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Financial Strategy: The Dialogue (Finally) Begins … May 24, 2011

Posted by Bob Cook in Financial Planning & Analysis.
2 comments

Mark the date:  May 3rd, 2011.  That’s when, at the Corenet Global Summit in Chicago, the long overdue dialogue began.   The Breakout Session title was: “Money Talks: How Corporate Language Drives Corporate Real Estate”.   It was a freewheeling discussion … some may say “too freewheeling” … about how companies do and should … two distinctly separate ideas … go about doing financial analysis for real estate decisions.

Some panelists spoke of a need for a type of “doctrine” that would set how companies should do analysis.  Others spoke about how analysis needs to be situation-dependent, even participant-dependent … given the realities of how companies work.   A panoply of words were spoken:  net present value, discount rate, weighted average, incremental, cost of capital, cost of debt, cost of borrowing  … to name a few.  There were differing opinions.   The discussion fell short of being a full-on debate … twasn’t nothing like the Lincoln-Douglas debates which occured in the same State of Illinois 150-some years earlier.  There was, though, an accusation of contrarianism on the part of some panelists …  which, I think, was a tribute to the organizers. 

It’s a good start but a lot of discussion … maybe even sometimes heated … needs to happen before interested corporate real estate professionals can begin to understand the complexities of financial analysis and how textbooks (and MCR classes) cannot provide an all-occasion cookbook recipe of how to do financial analysis but instead can only provide the foundational tools needed to decide which tool(s) are appropriate in any given situation.   We need a robust, broader debate to ensue in the profession.  The “Money Talks” session was a great beginning.

Kudos to Jane Mather and Richard Podos for organizing this session.  For way too long, Corenet Summits have neglected serious discussion about financial decision-making.  While financial analysis is deeply embedded in the Master of Real Estate (MCR) curriculum, it’s been notably absent from the Summits.  The Summit agenda has been dominated by other topics such as alternative workplace strategy, alignment with business operations, economic development and sustainability.   

Witness the guide to this past Summit which offered a “Topic Key” that organized the breakout sessions into topic categories:  Social Dynamics, Optimizing Resources, Workplace Strategies, Leading Issues, Economic Development, Sustainability, Technology, Industry Sectors, Advancing Skills, and Service Delivery.   Note: no mention of finance. 

The “Money Talks” session was categorized under “Optimizing Resources”, a topic that included sessions devoted to other-than-finance subjects.  Shouldn’t finance be important enough to merit its own topic category?  Aren’t there enough finance related subjects to populate such a category with enticing sessions?  Some of the many possibilities:  transaction structuring, financial analysis tools, finance methodologies and case studies, funding of real estate resources, new accounting pronouncements.

Related to the last of these, the new lease accounting standard forthcoming from FASB and IASB will force Corenet membership to strengthen their financial acumen.  Corenet, as the leading association serving the profession of corporate real estate, needs to help them do so.   When millions of dollars … and in some cases, billions of dollars … of liabilities go onto balance sheets, real estate execs are going to be called upon, by their Controllers, Treasurers, CFO’s and even CEO’s,  to explain their real estate financial strategy.  Own-vs-lease, funding of tenant improvements, term-structure of the lease porfolio and lease duration are just some of the issues likely to be raised.  Many real estate execs will not be ready to have those discussions.  To participate one must be able to intelligently and knowledgeably converse about finance matters.  Real estate execs will need to understand, in depth, the meaning of the words that were spoken at the “Money Talks” session and the concepts surrounding those words.  They’ll need to articulate their financial strategy and, of course, as a precursor to articulating it, develop it.   

In fact, if corporate real estate execs don’t step up to the financial-acumen challenge posed by the new lease accounting, they could find their recent promotion to the outskirts of the “executive suite” … and in some cases, into the suite, itself … to be in jeopardy.  Rightly or wrongly, the new lease accounting is going to force corporate real estate execs to become expert in financial strategy, lest their position in their companies be usurped by others who are.

I’m hoping future Corenet Summits elevate “finance” to being a topic area.  The discussions begun at “Money Talks” need an outlet, need to be heard, need to blossom.  Let the talks … even some debates … begin.

Workshops on New Lease Accounting May 23, 2011

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
1 comment so far

Along with Grubb & Ellis colleagues, I will be holding workshops on the new lease accounting in Boston (June 7), Los Angeles (June 14) and Newport Beach (June 15).  These workshops are not just on what is the new lease accounting (something that accounting firms are better at interpreting), but rather they are on what are the implications of the accounting for corporate real estate departments.  

