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Is Employee Housing Far-Fetched? What is Google up to now? November 22, 2010

Posted by Bob Cook in Company Case Studies, Corporate HQ, Financial Planning & Analysis, Real Estate Markets, Silicon Valley.
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Ask virtually any corporate real estate exec whether it makes sense for his company to provide housing for its employees, and you’ll get a dismissive “we don’t do that”.  So sums up conventional wisdom on the subject.

Now, it is true that some companies have provided housing for manufacturing employees in China where workers expect to receive it, but most U.S. companies now tap Chinese labor through contract manufacturers like Foxconn (infamous for its worker housing), so few provide housing themselves. 

And while it’s true that companies have in the distant past provided worker housing domestically, for example in Pullman which was built by the Pullman Sleeping Car Company way back in 19th Century Chicago, few companies provide employee housing today.   The exceptions are lumbering and mining operations and resorts, remote from existing housing.  Most companies, though, are located in urban areas with plenty of housing available, and in most cases, it makes sense for companies to rely on the “the invisible hand of the market” to provide housing for workers.   This is the conventional wisdom.

But, what kind of unconventional situation would make this conventional wisdom not wise?

And what is secretive Google planning for the Googleplex, its headquarters complex in Mountain View CA, where it has been reported it may build housing?

And are the two questions related?

Last week, the San Jose Mercury News reported on how “Google’s growth online [is] reflected by [its] expansion in Mountain View”.  The Merc revealed that Google may be building housing as part of its 1.2-million-square-foot expansion of its present four-million-square-feet of real estate holdings in Mountain View.  Previously TechCrunch and others had reported that Google was pushing the City of Mountain View to allow more residential and retail development in the vicinity of its campus … evoking visions of a “Googletopia” … so news of Google building housing is not surprising.

What exactly is Google up to, though?  One of the Merc’s sources says that as much as 120,000 square feet of residential could be built in the new campus development Google is planning … and “that would be the rough equivalent of 60 homes of 2,000 square feet”.   My thoughts on the math:  while the arithmetic is technically correct, it just doesn’t add up.

What on earth would Google want with 60 homes?  It’s not a number that would make a dent in Google’s ability to house its local employees … which the Merc estimates to be around 17,000 … and why would Google want the headache of deciding who should be allowed into such plum housing?  (A 2,000-square-foot house might not sound like much, but in Silicon Valley, that’s actually a pretty big home.)

Here’s what might make sense, though:  Google builds dormitories.  Google could squeeze as much as 400 dorm units (think small “nerd capsules”) in that 120,000 square feet.  While not enough to house a large percentage of its workers, it’s big enough to be noticed and plenty large enough to serve as a pilot to see if building and owning more dorms might make sense.  This is why it might …

Each month, Google hires a raft of twenty-somethings … many straight from university life, many from overseas … and many don’t want to live in the houses or two bedroom apartments that the market provides.  Why should they?   They don’t need kitchens; Google feeds them for free.   They don’t need space; they spend most of their waking hours at a desk.  They don’t need family rooms; they don’t have families … they’re nerds (which, BTW, today, is a complement … at least in Silicon Valley).  And they certainly don’t need to spend a lot on rent; it’ll be a while before their stock grants and options vest. 

Furthermore, these are not, of course, conventional people Google is hiring.  These are the cream of the crop.  They’re the people other companies oogle, and competition for them is the reason Google just announced it is raising salaries 10% across the board.  Providing these people with dorms on campus would be a great recruitment and retention tool.  With dorms, maybe the next salary increase would only have to be 5%.

So, if the demand for dorms is there, why can’t “the market” provide? Where is the “invisible hand”?   Zoning is the problem.  Two reasons.  The first has to do with geography.  The zoning in Mountain View has heretofore envisioned non-residential uses on the Google side of “the 101”, the U.S. highway that separates recreational, commercial, and aviation uses from the more residential, neighborhoody part of Mountain View.  A private developer would not be able to build a dormitory near Google’s campus… let alone right on it.   The second reason is that zoning in Mountain View and all the surrounding communities tends to limit the number of dwelling units that can be built on a site, either explicitly as a “DU per acre” limit or implicitly because of the physical and economic practicalities of providing the required parking.  Developers, therefore, being dictated how many units they can build, develop large and luxurious units which allow them to more easily recoup their high-Silicon-Valley land costs.  While some cities force developers to build some affordable housing as a condition of gaining their entitlements, the zoning still applies such that dorms are not in anyone’s product line.

