7/1/2004: CIA Commercial Investment Advisors

By Brent Shearer
July 01, 2004
Mergers & Acquisitions Journal

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In many mergers, real estate is an overlooked stepchild for bankers and principals. As a result, real estate professionals say, dealmakers often paint themselves into unprofitable corners when they neglect to fully consider the real estate assets that will change hands on closing.
“We’re involved with a lot of acquisitions and we see that M&A professionals don’t always look at real estate as a producing asset. We believe that the real estate is the second or third most important piece of the financial puzzle you have to put together to complete some of these deals,” says Tim Crowley, President of Net Lease holdings in St. Louis.
Noting that part of the rationale of many mergers is a reduction in headcount, Dennis Yeskey, head of real estate capital markets at Deloitte & Touche, points out a fact that some dealmakers don’t realize until it’s too late: “You can fire people, but you can’t fire real estate. You can sell it if you own it, but sometimes it’s now that easy to sell.”
It may seem obvious, but dealmakers need to keep in mind that when you have fewer people, you need less real estate. And despite the importance of real estate, some companies don’t realize the implications of bad real state decisions until it’s too late.
“If you are going to call in experts to look at the tax and accounting aspects of a deal, you should do so for the real estate as well,” Yeskey says.
Yeskey notes that merger partners must realize that real estate is a binary asset – either a potential liability or a potential asset – and it’s up to the buyers to make sure the purchased company’s holdings contribute to the buyer’s bottom line. “Real estate is the unsung hero of the balance sheet,” says Richard Podos, a Senior Vice President at real estate brokerage Cresa Partners.
Merger pros should therefore include real estate in their due diligence. To do otherwise is to court disaster.
“My impression is that in mergers between corporations, real estate considerations are a tangential and minor part of the due diligence procession, which is often done quickly and at the last minute, says John Guinee, Chief Investment Officer at Duke Realty Corp. in Indianapolis.
And if large companies sometimes overlook their real estate portfolios during transactions, it is even more commonly neglected at mid-size companies. Podos says that at mid-cap and private companies, it is common to find real estate assets not being managed proactively in deal situations.
To address this lack of emphasis, Mergers & Acquisitions spoke with a number of real estate professionals to get their recommendations for best practices in handling the real estate aspects of mergers.
For anyone wondering how a botched real estate decision can detract from a deal, the 1998 merger of Daimler-Benz AG and Chrysler Corp. provides a cautionary tale, real estate experts say.
After the deal closed Daimler decided to set up a joint headquarters for the merged firm in New York. According to one New York-based real estate broker, it leased about 20,000 square feet for 15 years at $100 a square foot in a landmark tower, and then the company changed its mind about occupying the space. When Daimler was unable to sublease the space, it had to buy out of the lease – at a loss of about $30 million.
GOING BEYOND SQUARE FOOTAGE
Jack Minter, an Executive Vice President at Trammell Crow Co., a provider of commercial real estate services, says that he sees bankers doing a better job of assessing the real estate aspects of their transactions. Some industries are more real estate-savvy than others, he notes, citing retailers and fast-food companies as among players that are attuned to real estate concerns since they are large holders of commercial properties. “Real estate is the underpinning of many of these companies so they are less likely to miss the value of their holdings,” Minter says.
Conversely, industries like biotechnology and banking are among those that frequently neglect to pay attention to their physical holdings, he adds.
In addition to the basics of real estate valuations, companies should take into account changing patterns of the use of their real estate, notes Minter. He says a company’s real estate holdings must be evaluated not only in terms of square footage but also from the perspective of what the most efficient use of space is. To evaluate this, executives must include recent developments, such as the impact of wireless communications, and identify how much time some types of employees, especially the sales force, actually need to spend in the office.
A common theme echoed by many real estate mavens is that their m&a brethren make a number of mistakes in using the most prosaic tool of real estate analysis: the appraisal.
SEND IN THE APPRAISERS
Jack Fraker, an Executive Vice President in the investment properties group at CB Richard Ellis, says that appraisers are sometimes given only a week to report back to executives calling the shots on a deal. He says it takes 30 to 60 days to do a new appraisal and recommends that dealmakers give the appraisers enough time to do their job right. The appraisal product will be better if dealmakers are able to define the scope of the appraisal in as much detail as possible, he adds. “You want to give the appraisers enough time to do their work and to test out their expected values using such techniques as determining the replacement value and the market comparables for a set of real estate assets.
