Commercial property - A capital idea

News that UK retailer Selfridges is thinking of raising up to £360m from its flagship Oxford Street store ought to be a wake-up call for finance directors. Property has been off the boardroom agenda for too long. Indeed, in most companies, it has hardly been on it. But there are some compelling reasons why it should be looked at closely.

In Selfridges’ case, the driver seems to be a desire by the new chief executive (and former FD) Peter Williams to strengthen the balance sheet. Selfridges is believed to have rejected the classic sale-and-leaseback approach in favour of a mortgage-type of arrangement that will leave it in control of the property. When (and if) the deal happens, it is probable that cash will be returned to shareholders.

Selfridges is by no means alone in finding external forces being the prompt to take action on property. In its case, the market had been disenchanted with its performance for some time and there have been suggestions that its low-ranking share price could make it a target for takeover. But Selfridges is not the only company taking a fresh look at property. Last year, Marks & Spencer entered a flexible sale-and-leaseback arrangement for some of its stores. The move has helped the company, which is recovering slowly from disastrous trading years in the late 1990s, to return about #2bn to long-suffering shareholders.

Harrods raised £350m on a remortgage of its Knightsbridge store to pay off debt, and House of Fraser completed a deal with British Land to raise money for store refurbishment. It is no accident that retailers with big and expensive estates in prime positions are leading the charge when it comes to new approaches to property.

But companies with significant amounts of property in any business area should also be looking at their options. UK private-sector commercial property is worth £400bn and represents 34% of total business assets, according to a recent study by Capital Economics for the Royal Institution of Chartered Surveyors (RICS).

According to CEO of RICS Louis Armstrong, firms could be missing out on huge savings. The Capital Economics’ study, Property in Business: A Waste of Space, suggests that UK firms could save up to £18bn a year on property, enough to boost gross trading profits by as much as 13%. Major savings include up to £9.5bn if all owner-occupiers use space as efficiently as tenants, and as much as £6.5bn if all office-based businesses implement new working practices such as hot-desking.

A couple of years ago, academics from London’s City University Business School (CUBS) completed a land-breaking study of 4,500 companies with £212bn gross book value of property. Some 68% of the property was held as freehold and 32% as capitalised leases. The study found that companies using capitalised leases generated “notably higher returns for their shareholders than the freehold companies”. According to the study, “The leasehold companies have higher market-to-book ratios, higher Tobin’s Q (the ratio of the market value of equity, plus book value of debt over total assets) and they generate higher stock returns than the freehold companies.”

Mark Norris, new business development director at Land Securities Trillium, doesn’t find this surprising. “What’s important is that occupiers’ capital isn’t tied up in buildings,” he says. “A company must believe it can earn a higher return on its capital investing in its core business than having hundreds of millions tied up in buildings.”

Richard Smee, a partner in the real estate group at Ernst & Young, believes the key issue for boards it to create improved strategic alignment between property holdings and the needs of the business. The argument about flexibility becomes especially potent in a business world where change takes place more quickly than ever before.

Yet the first step in doing anything about property seems to be promoting it as a boardroom issue. Armstrong believes there is “boardroom blindness” when it comes to property. “Given that property often represents the second biggest cost after salaries, it’s surprising that many businesses do not have an accurate assessment of the property costs they face and that management of property is usually handled at an operational rather than strategic level,” he says.

Smee points out that the property director is usually not on the board, and may only be a manager. He suggests that property managers don’t have much personal interest in promoting debate about new options. “The last thing they’re going to do is trot along to the FD’s office with a plan that makes them and their colleagues redundant.”

Norris believes that turning property into a strategic issue involves a change of mindset. “You have to recognise that property is not part of the core business. Once you’ve got over that important psychological barrier, you are into a number of important questions.” These include looking at the amount of capital tied up in property, along with issues such as operating costs and facilities management.

“The board has to ask, ‘If I want to do something with my property, what is the range of issues I am facing?’ Then it must invite the market to respond with a proposition that deals with the full range,” adds Norris.