So, the “invisible hand” isn’t working:  Googlers want dorms (or so one would think), but developers can’t get the zoning and, even if they could, couldn’t afford to build dorms.  Google wants to make the Googlers happy, but can’t rely on the market.  Google does, though, have influence over zoning (by virtue of being Mountain View’s biggest employer), and so could  act on its own if it wants dorms for its employees.  It certainly hasn’t been shy about providing Googlers with the good life on campus … from free gormet food to massages to pool tables to swimming pools.  Will it build housing?  The situation is unconventional enough to make conventional wisdom unwise.

Now … to be clear … there has been no announcement, as far as I know, that Google is going to build a dorm, and I have no insider knowledge to that effect.  But … putting two and two together … what do you think?

And if Google is not going to build dorms, maybe some of those other companies who are oogling the Googlers should think about doing so.

Window for Bargain Rents Closing Fast for Big Tenants: when being the 800 lb gorilla hurts November 14, 2010

Posted by Bob Cook in Financial Planning & Analysis, Real Estate Markets.
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Big users of office space have gotten used to throwing their weight around and getting what they want.  With the economic downturn, many have used their bargaining power to renew or “blend-and-extend” leases, relocate to better digs or consolidate operations.

The end of the party for big tenants, though, may be approaching … at least in some key markets.  Colliers’ Chief Economist Ross Moore provides interesting data in a blog post with an assertive title: “Office Vacancies are at Cyclical Highs, But Shortages Loom”.   He shows that “many cities have just a handful of options available to large tenants.”  One of those is LA where there is only one block of 200,000 square feet of contiguous space available downtown.  The same is true of downtowns in Philly and Cincy.  

Moreover, some tech and energy capitals … Houston, Seattle, and Denver … have fewer than five such blocks of space.  With their primary industries doing pretty well, it might not take too long for those spaces to go.  Consider: On-line-job-posting-aggregator Indeed.com shows Houston having 84K job postings, Seattle having 73K postings, and Denver having 56K postings … indications of the job growth that is starting to take hold.   How long will those big blocks of space be around?

The squeeze on large blocks of space results mostly from the dearth of new construction.  According to Colliers, if one ignores the large project at Manhattan’s 1 World Trade Center, there is only about 8 million square feet of office space under construction in downtowns across the U.S.   For comparison, I’ll add that in the past, it’s been common for larger CBD’s  like mid-town Manhattan and Chicago’s Loop, to have that much under construction all on their own.

Now … to be sure … it’s not time for office landlords, in general, to start partying.  Downtown occupancy rates will remain low for a while.  Mid-size to smaller tenants are going to have a lot of pickings to choose from and will continue to be able to demand low rental rates even as the big blocks of space get eaten up.  Landlords with large blocks will, though, benefit from the lack of such spaces.  Prices for those spaces will firm up quickly as landlords, anticipating the day when large blocks command a super-premium, become reluctant to lease at too low a price.  Landlords without large blocks of space, though, will continue to suffer.

This bifurcation of the market … the market for large spaces getting tighter and tighter and moving to a “landlords’ market”, while the market for middle-size and smaller-size spaces staying in oversupply and remaining a “tenants’ market” … will take many by surprise.  The conventional wisdom that large tenants can demand better rental rates than smaller tenants will become out-of-date.

For a period of time … until new construction is started to provide large contiguous blocks of space … it’s going to be better to be the one-ounce mouse than the 800-lb gorilla.

Comments to FASB on Lease Accounting – My Recommendations November 7, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
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Like every vote, every comment counts.

This past August, the U.S.-based Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) jointly issued the ”Exposure Draft on Leases” which details how the two accounting boards think lease accounting should work.   The Boards will accept comments on the new standard until December 15, 2010 with comments to FASB being shared with IASB, and vice versa.  The two Boards plan to jointly issue the final standard by the end of June 2011.

The thrust of the new accounting is to put  all lease obligations (with some minor exceptions) on company balance sheets (along with an off-setting “right of use asset”).   Most knowledgeable observers agree that leases, which today represent some of the largest obligations of companies, need to be on balance sheets … if balance sheets are to be  meaningful.  Comments to FASB that oppose the fundamental principle of putting leases on balance sheets are likely to be considered uninformed.

As they say, though,” the devil is in the details”.  Leases are sufficiently complex that accounting for them requires a lot of detailed, sometimes devilish, rules, and there are details of the proposed  accounting that merit comment .   In fact, the Exposure Draft lists nineteen questions that the accounting boards are interested in hearing comments on.