The agenda:

  • Overview of proposed standard for lease accounting
  • Update on FASB re-deliberations and the schedule for adoption of the new accounting standard
  • Original Grubb & Ellis research on the balance sheet impact for local companies
  • Implications for transaction structuring and real estate strategy
  • Implications for real estate processes and IT systems
  • Roadmap to compliance

The workshop is for corporate real estate executives.  If you would like to attend, contact me at robert.cook@grubb-ellis.com.

For more information, click below:

Grubb & Ellis Lease Accounting Workshop – Boston Area

Invitation to Grubb & Ellis Lease Accounting Workshop – LA and Newport Beach

Answer: Best place to get to work by public transit May 22, 2011

Posted by Bob Cook in Financial Planning & Analysis.
2 comments

For those of you old enough to remember, Johnny Carson got a lot of late-night laughs at the expense of L.A. traffic, smog and culture.  Ed McMahon would give Johnny’s Carnac an answer and Carnac would intuit the question.  It was sort of a comic Jeopardy

.

Ed:    Clean air, a virgin and a gas station open on Sunday

Carnac:   Name three things you won’t find in Los Angeles.

When Carson moved, in 1972, from NY to L.A the two cities were world’s apart.    New York was a traditional city with a strong downtown and people living in the boroughs and suburbs, like New Rochelle where Dick Van Dyke lived . Most folks either walked to work or road trains, subways, or buses. 

L.A., though, was different.  No one walked … anywhere.  Few people took public transportation.   Downtown was somewhere over there, but you couldn’t see it through the smog and, while Gertrude Stein originally said it about another California city, her description applied: “There isn’t any ‘there’ there”.   Urban theorists like Lewis Mumford derided L.A. as “100 suburbs in search of a city”, and if you wanted to go out on Sunday, it was a real problem that the gas stations were closed because you probably couldn’t get there (assuming, for the sake of exposition, there was a “there” there) via public transit.

Johnny Carson’s jokes about smog and traffic formed the American opinion about what L.A. and, by extention, the rest of California were like, and how they were so different from the rest of country.  California was a place of freedom but a place where people spent an inordinate amount of time in their cars, squinting through the smog, not actually being able to see the “Hollywood” sign.  It was not an inaccurate depiction … and it applied to many of the newer cities in the American West, not just to those in California. The resulting belief, though, of where transit was strong and where it was weak would within a generation be reversed.

Carnac must be scratching his head

Answer:   Best place to get to work by public transit

Question:   What is California?

That, Mr. Carnac, is not a joke.

According to a recently-released Brookings study, eight of the top ten U.S. metropolitan areas, ranked according to the share of working-age residents with access to transit, are in the West; four are in California.  The list:

  1. Honolulu HI  (97%)
  2. Los Angeles-Long Beach-Santa Ana, CA (96%)
  3. San Jose-Sunnyvale-Santa Clara, CA (96%)
  4. El Paso, TX (94%)
  5. San Francisco-Oakland-Fremont, CA (92%)
  6. Modesto, CA (90%)
  7. New York-Northern New Jersey-Long Island, NY-NJ-PA (90%)
  8. Salt Lake City, UT (89%)
  9. Miami-Fort Lauderdale-Pompano Beach, FL (89%)
  10. Las Vegas-Paradise, NV (86%)

As Gomer Pyle, another icon of mid-20th Century television would say, “Surprise, Surprise”. 

So, what’s happened over the last fifty years?  How could this be?  It turns out that low-density suburban sprawl … that nemesis of public transit … has crawled across landscapes in the East more than landscapes in the West.  Metros in California and other western states have avoided sprawl … partly through the discipline imposed by the physical geography and partly through political will.  It was the natural geographic barriers in the form of mountains, deserts, and an ocean, combined with strong land use controls, primarily resulting from a desire to preserve those natural resources, that resulted in metros of the West ultimately being built to higher densities than those of the East. 

Consider this comparison:  While the city of Chicago, proper, is probably more dense than the city of Los Angeles, proper, when you include the Chicago suburbs which have expanded unimpeded like a prairie wildfire, the Chicago metro is much less dense than the Los Angeles metro, where the surrounding hills and mountains block sprawl… because, besides, who wants to live where real wildfires happen?

