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In the headlines: Suicides and Chinese corporate real estate May 27, 2010

Posted by Bob Cook in Asian Expansion, Company Case Studies, Real Estate Markets, Silicon Valley.
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Update:  September 13, 2010:  The cover story of this week’s BusinessWeek is a profile on Foxconn and its founder Terry Gou.

Foxconn, a business unit of Taiwanese-headquartered Hon Hai Precision Industry, has, to its dismay, been in the news as of late. Foxconn and Hon Hai are not household names, even though Hon Hai is #109 on Fortune’s Global 500 and has the largest contract manufacturing operation in China. A slew of high tech companies – Apple, HP, Intel, Nintendo, Sony, Dell and others – outsource manufacturing to Foxconn, and the products manufactured by Foxconn are, in fact, household names:  iPhone, iPad, iPod, PlayStation, Xbox, Wii, Kindle and others.  Hon Hai / Foxconn typically shuns publicity and has developed the secretive culture necessary to assure customers that the IP entrusted to them remains guarded. Lately, though, the company’s operation in Shenzhen has garnered unwanted headlines: “String of suicides continues at electronics supplier in China”.

iPhone factorySome think the number of suicides (nine, confirmed, as of this writing) is not all that high given the fact that Foxconn employs at least 200,000 workers (and according to some reports, over 400,000) workers in Shenzhen. Over the years, though, there have been allegations of poor working – and living – conditions. You see, Hon Hai / Foxconn doesn’t have just factories for its workers, but it also has dormitories, all in an environment that – depending upon your point-of-view – is either like a college campus or like a prison labor camp. A few years ago, a famous muckraking article was written about “iPod City” where Apple products are assembled and assemblers are housed. The recent suicides have drawn attention to the factories and its dormitories once more.

The Hon Hai / Foxconn complex in Shenzhen is a city within a city.   In a walled compound, measuring roughly two miles by three-quarters of a mile, in amongst the factory buildings, there are dormitories, restaurants, a hospital, and all sorts of recreational facilities – a 21st Century company town, the responsibility of what-must-be one of the world’s largest corporate real estate departments.

Whether conditions are deplorable or not (which has been Apple’s appraisal) – whether it is a 21st Century Chinese version of 19th Century America’s Pullman or not – the scale of the real estate operation that supports the Hon Hai / Foxconn business is mind-boggling. Hon Hai / Foxconn doesn’t file SEC reports so there’s no public record of exactly how much of its real estate operation is devoted to housing employees, but you can get a sense of the scale from the SEC filings of Nam Tai Electronics, another (albeit much, much smaller) Chinese manufacturer. Nam Tai reports that it has 1.7 million square feet of real estate in Shenzhen. Of this, .7 million square feet – more than 40% – is for dormitories, cafeterias and recreational facilities. Nam Tai’s provision of housing accommodations is no small side-line. The same is probably true of Hon Hai / Foxconn which must be providing many millions of square feet of dormitories and related facilities to its employees.

The willingness of Chinese-based companies to provide living accommodations for their workers sets them apart from foreign companies and may be why they are the low-cost producers in the country. The word “willingness” may not, however, be apropos here. Some think Chinese-based contract manufacturers benefit from the resulting “dormitory labour regime” which gives them more control over the workers. In any event, the provision of worker dormitories is certainly part of  the engine that makes China the “World’s Factory” and is likely to keep it in that position for a long time. And, the lack of willingness on the part of foreign companies to adopt the practice is likely to keep contract-manufacturing as the predominant method that foreigners tap that Factory.

It will be interesting to watch the Hai Hon / Foxcomm story unfold. Apple’s involvement as a customer is going to assure press coverage. Today, it was briefly the world’s most valuable tech company, and for awhile, it’s been  the cultiest – just perfect for muckraking. Expect to see a lot of footage about poor working conditions and poor living conditions, debates about the benefits and evils of company towns … and maybe even an interview with a Chinese corporate real estate exec or two.

Preparing the company for sale: Palm did it right! May 17, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, M & A Integration, Silicon Valley.
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Real estate tends to be one of the last things evaluated during M & A due diligence by the acquiring company, and it’s not surprising that – surprise! – surprises are found there. Lengthy lease commitments, owned property worth less than net book value, contaminated sites, mission critical infrastructure that’s prohibitively expensive to move to the acquiring company’s site: these are just some of the surprises found by acquiring companies when they finally take a look.