As I’ve noted in a previous post, though … while there are many effects of the new accounting that may be seen as undesirable, either because they cause a large administrative burden or negatively affect P&L statements in ways that don’t seem intuitive,  this, itself,  is not a legitimate reason to comment to FASB.  Only comments that respect existing accounting principles and suggest a better way to account for  leases are likely to be seriously considered.   There is no use in making comments that are uninformed.  Said another way: “No belly aching”.

The new accounting affects companies on both sides of a lease transaction, and no matter what your perspective … tenant, landlord … equipment lessee, equipment lessor …  outsourcer, contract manufacturer … there is probably a lot to not like in the new accounting.  You’ll want to review the Exposure Draft carefully to see if your company has any idiosyncratic situations that would be affected by the new accounting in ways not intended by the accounting boards. Those special situations might merit comment and might prompt FASB and IASB to modify the proposed standard to avoid unintended consequences.

There are, though, controversial elements of the new accounting that will affect everyone applying the new standard, and these merit comment from you.   From a corporate-real-estate perspective, I believe two elements of the accounting rise to the top of concerns.  Here they are:

Concern #1:  Longest possible lease length more likely than not to occur

The accounting detailed in the Exposure Draft requires tenants to evaluate the likelihood of their exercising options-to-renew (and also, presumably, options-to-expand).  A company would then place onto its balance sheet the future obligations related to the “longest possible lease length more likely than not to occur.”  If you’re likely to renew a lease with an option to renew, you would include the obligations during that extension period in the amount that goes onto the balance sheet.

Most tenants will not like this element of the new accounting … that is including obligations related to the extension period … because it will increase the amount that goes on the balance sheet.   Companies, in general, will want to minimize that amount because the higher the amount of liabilities shown on a company’s balance sheet, the riskier will the company look to investors.  

The proposed treatment for leases differs markedly from how “capital leases” (or “finance leases”) are accounted for today.  Presently, capital leases go onto balance sheets but only in an amount equal to the company’s contractual obligation (albeit, including renewal periods where exercise of a bargain-renewal-option is reasonably assured.) 

Reportedly, the accounting boards want obligations related to extension periods on balance sheets because they fear that tenants would otherwise be able to hide obligations by writing short leases with multiple renewal periods.  The truth is, though, such “structuring around” the lease accounting is easier said than done.  The economic motivations of lessors would, in fact, prevent this from happening.  Lessors are usually not indifferent to having a long lease versus a short lease renewable at the tenant’s option.  If this is the Board’s concern, it seems unfounded.

It seems to me that lease obligations that go onto the balance sheet should be only those amounts for which a company is contractually obligated, plus those related to bargain-renewal-options.   That is, after all, all that they owe.   If a bargain-renewal-option does not exist, then obligations related to extension periods should not go on the balance sheet.

Issue #2:  Effective Date.  

The Exposure Draft calls for a tenant to “apply this guidance in its annual financial statements for periods beginning on or after” the Effective Date.  If, for example, the Effective Date were January 1, 2012, then a company’s first annual report after that date would have to comply … whether that report was issued on January 2nd or December 31st of 2012. 

For now, the Boards have left the Effective Date blank, but they have their task cut out for them in filling in that blank.

Debate about when should be the Effective Date will be lively.  On one side will be those who want balance sheets to be made meaningful ASAP; on the other side will be those who are worried about how long it will take companies to comply with the new standard.

Most companies do not presently collect all the information and assumptions related to leases that they will need in order to comply with the new standard.  In fact, many companies do not even have an inventory of leases that they could vouch as being accurate enough to be the basis for the amounts that will go on their balance sheets.  Companies have quite a bit of work before them to be ready to comply.

Moreover, IT applications don’t even exist yet to easily collect the required lease data and assumptions, to manipulate that data, and to export it to financial accounting systems.   Software suppliers are unlikely to put significant resources into developing such applications until the standard is finalized, and it could take them a year or longer before their new applications are ready for market.

Making matters even worse, the standard calls for companies to use a “simplified retrospective approach” to transition to the new standard.  To do this, companies will have to have data stretching back two to three years prior to the Effective Date for existing leases.  They’ll also need data on leases that have expired within the two or three years prior to the Effective Date.

