Real Estate: Give and Take

Some of the most eye-catching deals at the start of 2007 have been about property — the record $40 billion (€31 billion) private equity takeover in the US of Equity Office Properties Trust, a real estate investment trust (REIT); Swiss Re's record £600m (€900m) sale-and-leaseback of the landmark "Gherkin" office tower in London's financial district; even the takeover of Liverpool Football Club by US financiers George Gillett and Tom Hicks.

A focus on property, both direct and indirect, is a growing feature of takeover deals, and of corporate finance generally. Why? Because real estate has, after a long process, become a truly global, tradable asset class. The market for REITs, or securitised pools of property assets, is the main reason. REITs really took off in the US in the 1990s, some 30 years after they were introduced there — the market is now worth around $350 billion and growing fast. And REITs have exploded in the past few years in other markets, notably Australia, Hong Kong, Japan and France.

This year, REIT markets have been created by new laws in the UK and Germany — the latter, in particular, has enormous potential as Europe's largest property market. According to Baker & McKenzie, a law firm, the 65 largest quoted German companies alone hold real estate reserves of about €80 billion. And German REITs "create an incentive for selling any real estate deemed unnecessary for operation of the business by introducing tax privileges for the disclosure of hidden reserves," according to a Baker & McKenzie briefing on the new law.

In the UK, nine property companies converted as soon as the law took effect on January 1st this year, creating a market worth £37 billion, or about 9% of the global REITs market. That could double if other listed property companies choose to convert.

This explosion of liquidity is expanding the potential investor base for property. In anticipation of these markets, several European firms have already been unlocking capital through sale-and-leasebacks. But the development of a liquid property market is putting pressure on those that have been slow to move. J. Sainsbury, a £17 billion UK supermarket chain, looks set to be the target of a record European private equity buyout after CVC, KKR and Blackstone confirmed a bidding interest in February. As Jaime Vazquez, food retail analyst at JPMorgan, observed, "The approach to the company merely represents an attempt to arbitrage away the gap between the company's valuation and the value it would have as, separately, a property asset and an operating company."

The benefits to companies when they hive off their property are manifold. Michael Lindsay, a corporate finance partner at KPMG, says that it frees up capital for investment; it has tax benefits as lease costs are offset as an expense; it often improves the balance sheet as property has been held at below cost; and it transfers property value risk to a third party while leaving the seller with operational control. Lindsay adds, however, that a big issue for sellers is to get a grip on "the degree of operational flexibility you require and are prepared to pay for."

This is something that early adopters have been grappling with — none more so than the hotel sector, where some of the biggest chains have been adding contractual wrinkles to sale-and-leasebacks aimed at addressing their market's particular set of circumstances.

The Tough Questions
When Jacques Stern, CFO of Accor, a €7.6 billion French hotel group, first spoke to potential real estate investors in 2005, he knew it was going to be a tough sell. He wanted to pitch a new concept for the hotel sector — a sale-and-variable leaseback, which would require no minimum guaranteed rental payment. Stern concedes, "It was hard to convince them not to have a minimum."

That's understandable, as Accor's proposal effectively pulled the property owner's safety net away, says Arthur de Haast, CEO of Jones Lang LaSalle Hotels, a property advisory firm. If a hotel had zero income one month, so did the property owner.

However, he adds that the minimum guarantee rarely comes into play. A hotel would have to do catastrophically badly to hit that safety net.

As for Stern, he was trying to crack a problem facing most companies that have gone down the sale-and-leaseback route — it may reduce capital intensity, but not earnings volatility. Sale-and-variable leasebacks address that, up to a point — they give the property owner a fixed percentage of revenue but there is still a minimum guaranteed payment.

In 2005, Accor decided to sell just over 200 hotels, mostly in France, under a sale-and-variable leaseback arrangement.

"We selected assets that were midscale and economy hotels, far less volatile [than our upscale hotels in terms of earnings] and far more profitable from a ROCE standpoint," says Stern.

Accor entered into an agreement with Foncière des Murs (a consortium of property group Foncière des Regions and the life insurance arms of Credit Agricole, Credit Mutuel and Generali) for a phased purchase of 128 hotels from its portfolio of Mercure, Novotel and Ibis brands for €1.03 billion. Under the agreement, Accor pays rent at 14% of revenue for 12 years, with an option to renew four times — a total of 60 years. In March 2006, 76 properties were sold for €583m under similar terms. Stern intends to roll this model out to other markets and is looking for partners in the UK, Germany and the Netherlands to sell a portfolio of 120 hotels.

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