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It’s Time to Buy that HQ August 3, 2010

Posted by Bob Cook in Corporate HQ, Financial Planning & Analysis, Lease Accounting.
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The ducks are all lined up: low prices … low borrowing costs … cash hoards … lease accounting.

I’ve previously posted an article on Northrop Grumman’s decision to buy its new headquarters. Reportedly, the new lease accounting influenced the decision, but other factors were undoubtedly also at play … probably the ones I just listed, above.

Perhaps never before has the time been more opportune for companies to buy real estate assets… and because purchasing makes most sense where long-term occupancy is relatively assured, HQ’s are obvious acquisition targets for companies. We may see a reversal of the trend towards leasing HQ’s that began in the 1980’s … when many companies became enamored with the cash they could raise through sale-leasebacks or leasing space offered by speculative developers.

If a company does not already own its HQ, now is the time to buy.

Low Prices

Office building prices are significantly depressed. According to the Moody’s/REAL Commercial Property Price Index (CPPI), prices have fallen to the levels of 2003/2004, which were themselves low relative to the prices around the turn-of-the-millennium. And the decline in prices might not be over. 

Many industry observers think prices are likely to fall even more as we near, over the next couple years, the maturity dates of a huge number of commercial real estate loans … many of which are underwater. National Real Estate Investor quotes Trepp LLC, a servicer of collateralized mortgage-backed securities: “The average loan-to-value ratio among 1,125 CMBS loans in a survey sample was a whopping 160%, up from 72.7% when the loans were securitized.”

Earlier this year, Standard and Poor’s issued a report titled “The Worst May Still Be Yet to Come for U.S. Commercial Real Estate Loans”, stating that “the decline in collateral values poses a difficulty for loans that need to be refinanced” and that “refinancing needs will be somewhat elevated in 2011 and 2012, although the bulk of them will not come until 2015.” 

And with the vacancy rate of U.S. office buildings at 7.4% … a 17-year high, there is little hope that these buildings with underwater loans will be generating enough NOI anytime soon to be able to cover debt service on new loans of the same amounts, even at today’s historically low interest rates. Without the ability to attract debt financing, office building prices are likely to remain depressed.

Low Borrowing Costs

And while the low borrowing costs are not going to be of much value to property owners facing the prospect of buildings being partially or wholly vacated, those low borrowing costs are very valuable to companies that become owner-occupants.

According to the Wall Street Journal, today’s rates on corporate bonds are “some of the lowest borrowing costs in history.” Corporations are already flooding the market with bonds, raising cash … sometimes probably without a clear understanding of how the funds will be used. The borrowing frenzy is not just among investment-grade companies. According to that same WSJ article, referring to last month’s bond activity, “This month has been the busiest July on record for sales by U.S. companies with junk-credit ratings.” 

Access to cheap funds available to corporates is going to make ownership very attractive … and the discrepancy between their ability to borrow cheaply and real-estate-investors’ inability to borrow much is momentous.

Cash Hoards

Even without borrowing, many companies have large cash hoards. Many have purred through the Great Recession largely unscathed, sometimes generating even more cash than usual because their capital investment opportunities have declined. And companies continue to be reluctant to give this cash back to shareholders. Issuing dividends has been out-of-favor for awhile, due to the double-taxation affecting shareholders, and buying back stock has been a risky proposition given the volatility of the markets. So the cash has accumulated.

The tech companies are an egregious example of cash hoarding … Cisco has $40 billion, Microsoft has $36 billion and Google has $30 billion. Shareholders generally don’t like it, preferring to get the money back into their pockets so they can choose how to reinvest it. This has prompted Cisco, Microsoft and others to announce major stock buyback programs. Those programs could take years to execute, though … and in the meantime, more and more cash is accumulated.

The hoarding trend is not limited to tech companies. According to Fortune, “Non-financial companies in the S&P 500 index reported $837 billion in cash at the end of March … (and) are holding cash reflecting 10% of their value today, (while) since 1999, companies on average held cash equal to (only) 6.6% of their value.”

As companies decide what to do with all this cash, given low prices and the new lease accounting (see next), buying real estate has got to be among the considerations. 