The “simplified retrospective approach” is a compromise offered to the two sides of the aforementioned debate.   Those wanting the most meaningful balance sheets ASAP would prefer a “fully retrospective approach”.  That would have required companies to go all the way back to the inception of every existing lease and recreate what the accounting would have been over the years if the new standard had been in place.  The Boards deemed the cost of that approach to not be worth the benefits.  Those worried about the cost and difficulty of compliance would have liked existing leases to be grandfathered and for the standard to only apply to new leases.  This would be a “prospective approach”.  The Boards rejected this as not treating all leases the same and as an approach that would take many years before existing leases expired and all leases would be accounted for under the new standard.

The middle ground that is proposed, the “simplified retrospective approach”, calls for leases to be treated as if they are new leases at the time the new standard is applied.  The rub, though, is that the new standard has to be applied at the “date of initial application” which is the “beginning of the first comparative period presented in the first financial statements in which the entity applies this guidance.”   Most companies present in their annual financial statements, for comparison purposes, financial statements for the two prior years.  This means most companies will have to begin applying the new standard three years prior to the date they first issue financial statements using the new standard.  It’s three years because they need to apply the standard to the year that is the subject of the financial statements plus the two prior years.

That means, if the Effective Date were January 1, 2012 and if a company issued annual financial statements for the year ending, say, March 31, 2012, then the company would have had to apply the new standard way back on April 1, 2009.  That was over a year ago.  What company still has all the data around that it will need to go back and apply the standard at such an early date?  You can see the problem.

It would be unreasonable to require companies to apply the standard to a date prior to the issuance of the standard.  So, if the standard is issued on June 30, 2011, then the Effective Date shouldn’t be until June 30, 2014.  And since companies deserve to have a little bit of runway before they need to start the accounting, my recommendation is a date of December 31, 2014, in which case the standard would have to be applied no earlier than January 1, 2012.

This Effective Date is going to be hotly debated.  My suggestion means that some companies will not issue statements using the new accounting until they issue statements for fiscal years ending December 31, 2015.  Those won’t actually be issued until early 2016.  Some may think this is way too long to wait for balance sheets to become meaningful.

Your Comment Counts

It’s like voting.   Every comment counts.  Don’t miss the deadline:  December 15.  FASB and IASB are awaiting your comments.  Mobilize your company to prepare and send one, NOW!

There are other sources of recommendations for comments you might check out.   A group of members of Corenet Global have prepared a good document to guide you.  If you are a Corenet member you can access it from the homepage of Corenet’s Strategy and Portfolio Planning Community here.

See my other posts on lease accounting here.

CoRE Tech: a response to the new process orientation of corporate real estate professionals November 3, 2010

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting, Profession of Corporate Real Estate.
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Next Wednesday, November 10th, I’ll be moderating a panel at the inaugural CoRE Tech event in Chicago.  The topic: “The New Corporate Real Estate Accounting Standards – Technology’s Role”. 

On the panel will be John Clark, Marketing Programs Director for TRIRIGA and Denis DeCamp, Head of Real Estate and Facilities Management for AkzoNobel.  We’ll be talking about the implications of the new accounting for  technology solutions and for process management and leadership in the corporation.

CoRE Tech is produced by Realcomm which for 12 years now has run a conference devoted to the intersection of commercial real estate, technology, automation and innovation.  According to Jim Young, CEO of Realcomm, the annual Realcomm conferences were never targeted at corporate real estate professionals, but that group of people have, nonetheless, taken an interest in and attended the conferences.  So it was decided to create “an event specifically for those individuals involved in real estate issues and operations in a corporation”.  That event is CoRE Tech.

It is interesting how much the corporate real estate profession has changed over the years.  Two decades ago it was largely about doing real estate deals and constructing buildings.  Today, the profession is more about corporate planning and process management.  The real estate and building functions continue to be important but are more and more outsourced activities.  

If you are a leader in corporate real estate now, you are involved in corporate planning and process management … and you have to get involved in managing the supporting technology.  As Jim Young says, “The structure of how companies manage real estate is likely to change with technology being at the center of organizational realignment.”

It will be interesting to see the turnout for the first-ever CoRE Tech event.  I hope to see you there.

McKesson to Buy US Oncology; takes over $600 M of lease obligations November 1, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Lease Accounting, M & A Integration, Silicon Valley.
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Today, San Francisco-based McKesson, a medical supplies distributor, announced that it will buy Houston-based US Oncology, a provider of cancer drugs and administrative services to doctors.  The reported value of the transaction is $2.2 B , comprised of the purchase of the company stock for $560 M and an assumption of US Oncology’s debt obligations of $1.6 B.  The amount of debt is particularly relevant in understanding how much McKesson is “paying” (a slightly ambiguous term) for the company.  US Oncology has a huge amount of debt, and according to McKesson’s press release, “it is anticipated that substantially all of US Oncology’s debt will be repaid or refinanced”.

