Traditional trading businesses naturally focus primarily on their operating business, but often are unaware of the relatively simple options available to ensure they are making the most of their real estate assets. In a competitive and recovering market we are aware of the pressure to extract the most value from existing real estate interests or portfolios, once again taking into account the effect of COVID-19 on businesses as a whole. “Property companies” (companies whose primary business involves making money out of their real estate) are, of course, well-versed in maximising their financial position through their property portfolio. However, “non-property businesses” (where their real estate may not be the primary driver of the business, albeit they own or lease properties for the purpose of undertaking their business) are not as focused on taking advantage of their real estate assets to generate income and maximise their financial position. Below, we explore opportunities for companies to extract additional value from their real estate assets, both from an active asset management perspective as well as by leveraging their properties.
Each of the value extraction options discussed below may have tax implications, and specialist tax advice should be sought before implementation.
Sale and Leaseback
Implementing real estate sale and leasebacks as an alternative financing tool has been on the rise in recent years for corporates of all sizes and across a range of industries. This is likely to hold true in the post COVID-19 landscape as cash strapped companies seek to unlock cash currently tied up in their real estate.
A sale and leaseback transaction involves the sale of an owner-occupied property to a third party investor for a lump sum payment. Immediately after the sale, the investor leases the property back to the seller for an agreed period in return for the payment of rent by the seller. In other words, the investor immediately becomes the seller’s landlord. For the investor, the advantage is in purchasing a let property already generating income. For the seller, the arrangement can unlock more equity than a conventional finance whilst typically also being in a stronger position to negotiate more favourable lease terms for the property than the average tenant. A sale and leaseback also has the advantage of allowing the seller to focus on its core business without bearing the risks of property ownership.
This arrangement is adaptable to all industry sectors including corporate offices, logistics warehouses, retail units and alternative assets classes such as manufacturing plants and petrol stations.
Unutilized Land, Development and Change of Use
Many companies are unaware of the vast potential of owned land which could, through creative thinking and decisive action, become an income producing asset and significantly increase the market value of the property. Even “non-property companies” should take stock of their real estate portfolio and identify any under-utilised land. This could include vacant land, occupied land with a potential for redevelopment or simply identifying land which may not be integral to the functioning of the company’s business and is ideal to be repurposed. The market value of land can dramatically rise by obtaining planning permission for a different use (such as residential or a mixed use development) and with a surge in e-commerce over recent months, certain plots of land may have the potential to be redeveloped to take advantage of the increasing need for industrial and logistic space. Alternatively, companies could consider renting out vacant space or making such space available for “pop-ups” or “click and collect” providers to bring in additional base revenue and increase footfall. The options are endless and a little ingenuity could go a long way.
Although it is possible to raise debt against a business which owns real estate, some debt providers will not lend to an operating business primarily because it has more unsecured creditors, employees and potential pension exposure. A more efficient financing method is to split the real estate asset from the business creating an OpCo/PropCo structure where the property is put in a clean SPV owner and then a lease granted back to the operating business. This opens up the opportunity to obtain debt at lower pricing from the traditional real estate debt providers who want to take security over the real estate from a clean SPV property owning company without the direct operating risk of the business. Care does need to be taken not to expect to put too much additional debt through the Opco if this method is adopted.
Using ground rent leases as a financial tool is also a potential yield arbitrage play. The ground rent mechanism involves the sale of the asset itself (usually to a high income fund, or pension fund) followed by an immediate lease back of the premises on a long term lease at a fixed rent which provides the buyer of the freehold with long-dated, secure and inflation-protected income.
Ground rents can be a compelling proposition for institutional investors. In addition to providing attractive cash flows that rise in line with inflation, they incorporate very low default risk because the lease payments represent such a small outgoing for the tenant. Like a sale and leaseback, an investor in commercial ground rents owns the freehold outright.
However, the long investment horizons of ground rents means lease payments form the majority of these assets, while the low rent level gives the investor a great deal of certainty over the cash flow for the long term. Since ground rents are valued based on the discounted value of their expected future cash flows, this means in practice the residual value of the real estate makes up a much smaller component of the value of these assets. They are valued almost entirely on the basis of their expected cash flows.
Financing the Asset
The real estate that your business owns can be one of your most valuable assets. Many non-real estate businesses have substantial real estate assets in order to run their business. These can be used to raise debt against the real estate as collateral, in particular, business expansion by acquiring additional operating sites. Debt is available in many forms from investment to development and general working capital secured on the real estate and can be implemented conventionally or, if your business is Sharia compliant, using Islamic finance techniques. Pricing and risk will, of course, depend on a number of variables from considering lower leveraged senior debt, mezzanine finance for higher loan-to values or even equity style investments with investors coming in as preferred equity using debt instruments. For a business which generates long term stable income, the capital markets can produce interesting products to provide longer-term financing needs.
In the current market, many businesses are focusing on assessing and protecting existing assets, rather than investing in new stock.
The main focus for many companies is therefore to extract value from their current property interests, specifically via asset management, lease re-gears, possible changes of use, and of course talking to their lenders. These types of ‘conservative’ work-streams are likely to continue to be the main areas of attention for the remainder of this calendar year.
In the current environment, companies who may not consider themselves to be “property businesses” should still look to evaluate their real estate assets. The options outlined above carry differing advantages and disadvantages and of course, each business or portfolio of businesses will have their own operational procedures and commercial drivers for consideration.