The New Lease Accounting

I’ve written extensively here about the New Lease Accounting and how it will make leasing less desirable than it was. All leases will be going onto the balance sheet, taking away one of the benefits of leasing (at least for those companies who have been sensitive to how much assets are on their balance sheet). Also, from a P&L perspective, owning will often be more attractive, particularly where there are low borrowing costs and a low building value relative to land value.

While other considerations, e.g. NPV of cash, might be the main driver for own-vs-lease decisions, the New Lease Accounting removes the objections to owning that have been based on financial statement concerns and that have stopped many companies from owning in the past.

Can we expect to see a trend to ownership?

While there were prognostications that sale-leasebacks, including those for HQ’s, would become more common as a result of the financial-crisis-induced credit crunch of 2008/2009, we seem to be past that. The future trend is likely to be the opposite … more towards more companies buying HQ’s. The Northrop Grumman deal is one. Also announced in 2010 have been Andarko Petroleum’s purchase of its HQ in Woodlands TX and Horizon Blue Cross’s purchase in Newark NJ. I imagine there have been more … and that more are yet to come.

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Comments»

1. Cesar J. Chekijian, MCR - August 3, 2010

With 15-20% ROE (after tax) expectations of shareholders, not sure how any public corporation can justify carrying any PP&E on its Balanced Sheet, never mind buying it HQ. The answer could be in the PFI model (Private Finance Initiative), which has been growing appreciably over the past 30 years in the UK and several other countries, by spinning off all of CRE to stand alone public companies.

2. Cesar J. Chekijian, MCR - August 3, 2010

With 15-20% ROE (after tax) expectations of shareholders, not sure how any public corporation can justify carrying any PP&E on its Balance Sheet, never mind buying its HQ.

The answer could be in the PFI model (Private Finance Initiative), which has been growing appreciably over the past 30 years in the UK and several other countries, by spinning off all of CRE to stand alone public companies.

3. Bob Cook - August 3, 2010

Cesar…

It is true that a company can achieve it’s ROE if it were to buyback its stock, but most companies have chosen not to do much stock buybacks. And the reason that companies are building up cash accounts is that they don’t have enough opportunities to invest in their business to make the 15% +/- ROE they need. (The lack of alternatives to invest to achieve an ROE that the base business achieves is why so many companies embark on ill-fated M&A activties; they’ve go too much money burning in their pockets.) So the fact that they won’t make their expected ROE on investing in real estate is really a mute point.

Making the lower return on real estate more tolerable, though, is that it is much less risky. In fact, on a risk-adjusted basis (if there was an easy way to make that calibration), investing in an HQ might achieve a ** risk-adjusted ** ROE higher than what they could get in a stock buyback.

In the end, owning real estate is a good way to keep wealth in the company in a way that earns a much better return than keeping it in cash, which is what most companies are doing now.

Cesar J. Chekijian, MCR - August 3, 2010

Well put. Having said that, corporations cannot make ANY return on the purchase of CRE, unless they buy at deep discount, to reduce their Occupancy Cost substantially, or when they sell their CRE at 15-20% IRR (after Tax), which would defeat the argument on buying CRE in the first place. Again, PFI is the emerging trend in the EU, and precedents have been set in the US, with the separation as an example of Marriott International and Host Marriott, which was the CRE arm of Marriott.

4. Eric Bowles - August 4, 2010

I’m not sure that a separate company is the only way to address property ownership. But the level of disclosure for owned real estate assets could stand to be enhanced. Perhaps a good target is to approach owned real estate as a business unit with the related disclosure and business unit level return expectations.

Bob makes a good point. For many companies with strong balance sheets, there is no reason to lease long term core assets. The cost of capital for companies is likely to be much lower than real estate owners. Whether leased or owned, the company has a long term commitment to their HQ location. And with the right deal, companies have a good opportunity to meaningfully reduce real estate cost per worker in the long run.

Perhaps another filter to use in evaluating purchases is the long term impact of new trends. For example in 5 years a blue chip company would not want to own a building that is not LEED certified. As a real estate owner occupant, you probably would want to look at the flexibility of the building to incorporate trends in flexible work environments. And you would think twice about buying buildings in secondary locations that could be hard to sell. Failure to do so could mean buying a white elephant that could otherwise be avoided.

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