$2.2 B or $2.8 B?

Looks to me, though, that value-of-the-deal should be more like $2.8 B.  You need to include the $600 M of future operating lease obligations that US Oncology has … much of it related to space that will probably not be needed after a post-close consolidation of real estate portfolios.  A more accurate estimate of how much McKesson is “paying” (there’s that pesky, ambiguous word again) would include those obligations.  That would push the price up by 25% to $2.8 B.

Undoubtedly, McKesson knows US Oncology has $600 M of future minimum operating lease obligations; those obligations show up in the notes to US Oncology’s latest 10-K.  These minimum operating lease obligations are not, however, among the $1.6 B of long-term obligations referred to in press reports and which show up on the company’s balance sheet.  Yet, these operating lease obligations are as real as are the balance sheet obligations (or at least they are if you ignore the fact that McKesson might be able to disavow leases in a bankruptcy). 

If the lease obligations were on the balance sheet (as they will be once the new lease accounting standards are in effect; see below), then the reported value of the transaction would probably have been this more accurate number of $2.8 B.

Savings from consolidations

McKesson’s task will be to see how much of that $600 M obligation it can whittle down.  In its press release, the company said that “there is already an overlap between the goods and services provided by the two companies, and the combination will allow for cost-savings from shared operations”.  A large portion of those savings might come from consolidating the real estate portfolios of the two companies with the savings eventually realized either through the natural expiration of unneeded leases or through subletting or buying out of lease obligations.

The opportunity to find savings is large.  US Oncology has 5 M square feet of real estate or so it was reported a year ago when it awarded CBRE an exclusive right to provide real estate services.  McKesson, according to a report in 2007 that announced CBRE being appointed to provide services to McKesson, had 17.5 M square feet.   (Neither company discloses the square footage of their portfolios in their 10-K’s., something that will change significantly when the new lease accounting standard, with its required disclosures, is put in place.)

Millions of dollars of operating expenses are probably possible to be eliminated from the combined companies by reducing their combined real estate footprint.  Twenty-million-some square feet of space is a lot to work with and provides ample scope to find savings. 

And McKesson really should try to reduce that $600 M of lease obligation before the new lease accounting proposed by FASB and IASB comes into effect.

New Lease Accounting will put obligations on McKesson’s balance sheet

Those lease obligations that McKesson is taking on will not remain “off-balance sheet” forever.  When the new lease accounting being proposed by FASB and IASB comes into effect, probably in 2013 or 2014, whatever is left of those obligations will show up on McKesson’s balance sheet because there will be no grandfathering of existing leases.  A considerable amount might still be left because … even if all the leases expiring prior to 2014 were not renewed … according to the 10-K,  there would still be over $300 M of obligations due in 2014 and beyond.

In fact, the amount going on the balance sheet might even be considerably higher than the $600 M of obligations that existed at the end of last fiscal year.  That’s becauase the accounting boards are proposing that the amount of balance sheet obligations be based on the “longest possible lease term that is more likely than not to occur”.   That means McKesson would have to include, not just the minimum lease obligations on its balance sheet, but also the obligations related to extension periods related to options-to-renew that are likely to be exercised.  Who knows, if many of the leases expiring from 2010 to 2013 are renewed (perhaps because McKesson needs more time to implement a consoldiation plan) and if a lot of the leases have options-to-renew that are likely to be exercised, then the number going on the balance sheet could end up pushing $1 B.

A final note on lease accounting:  Reportage of the McKesson / US Oncology transaction is just another example of how the absence of lease obligations on balance sheets is problematic … particularly as more and more companies have more and more of their financial obligations in the form of operating leases.   And while we can probably assume that McKesson and its advisors fully understood that they were really “paying” $2.8 B for the company, not $2.2 B (even though its own press release used the latter figure), when others use the transaction as a benchmark for company valuations, they’re probably unlikely to adjust the price for the operating lease obligations. Balance sheets without operating leases, as now called for by GAAP, are way too imperfect.   Balance sheets are no longer meaningful.   Leases need to go on them … as they shortly will if FASB and IASB have their way.

To learn more about the new lease accounting, click here.