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Excess real estate is a growing financial burden. But some companies are creatively filling their vacancies.
Russ Banham, CFO Magazine
January 1, 2003
Inktomi's eyes were bigger than its stomach. Like other presumptuous technology companies in the Bay Area, Inktomi Corp. binged on real estate in the late 1990s, signing a 15-year lease on a nearly 400,000-square-foot office complex, a $300 million commitment for a partially built edifice that it would never occupy. "We were a voracious consumer of office space," sighs Randy Gottfried, CFO of the Foster City, California-based provider of Web search services.
Inktomi's ravenous appetite was stimulated by the company's nearly 30 percent growth rate per quarter from 1998 to 2000. But when the economy slowed, the company was left bloated with a long-term lease. "This was a tremendous drag on earnings, having a $300 million commitment hanging over our heads," Gottfried laments. "It was also very distracting — it's what investors wanted to talk about all the time."
The only way out was to sign a lease termination with the landlord, Chicago-based Equity Office Properties Trust. However, due to low demand in the Bay Area — vacancy rates hover at around 15 percent — that wasn't going to happen cheaply. "We ended up giving them $40 million in cash up front, plus another $10 million in cash equivalents and stock," the CFO notes. In preparation, the company took a $75 million charge to second-quarter earnings. The deal was struck in September, yet the now-completed buildings remain vacant.
Across the country, the number of similar vacancies is staggering. In Silicon Valley, more than 45 million square feet of commercial real estate — roughly one-sixth of the Valley — sits empty, according to commercial real estate information services firm CoStar Group Inc. In Manhattan, more than 20 million square feet of excess sublease space is now available. And there are few signs of relief: a survey in November of 1,000 member companies of CoreNet Global, an association of corporate real estate professionals, found that 42 percent of companies are planning a net decrease in the amount of space they will occupy in the next six months.
Little wonder that write-offs related to real estate have soared. Sun Microsystems took a charge of $365 million related to surplus real estate, while Nuance Communications has a lease loss that may total $69 million over the next 10 years. Such decisions, explains Robert Willens, managing director at Lehman Bros., reflect "that the real estate is unproductive and permanently impaired, and is carried on the books in amounts unrealistic given the [real estate] market and the company's ability to use the space."
Some companies view write-offs as the easiest way to deal with that inability. But rather than go that route, Cisco Systems Inc., The Boeing Co., and others are thinking outside the cubicle to solve their excess real estate problems. Strategies range from donating buildings to dickering with local communities over zoning regulations to doing what Cisco recently did with 150,000 square feet of unused space in San Jose, California. "We bundled in our own IP technology to make the space more attractive," says Cisco spokeswoman Sandra Wheatley.
Sweetening the deal often makes the difference in this market, which has no shortage of prospective buyers. "These days there's a flight of capital from equity to real estate, which is yielding between 7.5 percent and 11 percent — a hell of a lot better than the stock market," says Michael Silver, president of Equis Corp., a Chicago-based real estate advisory services firm. Moreover, says Harold Bordwin of Keen Consultants, headquartered in Great Neck, New York, when the last real estate crunch occurred 10 years ago it was accompanied by a credit crunch. "That isn't the case today."
The solution, therefore, often becomes creating the right deal with the right tenants. Take Boeing. The Chicago-based aerospace giant has operations in 26 states and a 115-million-square-foot portfolio of office, industrial, and warehouse space. Of this, the company estimates a surplus of 20 percent, courtesy of numerous acquisitions.
Part of that surplus is an empty 2.5-million-square-foot factory in Torrance, California, inherited from McDonnell Douglas. Initially, Boeing Realty Corp. president Phil Cyburt looked to sell the building and the 170 acres upon which it sat to a real estate developer. Then, he says, "I realized there was a political element that a developer would not appreciate. We were transitioning property that once represented significant employment for the community. A developer can come in, tie up the land, and become your voice, speaking about the property on your behalf to the media, the municipality, and the community — a potential PR debacle if you're a large employer in the state, which we are."
So Cyburt took matters into his own hands. "I worked with the city to negotiate development rights — basically the right to rebuild the plant for multiple-tenant commercial development," he says. "We had to measure the impact on the environment, traffic, noise, and air quality before receiving the OK. We also took care of environmental remediation and cleanup issues for the soil and groundwater, and built additional infrastructure on the property for all utilities." Overall, Boeing spent more than $60 million during the last seven years transitioning the site and facilities directly to corporate users. Cyburt estimates the company earned more than $25 million in net profit through the disposition.