And sure, while the West doesn’t have anything like the high-volume, high-speed rail systems of New York, Chicago and Boston, those systems … born more than a century ago … no longer serve a large proportion of those metros.  Only so many people can live in the boroughs, the precincts, and the close-in suburbs.  Now most live far from the reaches of those century-old transit systems … and they typically live in low-density communities that put their homes an un-walkable distance from the closest bus stop. And even for those who are close to the old hub-and-spoke systems, the jobs are no longer mostly at the hub, anyway.  Jobs are in the ‘burbs not served by those systems.

In California and the West, on the other hand, jobs and homes are frequently within walking distance of a bus stop.  And while … sure … not many people today ride public transit to work, they could if they wanted.  In the future … as gas prices rise, as legislation curtails the use of energy-wasteful, environmentally-unfriendly personal transit, and as growing populations and ever-increasing densities lead to traffic congestion … people probably will want to ride buses (or whatever it is we call multi-passenger conveyances in the future); in California and the West.  High-population densities will allow that to happen.

Implications for the geography of jobs

It used to be that discussions about “quality of life” focused around weather and natural amenities.  These were often cited as the main reasons for the western (and, to a lesser extent, southern) migration of the U.S. populace.  Companies expanded in the West because it was easier to recruit young employees there.  Some of us, including myself, used to think, “yes, it’s nice living in the West, but the lack of public transit will be its downfall … as oil prices rise and as cities grow so large that highway gridlock sets in”.   We thought the westward flow of jobs would cease.  We were wrong.   It’s the other way around.   While the older parts of Eastern cities … those with high population densities and good legacy transit systems are positioned to prosper with a greater desire for public transit, the metros, overall, are not.   Expect companies to continue to expand disproportionately westward.

Commuting to your job is and will continue to be a lot easier in the West.   Who would have thought it?  Surprise, surprise.

It’s a LinkedIn World after all …. May 19, 2011

Posted by Bob Cook in Financial Planning & Analysis, Profession of Corporate Real Estate.
7 comments

The dazzling success of LinkedIn’s IPO today took many by surprise.  Some people might be scratching their heads, saying “Linked Who?”  “Linked What?”  But LinkedIn is no stranger to those of us who have used LinkedIn to connect, learn and interact over the last few years.  Forget Facebook … too many under 25’s, over 65’s, and early retirees with too much time on their hands.  (Do I really want an update on what a “friend” ate for breakfast?)  For business professionals, the place to be is LinkedIn.

I remember my first invitation to “Link-In”.  (Is that the correct verb?  Is it in the dictionary, yet, like “to friend”?)  I must have received that first invite in the early-oughts.  I undoubtedly said to myself “Linked Who?”  “Linked What?”  I left the invite in my in-box for at least a year before I LinkedIn.  Since then, I’ve gotten to know scores of people through the platform.   And I’m flabbergasted by the fact that I’m only three degrees away from over 5,000,000 people (and, can you believe it, only three degrees away … not six degrees away … from Kevin Bacon! – is that really him on LinkedIn?)

For myself and many others, LinkedIn has eclipsed organizations like Corenet Global and IFMA (International Facility Management Association) as the primary vehicle through which people stay in touch.  Those professional organizations have other valid roles … like providing opportunities for face-to-face interaction (because we all need to come out of the cave occasionally) and providing structured education (which Corenet has done phenomenally with its MCR program) … but keeping people in touch in a fast-paced, flat world is probably no longer a valid mission for professional organizations.   These organizations need to mash-up with LinkedIn, let it serve as the day-to-day forum, and not try to compete by firing up their own social networking sites.

In fact, the mash-up is already happening.  There are, by my count, over 40 LinkedIn Groups with the word “Corenet” in their names and over 100 with the acronym “IFMA” in their names (although, to be honest, I didn’t weed out those that might be related to the International Foodservice Manufacturers Association or the Institutional Fecal Matter Alliance).

Yep, LinkedIn is the place to meet.  It’s no longer over golf (does anyone still have time for the links?) … or at a fancy restaurant  (do people still wear cuff links?) … or even at Joe’s (anyone still eat sausage links?).   Nope.  The place to be = LinkedIn.

And, today, on its first day of trading, it’s up 100%.

Full disclosure:  I was not smart enough to buy LNKD this morning.