Rarely, if ever, do these surprises derail an acquisition, but they do sometimes lead to re-pricing of the deal. And while the price cut might not be much as a percentage of the overall deal price, it can be a significant percentage of the amount had by the acquired company’s equity investors once they’ve paid off creditors and preferred-return equity holders. It’s at that point that the acquired company managers kick themselves for not more carefully managing their real estate portfolio.

You may ask: if they had managed their portfolio carefully, what would have they tried to achieve? What would have been the home run, the hole-in-one, the three-pointer at the buzzer? It would have been this: having real estate commitments (such as leases) and exposures (such as owned properties) that extended into the future no further than the date on which the acquiring company will be able to move the acquired company into its own facilities in an orderly fashion. “Not achievable!” you say? Think again.

Palm, which is being bought by HP for $1.2 billion, may have done it. According to its 10-K’s (see Table 1, below), Palm does not own any property and has done a masterful job over the last few years of decreasing its lease obligations. At the end of FY2007, the value of its minimum future lease obligations was $49.2 million; by end of FY2009, this had been cut in half to only $24.5 million.

Looking at the minimum future lease obligations net of sublease obligations from subtenants shows similar results – $34.7 million at end of FY2007 that were cut in half to $15.3 million at end of FY2009.

Making the story even better: if Palm has been able to avoid committing to any additional leases since the end of FY2009 in May of 2009, then as of the end of FY2010 which ends this month, it’s lease obligations should amount to no more than $13.2 million. After accounting for commitments from subtenants, its net lease commitment would be only $8.0 million. What an incredibly light burden for HP to have to take on! Miniscule in comparison to the value of the deal. It easily sets the stage for HP to be able to move Palm into HP facilities without HP having to bear much of an economic burden to pay rent on the unneeded property.

But wait! There’s more! By time the acquisition is closed and plans can be made and implemented to relocate Palm, it will probably be near the end of Palm’s FY2011 at which time only $2.4 million of lease obligations will remain and, incredibly, only $1.1 million of obligations net of obligations from its subtenants will remain. Can you believe it? Only a $1.1 million overhang of real estate obligation on a $1.2 billion M & A deal. That’s like driving the ball off the tee and coming to within an inch of a cup 700 yards away.

This light burden should make it economically feasible for HP to relocate the Palm operations to HP facilities. There should be plenty of space to accommodate Palm in HP’s 77-million-square-foot real estate portfolio, of which 7 million square feet was vacant and not sublet as of the end of HP’s last fiscal year in October 2009. For comparison, Palm’s Silicon Valley operation occupied only 347,000 square feet.

Yes, Palm did it right. From outside the company, it’s hard to know if it was from careful planning, from restrictions put on Palm by the real estate market or from just dumb luck. I’d like to think it was from the first of these possibilities – that there was an understanding of the need for careful real estate portfolio planning, that the planning was carried out consciously and that it paid off. A clear planning success story if ever there was one.

TAble 1: Palm’s Minimum Lease Obligations as Reported in 10K’s

Year in which rent was projected to be due FY2007 10K FY2008 10K FY2009 10K
2008 11.9 0.0 0.0
2009 11.7 11.5 0.0
2010 11.5 11.3 11.3
2011 11.2 10.7 10.8
2012+ 2.8 2.4 2.4
Total Min Lse Obligation 49.2 35.9 24.5
Less: Subtenant Income 14.5 13.0 9.2
Total “Net” Minimum Lease Obligation 34.7 22.9 15.3

Lease Accounting: Don’t Shoot the Messengers May 13, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.

In a previous post, I wrote about the scene at JLL’s presentation on the new lease accounting at the Corenet Global Summit in New Orleans – about how I had been told it was like the “chicken wire” scene in the Blues Brothers. The corporate real estate community in the audience, didn’t quite throw beer bottles, but it did vocally express displeasure regarding the new rules and the fact that someone like FASB should influence their world.

Anyone who has read my other blog posts, knows how I think the new lease accounting is going to be game-changing in corporate real estate and how it’s important for corporate real estate execs to spend effort to understand the standards and how they’re going to affect their lives. The Corenet meeting just showed how far from this ideal many in the corporate real estate community are. JLL was being a responsible corporate citizen by trying to inform the corporate real estate community about the coming lease accounting changes. It’s too bad the community didn’t listen as well as it should have.