Beyond that, Fraker points out that appraisals are traditionally conservative and are snapshots of an asset’s value at a static point in the past. “The real estate appraisal might have been done in the last few months before the deal was in the works and it might be complete, but a lot can change in a few months.”
He suggests that while appraisers do their best to keep their fingers on the pulse of the capital markets environment, their work should be considered in tandem with the advice of a commercial broker who knows who’s buying what and at what price in a local market.
Real estate appraisals often overlook the portfolio premium, Fraker notes. This reflects the concept that underwriters and lenders in the capital markets will pay a premium for a critical mass of properties based on the expectation of future economies of scale and the ability to extract concessions from vendors.
He recommends that dealmakers consider the results of an appraiser’s work from the holistic perspective, i.e., that they take into account other inputs about the value and prospects of the assets.
REAL ESTATE PITFALLS
Among the things that a real estate professional can bring to the table as a member of, or adviser to, a deal team is a specialized focus on such potential deal breakers as environmental problems, title insurance complications, liens that may exist on buildings, and personal injury cases that may be pending. “Most real estate is a magnet for lawsuits so you have to check that the asset isn’t encumbered by any pending legal problems,” Minter says.
Environmental problems, if recognized, need not be a deal killer. “If it’s on the state’s list of Superfund sites, you have limited liability as a buyer,” Crowley says. Yet, part of any real estate-oriented due diligence is to check for hidden environmental problems, he adds.
Minter suggests that buyers check whether each building that is part of a deal has a mortgage on it. And if it does, is it a single mortgage or one that is cross-collateralized with five or six other buildings? Also, they should check whether there are any outstanding loans or refinancings on the buildings. In one deal the new owner of a building was hit with the news that the building’s refinancing was coming due in the next week and 90% of the fee would then be due, he states.
Another item that will affect a dealmaker’s analysis of the real estate situation is whether the buildings that are changing hands are occupied or vacant. “It can be tricky to value the real estate when the percentage of occupied space might change,” Minter says. He notes that this is often the case when principals don’t yet have a solid idea of what the merged entity might look like.
While it might seem obvious, dealmakers should not neglect to look at whether a target owns or leases its property. Yeskey says it can be hard to get out of leases so if one is to be inherited, it can sometimes be renegotiated before the deal closes. He adds that a classic case occurs when Company A buys Company B and eliminates the target’s people and space. Two weeks later, the leaseholder on the shut-down space shows up and demands the rent.
One way to avoid acquiring leases, or even wholly owned buildings, that the buyer might not want is to exclude the properties from the deal. Of course, that only works if there is going to be a second surviving entity after the deal that will own real property.
Another contribution a real estate expert can make to a deal is to suggest tax tactics can be used the moment assets change hands. “When you’re closing you can excuse lease buyouts and structure them so they hit at the right time from a tax standpoint,” says Podos.
In fact, Podos suggests that if the merging companies have excess real estate, those holdings should be treated separately and sold off before closing the deal. A second piece of advice is to make sure leases are adjusted to reflect the deal and prevent a situation in which a landlord can hold up the closing.
Mark Gibson, head of Ernst & Young’s real estate practice, says that real estate doesn’t make a significant difference in 50% and 60% of deals. He figures that for another 20% of transactions, it makes a difference, but isn’t crucial. For the remaining 20% to 30%, however, it can be very material. “The real estate hit on a deal’s numbers and its rationale can be shocking,” he says.
TALES FROM THE TRENCHES
He recounts some war stories to prove his point. After being brought into one deal, Gibson says, he was able to calculate that a target company’s real estate holdings in the depressed San Jose, Calif. Market would add a $50 million hit to the value of the deal. Gibson’s client, the would-be buyer, decided not to proceed because on top of other problems, the real estate negative was too strong. “We were able to protect the buyer from this horrible shock that they might otherwise have stumbled into.”
