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Putting Property First

As money continues to pour into corporate real estate, more dealmakers are finding ways to cash in.
Don Durfee, CFO Magazine
May 1, 2005

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."

M&A-related leasebacks have primarily been the realm of private-equity buyers in the past. "Firms like ours are generally focused on operating businesses, as opposed to making money on the real estate side," says Robert Bergmann, a managing director with Centre Partners Management LLC, a New York­ and Los Angeles­based private-equity firm with a $1.5 billion capital base. "So when we see a company with substantial real estate, we ask, 'How can we buy down the price of the operating property by disposing of those assets?'"

Last year, Centre Partners did just that when it bought out San Diego­based Garden Fresh Restaurant Corp., a restaurant chain with about 100 locations. The sale-leasebacks on 20 of those properties raised in conjunction with the acquisition provided Centre with $40 million of the $100 million purchase price. What makes such transactions especially attractive, Bergmann says, is the opportunity to profit from the gap between the effective acquisition price and what the property could actually fetch on the open market.

"With attractive rates on the sale-leaseback side, you are effectively selling properties at earnings multiples of over 10 times," he says. "And as long as you are paying less than that for the operating business, you can benefit from the resulting arbitrage on the multiple you paid for the company and the multiple for which you can sell the real estate."

Investors Just Don't Care
The same principles apply to public deals as well, although corporate CFOs have been slower to embrace the concept. For some, sale-leasebacks may be seen to lessen the control that full ownership affords. Others simply don't need the cash. And often there is a concern that disposing of valuable assets may be a bad financial decision—a rule of thumb that often is misguided. "Institutional investors give no value for real estate when determining share price," says Hawkes, who was an investment banker with Salomon Brothers before joining U.S. Realty. "From an investor's perspective, there's no point in having productive capital tied up in illiquid, depreciating real estate assets."

Companies like Actuant agree. Although the Kopp purchase marked the first time treasurer Braatz had used real estate to finance an acquisition, it is a technique he says fits the company's approach to its balance sheet. "We generally prefer not to own real estate assets," he says, "and instead redeploy that capital into higher-returning activities."

Another is San Diego­based Petco Animal Supplies Inc. CFO Rodney Carter says that he always considers sale-leaseback transactions when acquiring new store locations. "Leasebacks are just one more financing alternative for us," he says. The $1.8 billion company, which has grown rapidly through acquisitions, hasn't yet used real estate to finance those deals. It did recently consider a sale-leaseback as a means of obtaining 17 former stores from Office Depot—although in the end Petco found a third-party investor to buy the properties directly from Office Depot, and grant leases to Petco.

Using real estate to finance M&A poses a few challenges. At a time when many investors view off-balance-sheet financing as potentially toxic, CFOs need to be prepared to argue the propriety of transactions such as sale-leasebacks. True net-lease transactions are in full compliance with accounting rules, says Hawkes, as long as (1) a company uses a third party to buy the property; (2) that third party obtains its own financing; and (3) the parties comply with all Financial Accounting Standards Board regulations.

Companies using a leaseback to fund an acquisition also must be alert to transaction costs. When the deal is complete and the acquirer then sells a property, for example, it may have to pay such costs as transfer and mortgage recording taxes twice. Instead, experts recommend structuring a sale-leaseback concurrent with the acquisition, so that the acquirer never takes title (a "net lease" transaction, in real estate terms).

How long will this strong real estate market—offering the promise of major help with the deal structure—last? Some say there is no end in sight. "Real estate has performed incredibly well for 10 years, and continues to do well as an asset class and as an investment," says Dennis Yeskey, Deloitte & Touche USA LLP's national director of real estate capital markets. "I don't see many bad things that could happen."

But no market rises forever. Some analysts argue that commercial properties are seriously overvalued already, which may suggest that the use of real estate as a financing mechanism is cresting. "We've seen it before: a euphoria of overzealous bidding for properties and attempts to find undervalued properties locked away in nonproperty companies," says Lehman's Harris. "But when interest rates rise, real estate becomes a less attractive place to put your money."

Don Durfee is research editor of CFO.

Real Challenges

During Daimler-Benz and Chrysler's merger integration after the 1998 deal, executives made a costly mistake: deciding to lease 20,000 square feet of New York's Chrysler Building for its new U.S. headquarters, paying $100 per square foot. Soon after the merger, the company opted instead for less-glamorous (and far cheaper) Michigan quarters. Unable to find a New York subtenant, DaimlerChrysler had to pay about $30 million to buy out the lease.

Such miscues stem from a failure to plan carefully for the real estate aspects of an acquisition, say some experts. Here are a few real estate­related pitfalls to avoid:

Failure to Include Real Estate Experts in Deal Planning.
"You need a standalone real estate deployment plan—and not one just developed by deal guys who don't understand real estate," says Dennis Yeskey of Deloitte & Touche USA LLP.

Inadequate Due Diligence.
Buyers need to check for obvious—potentially crippling—problems such as existing liens on property, outstanding loans or refinancings, pending personal-injury cases, or environmental-liability surprises. "Facilities due diligence is often lacking on the front end," says Tony Florence of the Boston-based real estate firm VFA.

Mishandling the "Crown Jewels."
For emotional reasons, executives often declare certain properties to be off limits, even if it makes strategic sense to sell them. But as the DaimlerChrysler case illustrates, attachment to certain real estate connections can cut both ways.

Unjustifiably Rosy Assumptions.
Space is typically harder to dispose of than buyers assume. Market prices are often lower than predicted. And it can be surprisingly difficult to convert acquired properties to a new use. "Real estate gets built for a purpose," says Yeskey. "Converting it can take years."—D.D.

Getting Bang For The Buck
Some cases of real estate leasebacks after M&As.
When Closed Target Buyer Deal Value Leaseback Value
March 2005 Telecordia Technologies Warburg Pincus and Providence Equity Partners $1.4 billion $119.3 million
January 2005 K-Mac Enterprises Olympus Partners $220 million $100 million
September 2004 17 IHOP restaurants Argonne Capital Croup Undisclosed $33.7 million
June 2004 Metro Corral Partners Winston Group Undisclosed $31.7 million
May 2004 Lillian Vernon Ripplewood Holdings $60.5 million $37 million
March 2004 Garden Fresh Restaurants Centre Partners Management $100 million $40 million
October 2003 Circle K Alimentation Couche-Tard $830 million $300 million
September 2003 National Tire & Battery TBC $225 million $134 million
Source: Real Capital Analytics, press reports

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