Print this article | Return to Article | Return to CFO.com
When contemplating an acquisition, don't overlook real-estate issues.
Jennifer Caplan, CFO Magazine
May 1, 2003
Alan White knew he had a tough sell on his hands.
Back in the 1990s, White was in charge of managing the property portfolio of British Telecom. At the time, the telco was engaged in a pitched battle with local start-ups, which were beginning to poach from the company's customer lists. Meanwhile, powerful cross-border rivals such as Deutsche Telekom and Sprint were hooking up in highly touted, and threatening, alliances. BT's management decided that the telco had to start buying companies or risk losing ground to more-acquisitive rivals.
White's dilemma: how, in a buy-or-die climate, do you convince management to consider real-estate issues when sizing up merger-and-acquisition targets?
Some executives balked at the idea of inviting property executives to strategy sessions. But the way White saw it, real estate would play a sizable role in the success of any deal. For example, he believed it was crucial that BT executives devise a plan to secure ownership of a takeover target's switching centers before launching a bid. If the company's managers overlooked a contract provision that could jeopardize ownership down the road, it would be exorbitantly expensive for BT to transfer its switching equipment. That, in turn, might interfere with the telco's ability to provide its full range of services, which could limit revenue growth.
Eventually, White made his case. "We were able to convince the strategy people that as part of their initial consideration of which businesses to buy, they should listen to the real-estate guys. But it took us 18 months," says White, who now serves as chairman of the Global Commercial Real Estate Group for RICS (Royal Institution of Chartered Surveyors), a global real estate industry association based in the UK, and heads up the Corporate Consulting Group at real estate advisers DTZ in London.
Such a struggle is hardly surprising. During the initial phases of a merger or acquisition, real estate rarely makes it anywhere near the top of a management team's list of concerns. "Nine out of 10 times, real estate is just considered the physical location where business is done," says Chris Price, a partner at the New York office of property specialist King & Spalding. "It's not considered a central component of the business itself."
And that's the problem. While real estate may not be a central component of a business, assessing real estate is often a central component of business deals. Lack of attention to even simple factors — think title and certificates of occupancy, lease provisions, and taxes — can turn a good purchase into a dog. "Companies tend to overlook very basic items, like failing to get the proper consent for exchange of control," says Price. "And those things can come back to bite them later."
Think Love Canal
Some of those failures are fundamental, such as overlooking environmental hazards. Given the potential for lawsuits — not to mention the costs of cleanup — the risk experts strongly advise suitors to conduct exhaustive environmental surveys before completing an acquisition.
That's exactly what Atlanta — based InTown Suites did when it bought Suburban Lodges of America for $220 million in May 2002. In fact, CFO Bill Brewer says environmental assessments were a key part of the company's due diligence in its purchase of 65 hotel properties from Suburban. "We wanted to make sure we were not inheriting obligations that were unrecorded," says Brewer.
Typically, acquiring companies examine local, state, and federal records to determine potential environmental violations. If anything suspicious is discovered in an initial assessment, soil, gas, and groundwater samples can be taken to test for contaminants.
Such tests can lead to even more testing (which may or may not include additional sitework). On two recent occasions, for example, Toronto — based Fairmont Hotels and Resorts's initial environmental assessments of target assets led to deeper inquiries. On further review, however, "the problems were not deemed to be environmental or structural problems, but rather deferred maintenance issues," says Fairmont CFO Jerry Patava. Although no environmental liabilities were uncovered, the surveys did help convince Fairmont's managers that they didn't need to adjust their offer price.
That underlines a crucial point. When companies fail to conduct adequate assessments — environmental or otherwise — of assets, purchase prices can be way off. This is particularly true when real estate is a big part of the overall transaction, such as deals involving hotels or supermarkets.
Experts sometimes see even more rudimentary failures. In a few cases, acquirers have been known to buy companies without performing title searches and full due diligence, including condition surveys of key facilities, on a target's property holdings — a sure path to disaster, especially in places like Eastern Europe and China, where determining ownership of a property can quickly turn into a comedy of errors.
"It's always important to know if a title is actually registered under the company you are buying," notes InTown Suites's Brewer, "and if there might be any recorded liens on the property." To protect against nasty surprises, some companies purchase title insurance, whose cost can vary substantially from state to state. Generally, premiums vary anywhere from 50 cents to more than $5 per $1,000 of value. Taking out title insurance becomes absolutely crucial when acquiring a company with older properties, simply because existing policies held by the company may not be sufficient.
To be sure, gathering information about a target's real-estate assets may be anything but easy. Many corporations manage their real estate in a decentralized fashion, with data stored in disparate, unconnected systems and databases. As a result, "a surprising number of businesses don't know the value of their operational [real-estate] portfolio," asserts RICS's White. "And they have only a vague notion of what their real estate is costing them."
For acquirers, pulling all the data together in order to assess the value and performance of a target's portfolio can be a Herculean task — and can disrupt the timing of a deal. Once a deal is done, the acquirer then faces the problem of managing new portfolios and systems. That's currently the case at SBC Communications. The Dallas — based Baby Bell has done several major mergers since 1997, and each company involved has come with its own real-estate-management system.
"The challenge now is managing a 130 million-square-foot portfolio and approximately 5,000 buildings requiring facility management — without a common system," says Mary Manning, senior vice president of real estate at SBC. The telco is implementing a building-management system and a data warehouse to centralize portfolio information. Still, new real-estate systems aren't high on the corporate priority list, says Manning.
They may move higher up if the accounting standards for real estate change. Currently, real estate is accounted for at historic cost, but the International Accounting Standards Board is pushing to require companies to measure real-estate worth at fair value. If the IASB gets its way, companies will be obliged to generate better information about their real-estate assets.
But the advent of fair-value accounting for real estate is not expected to arrive before 2005. In the meantime, corporate real-estate managers will have to continue exercising their powers of persuasion. Concedes former BT executive White, "It will probably take another two to three years to bring about a noticeable change in managers' thinking about property."
Sidebar: Synthetic Risk
Another real-estate red flag for acquirers these days is synthetic leases, which experts say can camouflage significant liabilities. These vehicles grew popular in the late 1990s as a way for corporate lessors to obtain off-balance-sheet financing while avoiding the earnings hit from depreciation associated with owning real estate both of which improve reported return-on-asset ratios.
But most synthetic leases are short term (usually between 3 and 10 years), and many are coming due now. The reset can have a sizable impact on the value of a takeover target. "What might scare an acquirer is a synthetic lease coming due in 3 to 5 years, which might mean a big refinancing risk," says Sean Sovak, chief acquisition officer at New York-based corporate real-estate financing firm W.P. Carey & Co. LLC.
What's more, synthetic lessees often reserve the right at the end of a lease to buy a property, extend the lease, or sell the property and take any gain or loss in its value. "There's also a risk that when the leases expire, the value of the real estate may be less than the value of the synthetic itself," notes Sovak. It's critical, therefore, that acquiring managers be aware of maturities on synthetics.
Finally, new accounting rules that took effect earlier this year may further complicate the picture. The rules will require lessors to either unwind their deals or restructure them with more outside capital. If the deals are not unwound or restructured before an acquisition, buyers will inherit the job.