In the case of Ford Motor Co., public-relations concerns mingled with historical ones when it tried to unload a 340-acre parcel in Shelby Township, Michigan. The land included an old Packard Motor Co. test track. "We got inquiries about the land from several developers, but they wanted to turn it into tract housing," says Tim O'Brien, vice president of real estate.
Instead, O'Brien sought to preserve the parcel's historic heritage and still sell it at a good price. "Ford met with a group of stakeholders that included the historic folks associated with Packard and various local and city leaders to devise a way to dispose of the property that would be favorable to all involved," he says. Ultimately, a deal was struck with a residential real estate developer to buy about half the land, with part of the proceeds used to create a green space. The parcel that contains the test track was conveyed to The Packard Motor Car Foundation, which worked out a deal with the state's historic-preservation agency to restore the facilities. "We didn't make much money from the deal, but we earned incalculable goodwill," says O'Brien. "This is a good model for how we plan to rationalize our portfolio."
For other firms, that rationalization process can mean refitting a property. "A century ago, companies built buildings that were retrofitted when needed, either for their own use or others. Today, it's often 'build to suit,' and that can backfire," says Glen Sibley, general manager of the Denver office of Corporex Colorado LLC, a Cincinnati-based real estate development and investment firm.
TeleTech Holdings Inc., for example, recently found itself saddled with a planned headquarters that was too small. As the 124,000-square-foot building neared completion, the Englewood, Colorado-based customer management services firm was ultimately compelled to arrange a deal with AT&T Broadband to buy a larger building in Denver. Selling its anticipated headquarters came with a hitch, however: the building was designed to fit TeleTech as its sole tenant, limiting its suitability for other buyers.
So TeleTech went back to the drawing board with the building's architect and engineers. "We took the existing design and modified it for multiple-tenant use, incurring the extra design and construction expenses," says Deborah Miller, vice president of real estate and facilities, declining to divulge the cost. The building was sold in October to Chicago-based RREEF, a real estate investment trust.
While such refitting "can approach the cost of new construction if the change in use is dramatic," says Sibley, it is becoming increasingly common. So has the option of refitting part of the building, "especially when a company does not need to occupy the entire building space and the seller still needs some of it," says Tony Marano, former vice president of business services at telecom Lucent Technologies.
To unload a 2-million-square-foot former electronics facility, Lucent recently worked with Cushman & Wakefield to discern the best uses for the building. What's interesting about the deal (the company declined to name the potential buyer), however, is that Lucent plans to lease back 100,000 square feet of space, "creating cash flow for the buyer," says Robert Donnelly, executive vice president of Cushman & Wakefield of New Jersey. "Although Lucent may use some of this space, the plan is for them to fully transition out."
Just Give It Away
For firms that can't find the right tenants or the right deal, there is always the donation option. The Conservation Fund, an Arlington, Virginia-based nonprofit, for example, "works with companies to determine the dogs in their real estate portfolios," says CEO Larry Selzer. "If these nonstrategic surplus real estate assets can yield a good appraisal, the company can donate them for a significant charitable tax write-off, while minimizing their operating and carrying costs."
In most cases, the fund holds on to the donated property for two years to meet the statute of limitations on donor value, and then sells it in the private market. The net proceeds are put into its risk-capital pool to buy land for conservation purposes. Recent donors include Pfizer Inc., which gave 1,500 acres of old mining properties that the fund later sold to a residential real estate developer.
Of course, there is always one other way to offload real estate, particularly leased property: bankruptcy. The Warnaco Group, which expects to emerge from Chapter 11 court protection this month, was able to walk away from leases with landlords covering some 92 retail outlet stores. "Chapter 11 let us step back and say, 'How much real estate do we really need?' and then achieve that," says CFO Jim Fogarty. "Meanwhile, we're not stuck having to do a deal with some recalcitrant landlord, because we've got the bankruptcy judge behind us. Thus, we're able to get a substantial amount of cash out of these nonperforming assets." Basically, says Fogarty, "we view Chapter 11 with respect to real estate as a magic wand."
Russ Banham is a contributing editor for CFO.
Where are the largest real estate vacancies?
Source: CoStar Group Inc.
Total Vacant Space
|New York City|