But one problem the study identified is that FDs often lack the kind of sophisticated cost data on property that would help them make more informed decisions. In some cases, asset registers are out of date, incomplete or non-existent. Armstrong advises companies to relate property costs to business units or to calculate them on a per employee basis, so there is a measure which can be used to relate the costs to business strategy as a whole.

But the greatest barrier to more flexible property ownership seems to be cultural rather than financial. “You find that many companies are holding property not because they’re necessarily going through a rational analysis and have concluded it’s the best thing, but because they haven’t actually questioned it in the first place,” says Norris. This particularly applies to properties with what Norris calls “iconic status”, such as trophy assets like corporate headquarters. Yet, as Selfridges is showing with its Oxford Street store, even trophy properties can be used to re-engineer the balance sheet.

The danger of long-term property ownership is that boards fall into the trap of thinking that property is somehow free. So there is less focus on using the property efficiently and no debate about the opportunity cost of applying funds invested in the property to the core business.

That is the main reason owners use property space less efficiently than lessees.

Within the next two years, it is likely there will be a new international accounting standard on leases. This should focus FDs more on the balance sheet implications of holding property in different ways. Way back in 1999, the Accounting Standards Board (ASB) published a discussion paper entitled, Leases: Implementation of a New Approach. This included a position paper which recommended that lessees should record, at the beginning of a lease term, the fair value of the rights and obligations that are conveyed by the lease. The effect would be to bring off-balance sheet operating leases on to the balance sheet. The position paper suggests that the fair value of the rights obtained by a lessee would, in general, be measured as the present value of the minimum payments required by the leases, plus any other liabilities incurred.

At the request of the IASB, the ASB expects to start a research project later this year to develop an international accounting standard for leases, says Andrew Lennard, ASB director of operations. Lennard says it is unlikely any new standard will be operational before 2005.

The earlier position paper is likely to be influential in developing the standard, but Lennard believes there will have to be “further consultation because we are now looking at an international standard. There will have to be an international exposure draft, if not an international discussion paper.”

None of this should prevent FDs taking an initiative now to review property ownership and management. “The current low economic growth has raised the significance of property,” says Norris. “It’s time to consider the questions of balance-sheet efficiency and property operating costs.” Perhaps it’s time for that peculiarly British love affair with property ownership and long leases to end.

PROPERTY LADDER BLUES
Three years ago, BT had £30bn of debt on its books – the legacy of a decade’s drive to become a major player in the global telecoms market.

The board was urgently looking for ways to reduce its debt and huge property portfolio – 5.5m square metres in 6,700 buildings was an obvious target.

In December 2001, BT formed a joint-venture called Telereal, with Land Securities Trillium and William Pears, to manage nearly all the properties.

The deal unlocked £2.38bn of debt from real estate, partly through Telereal’s ability to issue bonds at lower yields than BT corporate bonds.

But BT’s directors also found that Telereal has delivered a much wider range of benefits. Mike Schraer, director of commercial partnerships at BT, explains that, “By removing the property assets from BT’s balance sheet – which is, in essence, a non-core asset to BT – it allows us to achieve a more efficient capital structure and invest our funds in our telecoms business to achieve higher returns.” According to insiders, just under 18 months down the track, the deal is achieving its twin financial objectives: ensuring an earnings-positive effect on BT’s profit and loss account, and improving liquidity.

But there have also been other benefits, not least transferring property risk. More than 6,000 of the properties covered by the deal were freehold or long leasehold. This meant that BT’s property portfolio was relatively inflexible at a time when its business was, and still is, changing fast.

During the 30-year course of the deal, BT can vacate up to 35% of its current property space without financial penalty, subject to a maximum each year. “We’ve taken on the risk of being able to realise the value of the property when BT vacates,” explains Mark Norris, new business director at Land Securities Trillium.

“It became clear when we were discussing the deal that BT faced lease obligations on properties that were becoming quite onerous. So the flexibility to downsize the leaseholder stake is an important dimension of the transaction,” he adds.

As part of the deal, BT’s 350 property staff transferred to Telereal.

Not having to handle such a large real estate portfolio has freed up management time. “This allows us to focus on our core telecoms business,” says Schraer. “It is critical that we meet the ever-changing needs of our business in the most cost-effective way.”