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With mergers creating more unwanted property, finance executives must come up with creative ways of unloading it.
Jennifer Kruger, CFO Magazine
February 1, 1999
Fruit of the Loom had a vast amount of real estate, plant, and equipment in 1996, when all of its manufacturing operations — from spinning yarn and cotton into fabric to cutting and sewing that fabric into clothing — were done in the United States. The Bowling Green, Kentucky-based clothing manufacturer's portfolio of fixed assets stood at $900 million, or 35 percent of its total. Thus, when the company decided to sew fabric offshore and consolidate textile production into five manufacturing facilities in the southeastern United States, the move saddled it with over 10 unneeded factories.
By January 1998, all of those unneeded factories had been sold, leaving the company with $514 million in fixed assets, or about 20 percent of its total. Selling the factories was not easy, although Fruit of the Loom did sell the plants more or less "as is" to other textile makers. "We tried to package the facilities with equipment that would enable other people to run them as they were run before," says Calvin McKay, controller of Fruit of the Loom. To clinch the deals, the company had to agree to buy raw materials from the new owners until they got up and running.
Many other companies find themselves in a similar situation, with fixed-asset portfolios consisting of everything from plant and equipment to office space and warehouses. These assets account for between 35 percent and 50 percent of the typical Fortune 500 company's assets, says Edmond Prins, senior partner at Corporate Asset Advisors, a Lighthouse Point, Florida, consulting firm. Those figures could rise as more companies engage in mergers and acquisitions. "Mergers result in at least 10 percent waste, in terms of excess assets, on average," says Michael L. Silver, CEO of Equis, a corporate real estate services firm in Chicago.
More companies will be shedding excess assets in 1999, if projections of lower corporate earnings pan out. Silver expects a 20 percent increase in the volume of existing commercial properties coming onto the market this year, on top of a 25 percent to 30 percent increase in 1998.
New nonresidential construction, meanwhile, remains strong, at least in some quarters, despite signs of a slowing economy. While outlays for new plants and warehouses have weakened, Cushman & Wakefield, a real estate firm based in New York, expects 68 million additional square feet of suburban office space to be constructed in 1999, almost 60 percent more than the 43 million constructed last year.
All this could put pressure on prices of vacant properties, unless demand rises with supply. That's unlikely. Investors such as real estate investment trusts (REITs) and pension funds have grown more conservative, and are now focusing on rental income rather than appreciation. REITs, for one, "were buying stuff that didn't make sense," says Janice Stancon, director of investment research at Cushman. "We're looking for them to hone their portfolios. A lot of the stuff they're going to sell [will] be lower quality." So the simplest means of divestiture — vacating a building and looking for a buyer — is likely to become a less-viable option.
With real estate investors pulling in their horns, some companies have found an alternative — sale/leasebacks — increasingly attractive. In such arrangements, a company sells a facility to a buyer, which leases it back to the seller. The buyer gets immediate income from the lease, as well as ownership of the property; the seller gets to move the asset off its balance sheet. Stancon of Cushman expects an increase of at least 15 percent in the number of new leasebacks this year.
Avoiding a Fire Sale
For a leaseback to be worthwhile, of course, the rental payments must be less than the potential earnings from reinvesting the proceeds of the asset sale. For that reason, Woodland Hills, California-based Litton Industries Inc., a defense contractor that has made frequent use of leasebacks, may prefer divestiture if it can sell a property for at least eight times the amount of potential lease payments, according to vice president and controller Carol Wiesner.
Also, leasebacks make sense only if a company wants to continue to use the property. If not, there's little choice other than an outright sale. To avoid divestiture at fire-sale prices, companies like Schlumberger Ltd., an oil-field services and technology company headquartered in New York, and Fruit of the Loom have sought to redevelop property and lease it with the eventual aim of selling it to an income-oriented investor, or to find users in hopes that they will place a higher value on the property.
Both alternatives, of course, may require considerable time and expense. From that perspective, Fruit of the Loom was lucky. Its industry contains some 25 potential users, yet is intimate enough for Fruit of the Loom to know these users' needs well. As McKay puts it, "Everybody knows everybody." So Fruit of the Loom found it relatively easy to target its search to appropriately sized companies that needed extra capacity and would supply the raw materials it required. Even so, the process took as long as 18 months to complete. To get the most for the plants, the company focused on those producers it believed would pay a premium for a ready-to-go textile mill, instead of one they had to shut down and restart with new machinery on which they would have to retrain workers.
Despite the time involved, McKay contends the cost of its search was nominal. And he estimates that the company sold the plants for 10 to 20 percent more than it would have received had it simply sold them as brick and mortar.
Sometimes, developing a property for an investor can draw interest from users, as Schlumberger found with a facility in Ann Arbor, Michigan, that it finally sold in 1997. The facility, which included several buildings and excess land, was originally constructed for one user, a software development subsidiary that the company sold in 1992. To make the property more valuable, Schlumberger redeveloped it for multi-tenant use, which involved reducing the common space. Once it was fully leased, Schlumberger intended to sell out to an investor. Although the work cost $400,000, Gary Cozart, director of real estate, says rental income from tenants more than offset the investment. Plus, Schlumberger believed the building would be worth more to an investor if there were tenants.
It so happened that its largest tenant, the University of Michigan, needed more space. And Schlumberger's development efforts helped convince the university that buying the property would be a good investment. The two parties agreed to a price of $13 million. Schlumberger meanwhile had subdivided the land from the buildings and sold it to Domino's Pizza, which was headquartered down the street, bringing Schlumberger's total proceeds to $17 million.
Cozart says that if the company hadn't developed the buildings and sold the land separately, it would have received $6 million to $7 million less. And he suggests that other companies may have more opportunities to take advantage of land subdivisions than they realize. "In many cases," says Cozart, "if you combine the land around it with a building, you'll let the land go for a very low price."
Some of Fruit of the Loom's and Schlumberger's efforts to sell surplus property have required extensive outside help from consultants, real estate brokers, engineers, and land planners. Yet, after relocating an oil-field research lab from Tulsa, Oklahoma, to Sugarland, Texas, Schlumberger found a user for the Tulsa property — the county health department — within six months, through some inexpensive public resources, the local chamber of commerce and economic development council. And, so long as recent M&A trends continue, corporate real estate departments are likely to call on outside resources of all kinds.
Jennifer Kruger is a freelance writer based in Hoboken, New Jersey.