market value of the real estate assets?

Geographic location - Is the organization located in those sites that maximize value to its customers and employees and hence the stockholders?

Lease or buy - Does the organization have too much capital invested in its real estate assets? Do some of the more exotic leasing arrangements (such as synthetic leases) make economic sense?

Leased facilities - Are the leases activity monitored and do they contain provisions that maximize our flexibility?

Strategic Plan

First and foremost the company's real estate assets must support the strategic plan. If the company might outsource the production of its clothing line to an offshore firm in the future, the decision to lease a manufacturing plant or to buy a facility (in addition to the equipment that would need to be secured) must consider this alternative: a decision to buy a facility or to lease a property for 20 years would clearly conflict with the plan. Similarly, we see banks challenging the need to deliver their products and services from free-standing branches - many are seeking strategic alliances with grocery store chains to establish banking facilities within the grocery store.

Given this goal, long-term branch bank leases or ownership of the real estate itself are questionable and probably a poor use of the bank's capital and again in conflict with the strategic plan: short-term leases would seem appropriate.

Real estate must support the company's strategic plan and provide the flexibility to adjust as market conditions dictate.

Facility Costs

Whether an organization uses cost per square foot, square foot per employee or cost per $1 of revenue, real estate costs are being measured and benchmarked to assess the competitive position of the organization. In the process, companies are discovering that real estate costs are not fixed but rather are variable. By benchmarking your real estate or facility costs against your peers, industry averages or prior operating results you can identify areas of potential cost savings and/or permanent cost reductions.

The key is to understand your costs while retaining the ability to alter your cost structure. Should market conditions dictate a decision to close or reduce the size of a facility, (be it a manufacturing plant, a sales office, a bank branch or a retail outlet) the company must be in a position to act swiftly to alter the organization's real estate cost structure and enhance future profitability. Flexibility and the need to be nimble are hallmarks of today's corporate structure.

As part of real estate management process, companies are also obtaining information about the market value of their real estate assets.

The intent of this assessment is not to decide when to sell but rather to use the information to help assess and evaluate business alternatives and measure performance - if you are considering shutting down a facility, it is good to have the information at hand to assess the costs involved; if you wish to assess performance of a business unit, use of market as opposed to historical costs produces a better result.

Geographic Location

After analyzing your operations from a strategic point of view, and challenging your costs, reviewing the locations you do business with may be in order. Just as recognizing that real estate costs are not fixed, organizations have come to recognize that while their operations may have once been sited in the best location, due to a changing customer base, workforce, supplier base or production cost, a facility may be in the wrong location.

After deciding that site location may be an open question, the next step is to explore the costs to relocate and the incentives being offered by the various government entities to entice organizations to stay or to setup shop in their location. Professional sports teams do not have a monopoly on the receipt of government incentives. From tax abatements, to relocation loans and employee training programs, governments are recognizing that they must compete to attract or retain their employer base. These incentives can and will impact your decisions - however, they should not drive the overall decision: that should be driven by the economics of your operation now and more importantly in the future.

The key is to recognize the geographic alternatives and explore them to enhance long-term shareholder value.

Lease or Buy Decisions

Each organization (large publicly held entity, multi-location retailer, professional service firm, closely-held company or non-profit entities) is being challenged on their decisions to buy or lease facilities. The amount of capital invested in real estate continues to be a concern of managers, corporate analysts and shareholders seeking to enhance profitability or sales. Absent a very compelling reason to purchase a facility, corporations generally seek to lease in order to maximize their future operating flexibility and minimize current capital outlays: it is much easier and hopefully less expensive to relocate an operation if the organization is merely a leasee rather than an owner.

Today's leasing options have expanded with the emergence of the synthetic lease. In a nutshell, a synthetic lease is designed to avoid treatment as a capital lease for book purposes (requiring that the entity treat the lease as if they had purchased the asset and financed the acquisition via a loan) while at the same time recording the transaction as if the asset were purchased for income tax purposes. The benefits to the leasee are:

* Lower initial investment in real estate assets;

* Off-balance sheet treatment for the transaction;

* Increased leverage for the business or the ability to invest capital in other revenue enhancing endeavors;

* Reduced income tax payments as the organization is able to claim depreciation on the asset and shelter a portion of its taxable income.

While these are definite benefits, the corporation will retain the underlying real estate risk and end up compensating the lessor if the value of the property declines more than a set amount.

The real estate risk aside, the ability to free up capital to be used to invest in new products or to purchase new businesses is a major incentive to many organizations. Again, the key result of this analysis is the enhancement of shareholder value based upon a thorough understanding of the current and future real estate needs of the company.

Leased Facilities

Much time and effort is invested by the landlord and tenant reaching a satisfactory lease agreement. On the tenant side, the turnover of key people and the expansion (both geographic and product line) of the operation may lead to a situation where the management of real estate leases consists solely of paying the monthly lease payment and responding to landlord correspondence.

Unfortunately the correspondence may be to alert the company to a near term lease expiration (with or without the ability to extend the term) or request the tenant to vacate due to the termination of the lease: issues that can and should be managed not dealt with in a reactive mode.

Today's business environment requires a much more proactive approach to lease management - tenants must acquire a lease database capable of tracking option exercise dates, lease termination dates, lease rates and other relevant information to place the leasee in the position of being able to actively manage the leased assets.

In addition, leased real estate presents the company with additional information needs: while many of the business units or subsidiaries desire to operate autonomously, the company needs to centrally gather data to determine:

* State Income Tax Allocations

* Whether contracts for the upkeep of the facilities (such as the janitorial service) could be concentrated in a smaller group of vendors to reduce cost and increase service quality;

* Lease expiration dates that may require capital outlays in the near term to protect a production facility.

All of these needs, and many not listed, argue for the company to maintain a central file on the leased assets to manage the process and support the strategic goals of the organization.

Conclusion

Companies are becoming better informed about their real estate assets, their options and steps that can be taken to enhance shareholder value. The key is information and the ability to manage rather than react to opportunities.

Douglas J. McEachern is Partner-In-Charge Western Region Real Estate Services Group. He has more than 21 years of experience meeting the accounting and auditing needs of the Firm's real estate clients. Mr. McEachern is a member of the American Institute of Certified Public Accountants (AICPA) and the California Society of Certified Public Accountants (CSCPA) where he is a member of the Real Estate Committee.

Stuart Laff is Director, Corporate Real Estate Services. He was formerly Executive Vice President, Corporate Properties, First Interstate Bank and Executive Vice President of Corporate Properties for First Interstate Bank. In 1995, Stuart Laff was selected "Corporate Real Estate Executive of the Year" by National Association of Corporate Real Estate Executives (NACORE).