Putting Property First

In mergers and acquisitions, real estate has typically been an afterthought. Recently, though, property has taken center stage. Consider the current plans for a $6.6 billion private-equity buyout of Toys "R" Us. "We became interested in Toys "R" Us principally because it has lots and lots of terrific real estate, in the U.S. and abroad," said Steven Roth, CEO of Vornado Realty Trust (one of the three buyers), at a real estate conference at New York University.

Lehman Brothers real estate analyst David Harris estimates the toy retailer's properties to be worth $2.6 billion. Property values also figured prominently in Kmart Holding Corp.'s $12.3 billion purchase of Sears, Roebuck and Co. Analysts expect Kmart to sell off many underperforming Sears mall properties and plow the proceeds back into redeveloping Kmart's freestanding stores. Federated Department Stores Inc. is expected to do something similar with its $11 billion purchase of May Co.

"The prevailing view is that real estate has really motivated these big retail mergers," says Steve Tinsley, senior vice president of corporate finance at Equis Corp., a Chicago-based real estate transaction and consulting firm.

Corporate property has also played a major role in smaller deals. In 2003, for example, Milwaukee-based toolmaker Actuant Corp. financed almost the entire $17 million purchase cost of German company Heinrich Kopp AG through a sale-leaseback of one of Kopp's facilities to W.P. Carey, a New York­based commercial real estate firm. "We would definitely consider doing something like this again," says Actuant treasurer Terry Braatz.

Finding Cash in The Building
What accounts for the focus on property? A new level of visibility, often brought on because the price of corporate real estate has risen so high that it is simply too expensive for dealmakers to ignore. In the case of Sears, for example, Deutsche Bank estimates that the total value of the retailer's real estate is greater than the company's entire premerger market value. Political sensitivity has sprouted from other deals, where there may be community ties to a property. Procter & Gamble Co., for instance, which paid $57 billion for Boston-based Gillette Co., had to ease concerns in the shaving company's hometown by declaring that it would invest $200 million in Gillette's prime manufacturing property there—and wouldn't sell it.

The real estate revival in general reflects the relatively slim returns offered by stock and bond markets, not to mention historically low interest rates. Those rates have made financial institutions more aggressive about pursuing better yields, often by pouring money into property, then leasing it long-term to stable corporations.

As a result, transaction volume for U.S. commercial real estate properties with prices of more than $5 million jumped from $120 billion in 2003 to $160 billion last year, according to Real Capital Analytics, a New York real estate research firm. And the market is not cooling. "There's still a tremendous amount of money chasing property," says Equis's Tinsley.

Sometimes, sellers are the ones to realize that the value of their holdings can create beneficial M&A strategies. Before its $10 billion acquisition by Manulife Financial Corp., in 2004, John Hancock sold its landmark Boston headquarters building for nearly $1 billion. At the time, Hancock's management had been talking with possible buyers, and realized it could get more money by selling in a transaction separate from the takeover. The sale had the added benefit of strengthening Hancock's preacquisition balance sheet; the company booked a $500 million gain.

Such a strategy often makes sense, says Bob White, president of Real Capital Analytics. "A company like John Hancock can claim its real estate is worth $1 billion, but the buyers of your company usually aren't real estate guys," says White. "They're going to discount it heavily, especially in a multi-billion-dollar deal."

The Leaseback Tool
When real estate ends up starring in an M&A deal, it's usually as a financing tool in the hands of the buyer. In some cases, companies sell off their own real estate assets to create a pile of cash they can use either to pay for a company directly or to reduce debt and free up credit lines. More commonly, though, sophisticated buyers are scanning their target's property, picking the land or buildings that are prime to be sold and leased back, or identifying attractive existing leases that a buyer could sell to someone else at a profit.

Sale-leasebacks and net-lease transactions are especially attractive in today's market because capitalization rates—the yield on a property, expressed as annual lease revenue divided by the price paid for the property—are so low. In other words, investors are paying a lot for properties, while rents are comparatively cheap. And with more companies in the M&A hunt these days, acquisition-related leasebacks are increasing. "We've definitely seen an increase in activity, especially over the last six months," says Laurie Hawkes, president of U.S. Realty Advisors LLP, a New York­based real estate investment firm (see chart, page 32). She thinks "sale-leasebacks will increase significantly."

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