Lease Accounting Change Still Coming; Waiting for the Fat Lady to Sing May 15, 2011

Posted by Bob Cook in Financial Planning & Analysis, Lease Accounting.
1 comment so far

FASB and IASB are working feverishly to get their new lease accounting standard out.  They’ve admitted that they’ll miss their target date of June 2011 by a few months but claim to be as committed as ever to reform lease accounting.  Their goal: greater disclosure of lease liabilities.

Over the last few months, the accounting boards have met frequently to “re-deliberate” (which is their word) aspects of the new lease accounting they proposed in their Exposure Draft on Leases issued last August.   They’ve been trying to respond to objections raised in the more-than 700 comment letters they received during the comment period that ended December 15, 2010.  Bit by bit, the boards are addressing concerns raised and making tentative modification to their original proposal.  In general, though, the main tenet of the original proposal … that all leases go on balance sheets … remains intact.  In fact, the strategic and process implications of the new accounting are as big as ever.

So, where are we now?  Following is a summary of the accounting proposal as it now sits.   Be aware, though, that this is a digest.  It only covers main points, and it glosses over the many nuances of these points.

Also, remember: “the fat lady hasn’t sung yet”.  The “Re-Deliberation Opera” is still on and there could be more changes, reversals, and reversals of reversals in the offing.

For more information on the implications for real estate strategy and proceses, see my other posts on the new lease accounting here.  In particular check out an earlier post on “Ten Things You Should Know about the New Lease Accounting Standard” but make sure you read below to understand how the capitalization of optional renewal periods and P&L accounting are still being re-deliberated.

All leases will go on balance sheet.   The main thrust of the new accounting is to require lessees to capitalize their leases and put them on balance sheets … as both right-of-use-assets and lease liabilities.  A lease will be capitalized in an amount equal to the present value of its future lease obligations, discounted at the company’s incremental borrowing rate.  There has been little opposition to this idea of putting leases on balance sheets, and it will undoubtedly happen.

Don’t be confused about talk that the accounting boards are considering the possibility of allowing two types of leases: “finance leases” and “other-than-finance leases”.  First, the boards are second-guessing their idea of having two types of leases, and so the concept might not survive.  Second, though, if the concept does survive, know that the reason the boards are considering two types of leases is only to allow two different types of expense recognition for P&L accounting. (See below.) Both types of leases would still go on balance sheet.

More than just minimum rent obligation will go on balance sheet, but we’re not yet sure how much more.  Companies will have to capitalize more than just their minimum rent obligation.  They will also have to capitalize some types of contingent rent and some optional renewal periods.  It looks like contingent rent will have to be included as long as it is based on something other than business conditions. For example, rent escalations tied to CPI would have to be included, but rent that is determined as a percent of revenue, such as for a retailer, would not.  (The latter case, though, changes if the threshold of revenue at which that contingent rent kicks in is so low that the contingent rent is deemed to be “disguised base rent”.)

As for optional renewal periods … one of the most contentious aspects of the proposed accounting … the accounting boards have tentatively changed their original proposal and now propose that an optional renewal period would only be capitalized if there is a “significant economic benefit” to exercising the related option. The boards have not, however, provided any guidance on what would constitute “significance” … and it is unclear if they will … and so it is uncertain at this point how significant this “significance test” will be in reducing the number of optional renewal periods to be capitalized. (It seems to me that most options to renew carry a significant economic benefit in the form of avoidance of relocation costs.)

The original proposal would have required capitalizing the optional renewal period when it was “more likely than not” that the renewal would occur.  It was strongly criticized on three counts: capitalizing renewal periods for which companies are not obligated, requiring difficult-to-make forecasts of whether a lease will be renewed, and requiring complex processes to make those forecasts.  Presumably this ”more likely than not” wording has gone away, but conceptual gaps seem to exist, such as whether or not the likelihood of renewal is to be considered before capitalizing a renewal period associated with an option containing a significant economic benefit.

The boards still have work to do in defining when obligations related to optional renewal periods should be included.  They will almost definitely require some optional renewal periods to be capitalized; otherwise companies would be able to structure short leases with options to renew as a way to avoid capitalizing lease periods that will inevitably occur.