The lease accounting changes are long overdue. Today, our largest companies lease huge amounts of office space to accommodate their legions of “knowledge-workers”, yet the obligation to make rent payments are not shown on company financial statements. Other big financial obligations, such as to repay money borrowed via bonds or bank loans, are on the balance sheet, but rent obligations are not. Yet, for some companies, rent obligations amount to billions of dollars – in many cases, much more than the obligation to repay bonds or loans. It is not possible for investors to get clear pictures of the financial conditions of these companies without these leases going onto the balance sheet. Putting these lease obligations on the balance sheet is at the core of the new lease accounting standards. 

It is really important that corporate real estate execs become familiar with the accounting… and even more important … to get familiar with how it will change their lives. This is not something just for accountants to think about. It is going to affect corporate real estate execs’ lives at many levels – from determining the financial impact of signing a lease … to evaluating the lease-vs-own question … to documenting formal portfolio plans … to determining chargeback policies … to designing department processes … to hiring and training department talent.

All the big real estate service providers are publishing pieces describing the new lease accounting standards. Educate yourself.  But don’t shoot the messengers.

Corporate real estate execs before Congress. Could it happen? May 12, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting, Profession of Corporate Real Estate.
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A couple weeks ago, as I watched the Congressional interrogation of Fabulous Fab, I was struck by how this young guy, who toiled deep within Goldman Sachs’ 30,000-some-employee corporate hierarchy, had become so quickly notorious. This was not the Chairman or CEO or CFO or any other C-suite exec who was being drilled; this was a guy who was only 28 years old and barely out of grad school when he masterminded the trades that some think exemplify the greed of Wall Street and that landed him before Congress. 

This all got my mind to thinking whether or not a corporate real estate exec would ever be up in front of Congress. It’s clearly never happened before… but the new lease accounting standards are going to place corporate real estate smack-dab in the middle of preparing some of the biggest numbers on company balance sheets – the present value of existing lease obligations. Corporate real estate execs are going to be in the uncomfortable, unenviable, and sometime untenable position of having to attest, to their management, the reasonableness of forward-looking projections regarding existing leases – including hard-to-make assumptions like the likelihood of lease renewal and the likely rental rate at renewal. If their assumptions turn out to be wrong, no one will go back and check — unless, of course, their company ends up in bankruptcy and investors claim the company financial statements were erroneous – in which case – Look Out!

Never before, have corporate real estate execs been front and center on anything quite so large. For many companies, the present value of their lease obligations will exceed the amount of debt they have in the form of bonds, bank loans, etc. These companies are going to look a lot more risky to investors than they have previously. While companies have been showing lease obligation information in the notes to their financial statements, the new accounting will show it right on the balance sheet. And the number is likely to be larger – in some cases, much larger. Presently, companies only report the minimum lease obligations for existing leases (and, again, only buried in footnotes); the new accounting will show the likely lease obligation for existing leases, taking into account likely renewals (and, again, right on the balance sheet). It’s going to be a very large number. Some companies are going to see billions of dollars of obligations appear on their balance sheet.

And what’s going to keep corporate real estate execs up at night is the fact that they are likely to be the ones responsible for making and documenting assumptions that significantly impact the size of obligation recorded on the balance sheet. Fast forward twenty months or so to when the new standards will take effect. Take the case of a ten-year lease costing $1 million per year that has only, say, two years left to run but which gives the tenant the right to renew for another ten years at the same rate. If one assumes the lease is not renewed, $2 million of obligations go on the balance sheet. If one assumes the lease is renewed, then $12 million goes on. Quite a swing. Just imagine the pressure from management who will want the corporate real estate exec to find a way to legitimately opine that the lease will not have to be renewed. And imagine the pressure from auditors who will say “show me the plan” before they sign-off on a no-renewal assumption. It’s not hard to imagine that corporate real estate execs – when they are able to sleep, in spite of all this pressure – will have vivid nightmares of having to defend their renewal assumptions before Congress.

Some corporate real estate execs got a small taste of what it could be like back in 2005 when a slew of companies needed to restate their financial statements due to what-the-SEC-said-was faulty lease accounting. In that situation, though, the problem was one of technical accounting and how companies and their auditors thought leases should be accounted for. The practices that the SEC said were faulty were, in fact, widespread. The SEC set everyone straight, and while there was a lot of egg on faces and hands got slapped, there were no allegations of intentional wrong-doing. There were no Congressional hearings. No corporate real estate execs before Congress.

With the new lease accounting standards, though, corporate real estate will be cast in a new role – an important financial role.  Corporate real estate execs before Congress?  It could happen.