Should Operating Companies Own Non-Strategic Commercial Real Estate?

Many public companies have substantial sums invested in commercial real estate that they own and use in their businesses. The real estate can be a headquarters office building, industrial warehouse property, retail-store site, or restaurant building.

Dillard’s and Sears/Kmart, two department-store operators, own many of their own stores. Cracker Barrel, Bob Evans Farms, and Ruby Tuesday, three restaurant chains, also own a large number of their restaurant buildings and sites. Zynga, the online game maker that went public in December 2011, bought its headquarters building in San Francisco’s South of Market neighborhood in 2012 for approximately $230 million. Google, a technology company, bought its 2.9-million-square-foot New York headquarters building in 2011 for $1.9 billion.

Commercial real estate is considered a capital-intensive asset and includes four main property types: office buildings, retail centers, industrial warehouses, and apartment buildings. Each type of property (except apartments) is subject to a lease contract that typically has a base rent, additional rent for the payment of property operating costs such as real estate taxes and maintenance, a term of three to ten years, and options for renewal. The base rental rate varies depending on the location and market of the property, age of the building, lease terms, and credit of the tenant.

Own or Lease?

Should an operating company own or lease its real estate?

Does it make economic and investment sense for a public operating company to sink large amounts of capital in its own real estate like Zynga and Google? From a return on capital perspective, the answer is no.

A public company should not tie up capital in commercial real estate, whether it’s used for office, industrial, or retail purposes. Companies with large real estate holdings should sell the assets or do sale/leasebacks transactions unless the assets are of strategic importance or investment value. Some companies do need to own real estate for strategic and marketing purposes. Examples are a retailer buying a building on Fifth Avenue in New York or Rodeo Drive in Beverly Hills for a new, high-profile store location to advertise its business or a company buying a suburban office building for its national headquarters. In most other cases, the capital tied up in real estate should be reinvested into the company’s core business, where the rate of return is higher than in a real estate investment.

The realized return from investing in an operating business is higher than a real estate investment. This is because of risk. Operating-business investments are riskier than real estate investments due to the volatility of the business and industry, difficulty in generating increasing EBITDA (earnings before interest, taxes, depreciation, and amortization), free cash flow and net profits, regulations, and, of course, intense competition. Commercial real estate investments are less risky because properties are encumbered by leases, as stated above, which can deliver a more reliable and steady income stream and the ability of the lease income and asset to be easily financed.

Returns – Real Estate Compared to Private Equity

The best proxy for operating-company investment returns is the return from private-equity-capital investments.

Per Cambridge Associates LLC, a financial research and advisory firm, the average annual return for private-equity investments for the ten-year period ended September 2014 was 14.11 percent. The average annual return from investing in commercial real estate can be viewed through data provided by the National Council of Real Estate Investment Fiduciaries (NCREIF), a nonprofit provider of institutional real estate investment data, and the FTSE-NAREIT All Equity Index, which is an index of the return of all public-equity real estate investment trusts. NCREIF provides a quarterly property index that is a time-series-composite total rate of return measure of investment performance of a very large pool of individual commercial real estate properties acquired in the private market for investment purposes. The NCREIF average annual return for the same ten-year-period ended September 2014 was 5.44 percent and the FTSE-NAREIT All Equity Index average annual return for the same ten-year period was 8.53 percent.

The realized return in private equity at 14.11 percent is greater than the NCREIF 5.44 percent and NAREIT 8.53 percent return in commercial real estate. Therefore, operating companies should dispose of their real estate and reinvest the proceeds in their core business. Operating companies should be able to increase their investor return by selling real estate assets and redeploying that capital back into their core business.

Hypothetical Scenario

As an example, a hypothetical operating company, ACME Digital, that manufactures circuit boards and disc drives has delivered an average annual return of 22 percent since going public in 2000. It owns a headquarters office building, free and clear, bought for $60 million with a book value of $50 million and a market value of $100 million. If the building is sold in a sales/leaseback for $100 million, the net proceeds after a 35 percent tax rate are $82.5 million ($100 million sales price less the $17.5 million paid in taxes from the gain on the sale). If the company has a weighted-average cost of capital of 12 percent but can earn a 22 percent return (the company’s historical return on equity) on reinvesting the $82.5 million in its business, the company will add $18.1 million in value annually to its shareholders. ACME Digital will have to pay rent for the sale/leaseback, which will reduce EBITDA and net income; however, this transaction will result in a higher stock price and enterprise value.

Free Cash Flows

The intrinsic value of a company is the present value of its free cash flows and terminal value discounted at its weighted-average cost of capital. The incremental cash flows generated from the above investment will increase this intrinsic value. If ACME Digital decided to keep the real estate, it would have a slightly higher net income because the depreciation would be less than a comparable rent; however, it would not have the capital to reinvest and earn the incremental 22 percent return.

The capital companies have tied up in real estate is not earning a return other than the amount of rent being saved by owning the property. However, this amount is very small compared with the lost capital investment. Today, many public companies are evaluating their return on capital and asset utilization in a difficult economy. One way to increase these returns is to dispose of non-strategic real estate assets and reinvest that capital in the business operation to generate organic growth. Companies that reinvest this real estate capital into their core business can earn a much higher return on equity, which will result in a higher stock price and market value.

For more CRE insights, check out the monthly column Commercial Real Estate Insights with Joseph Ori.