The pattern of expense recognition will be high in early years … for at least some leases … and maybe for all leases.  The straight-line pattern of recognizing lease expenses evenly over the course of the lease … as is done today with operating leases … may no longer exist.  The original accounting proposal was to entirely do away with today’s P&L accounting for leases (which, BTW, is the accounting most companies use for their internal budgeting).   The proposal was to replace rent expense with two new types of expenses: amortization of the right-of-use asset and interest on the lease liability.  The latter would be higher in the early years of a lease and lower in the later years, just as is the case in a self-amortizing loan. The resulting high-then-low expense recognition pattern was criticized in many of the comment letters, and so the boards are considering the possibility of defining two types of leases … “finance leases” and (the presently inelegantly named) “other-than-finance-leases”.  The new expense recognition pattern would apply only to the former; the latter would have a straight-line expense recognition pattern similar to today’s expense recognition pattern for leases.  (Whether it would be categorized as rent expense or as asset amortization and liability interest is unclear.)  Debate continues, though, particularly as it is becoming clear to the boards that defining two types of leases creates definitional problems, might require the types of “bright line” rules that are inconsistent with the boards’ goal of creating a principles-based standard, and would likely increase the complexity of compliance processes.

The new accounting will apply to some contracts you do not now think of as “leases”.  A big issue that has caught a lot of people by surprise is that the new accounting necessarily will apply to implicit leases, i.e. those contracts that may not be thought of as being leases but which convey to the buyer the right to control one of the vendor’s assets and specify exactly which asset is used.  An example is a photocopy contract which might be thought of as a service contract but which … because it conveys control over specified assets … would be deemed to contain a lease.

The issue applies to assets much larger than photocopiers, though.  Think buildings.  An example might be a logistics contractor who manages logistics for a customer out of a warehouse that is used solely for that customer.  Such a contract might be deemed to contain a lease, and the customer would have to put, on its balance sheet, a portion of the projected future payments to be made to the logistics contractor.  See my previous post on this topic.

Initial application of the new standard may be only a year away … long before the “Effective Date”.  The boards have not yet specified when the “Effective Date” of the new accounting standard will be.  When they do, there is likely to be much misunderstanding because the “Effective Date” is a misnomer.  Companies will actually have to begin applying the new standard retrospectively to leases a couple years prior to the effective date.

According to the Exposure Draft on Leases, the Effective Date will apply as follows.   A company will have to apply the new standard to its annual financial statement for any fiscal year that begins after the Effective Date.  This means, for example, if the the Effective Date was designated as December 31, 2014 (which would be three years after the anticipated issuance of the standard by the end of this calendar year)  any fiscal year starting after that date would have to use the new accounting in its annual statement.  Let’s say the company’s fiscal year began on February 1, 2015, the annual statement for the year ending January 31, 2016 would be the first time that the company would report using the new standard.

That sounds like a long time from now, but consider this: the standard will require that the company retrospectively apply the standard to any financial results for prior years that it presents for comparison purposes in its FY2016 annual report.  The typical company presents two years of prior results and so would have to recast its FY2015 and FY2014 statements using the new accounting.  The latter fiscal year begins on February 1, 2013 and so the company would first apply the new standard on that date, even though it won’t report using the new standard until three years later.

Continuing this hypothetical (but very possibly real time table), February 1, 2013 is only a little over a year after issuance of the standard, assuming issuance by the end of Calendar Year 2011.  This leaves little time to put in place the processes to collect the information and make the assumptions (such as for optional renewal periods) needed for this retrospective application. While companies will not absolutely have to have these processes in place before the initial application, if they don’t, they risk losing information that will later be required for this retrospective application forcing them to undertake the time-consuming and costly reconstruction of historical data and the determination, to the satisfaction of their auditors, of what assumptions they would have likely made in early time periods about things like optional renewal periods, contingent rents, etc.  Putting processes in place to capture this information prior to the date on which initial application takes place will be a wise choice.

There will be no grandfathering of existing leases.  Leases that are already in place today, as well as those signed between now and the Effective Date, will go on balance sheet on the Effective Date if they are still active.  Considering this, the standard … even though it is not yet set … is for all practical purposes already in effect.  Companies should already be taking the new accounting … at least those aspects that are not under debate … into account in setting strategy and making decisions.  This is something that few corporate real estate execs truly understand yet.

Standard will probably be issued before end of this calendar year. Once the boards issue the new standard, companies will have to shift into high gear to address the strategic and process implications.  Companies should already be mobilizing to do this.  I suspect many are not.  For their sake, let’s hope the  fat lady sings the finale of the “Re-Deliberation Opera” loud enough for them to hear.