In a second tale from the trenches, Gibson says he was called in at the last minute to evaluate the Manhattan real estate assets of two banks that were about to merge. In the target bank’s pricey Park Avenue digs, he found a warren of small subtenants, who had been granted their office space for next to nothing to encourage them to place trades with the primary tenant, the target bank. The deal did go through but the buyer was able to shave off some $30 million in transaction costs by renegotiating the subtenants’ leases.
“We offer our clients an honest and open view of their real estate issues backed by our understanding of accounting rules,” Gibson says.
Besides protecting themselves against bad real estate news post-closing, dealmakers should consider a sale-leaseback arrangement where appropriate.
In this financial structure, a buyer acquires a property and leases it back to the tenant company on a triple net long-term basis. This allows the tenant company to preserve operational control of its property and to benefit from the immediate access to capital, which can be used to improve its balance sheet, fund future growth, or reduce debt. The company also maintains investment control with renewal options. Accordingly, companies bear the responsibility for maintaining the premises, insuring the building, and paying real estate taxes.
“If you’ve got a depreciated assets on the books, you have to pay capital gains. We can help a company avoid that kind of hit,” says Anne Coolidge, a Managing Director at W. P. Carey & Co.
Lease buybacks allow companies to pay down debt, expand their business, fund acquisitions, transition out of a synthetic lease, or construct new facilities. Options are borrowing funds, issuing stock, or selling assets, all of which can be expensive, onerous, and pose financial consequences such as balloon payments. Sale-leaseback financing provides a company with access to 100% of the value of those hidden assets, generating funds that can be used for other corporate initiatives while providing the company complete control of its facilities.
Coolidge says that sale-leasebacks can make up for the reluctance of some asset-based lenders to fully value a company’s real estate. “We provide an alternative source of financing to underwrite the business going forward.” She notes that W. P. Carey and other providers can write their leases for whatever period is needed.
Another sale-leaseback provider, Tim Crowley, says that real estate values can either enhance or inhibit the value of a deal. And he strikes the common note heard from many of his fellow real estate professionals: Get us involved early!
“It’s critical to call us in early in the process so we can help the buyer or seller avoid typical real estate mistakes that can plague deals.” He mentions the tendency of some buyers to overlook real estate easements when they evaluate a transaction. “You may be buying a plant with an extra 15 acres. But if you don’t have a real estate easement to guarantee access to that extra acreage, it will be useless, he says.”
Minter says that because sale-leasebacks come in all shapes and sizes, it’s important for executives to make sure the pact provides the structure they are seeking. “You can set them up with a low rent to reduce operating expenses or with a high rent that will have the opposite effect,” he says.
Gibson says that while a thorough real estate analysis can make or break a small percentage of deals, the challenge of post-closing real estate work is making sure the real estate contributes to the ongoing profitability of the buyer.
He suggests that part of any postmerger integration plan should include real estate experts to maximize the use of the newly combined company’s holdings, and advocates bringing in an external specialist to concentrate on integrating these properties. “The internal corporate real estate people don’t have any experience in doing this kind of work, and, in any case, they’re too busy with other real estate chores created by the merger.”
He says that just as companies must combined their accounting and IT systems, real state assets much be tied together in the most efficient manner. “You want the real estate assets to help support the strategic planning of the whole company.”
WHERE ARE THE PROS?
There are reasons that go beyond simple oversight to explain why some dealmakers neglect to bring in real estate experts on deals. Noting that he sees less due diligence on real estate in m&a situations than would be ideal, Jack Petrie, a Senior Vice President at New York-based real estate brokerage firm Cresa Partners, says confidentiality concerns are an issue. “They don’t want to bring in outside parties while a deal is at risk,” he says, but adds that confidentiality agreements can be built into the engagement to minimize disclosure risk.
Another problem for dealmakers who may want to involve commercial brokers is the real estate professional’s payment structure. “In our industry, we don’t get paid if a transaction doesn’t close,” Fraker says. But he suggests that it would be worth it for investment bankers and principals to develop a fee structure that would make it easier to solicit advice from a commercial broker. Some combination of a retainer and a contingency might work, he notes.
“In a lot of cases, the money saved by taking advantage of the strategic view we could offer would be more than the fee we might collect.”
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