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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.

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Tax Week Special: Dare we ignore taxes the other 51 weeks? April 12, 2010

Posted by Bob Cook in Financial Planning & Analysis, Silicon Valley.
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It’s tax week. Oops. There goes 35% of my marginal income – or actually even more considering the state tax. “Why,” I ask myself rhetorically, “did I bother working those last few hours last year? I should have left for the New Year’s Eve party early.”

Likewise, I wonder, why do corporations burdened with a 35% Federal tax and additional state taxes fret so much about all the little cost savings they pursue when billions of dollars flow out the door as tax, sometimes with nary a look? Tax expense is one of the largest expenses companies have – yes, sometimes more than real estate and facilities, sometimes even more than salaries – yet companies do a miserable job of managing it. Most don’t even really try.

Many people think tax expense is not manageable, that the amount you’ll pay is predestined, inevitable – that you’re going to send 35 percent of your before-tax-income to the Feds and whatever percent to your state, no matter what. Not true. If it were, the tax paid as a percent of income-before-tax would be pretty much the same across companies. But take a look, below. I present the overall three-year-average tax rate shown on the income statements of some large California companies. All are headquartered within a few miles of one another, and all are in high-tech such that they are inherently similar (albeit, they have over time chosen different models for production, geography, financing, etc – but that, of course, is the point!)

 

Income-before-tax (3-yr average)         Tax (3-yr average) Tax as % of Income-before-tax
HP 9,688,333 1,937,333 20%
Cisco 9,136,333 1,963,333 21%
Google 6,636,255 1,652,580 25%
Intel 7,518,667 1,973,000 26%
Oracle 7,218,000 2,088,667 29%
Apple 8,673,000 2,723,333 31%

 

There’s an 11% point spread from high to low. Apply that to a multibillion-dollar-plus income-before-tax and you’re talking serious money. Granted, the GAAP accounting for taxes may skew things a bit as do things like tax losses being carried forward (although, the 3-year average should ameliorate this), but it’s nevertheless clear that the tax rate is not inevitable and that some companies pay much less than others. Whether the large spread in their tax rates is caused by conscious tax-planning or dumb luck can’t be known, and one shouldn’t jump to the conclusion that high-tax-rate companies are doing a poorer planning job because they might be making intelligent choices taking into account tax and other factors. The wide point spread should, though, open one’s eyes to the scope of opportunity available if one were to consciously pursue tax-planning.

(In case you’re wondering: while the Federal plus California marginal tax rate for corporations is 44%, the threshold for reaching this rate is very low, so the lower-than-44% overall tax rate of these companies cannot be explained by an overall-vs-marginal-tax-rate argument; there are other things going on that cause it.)

A company’s tax rate is determined by the business decisions – the big ones and the many, many small ones – made throughout the company. The way to manage income tax expense, therefore, is to routinely take taxes into account in decision-making – or at least for those decisions that can be identified as impacting tax.

That’s easier said than done. Tax analysis can be complex, and more importantly …. few, if any, managers in a corporation have an incentive to take taxes into account in decision-making. Budgets are almost always before-tax with bonuses based on before-tax performance. (I might add that they’re also based on “before-capital-cost” budgets and performance goals – an even bigger topic that merits a future blog post.)

Many of the decisions impacting a corporation’s tax rate have corporate real estate execs as participants – sometimes even as decision-makers. Location decisions are obvious examples. Should the facility be on this side of the state line or that? Should we own there or lease? Invest more there or here? These decisions affect individual state’s claims on how much of a corporation’s income is from their respective states and hence how much income is taxable in their state. It can make a big difference. Some state’s (NV, WY, SD) have no corporate income tax at all; some have rates close to 10% (PA, CA).

Even more obvious examples of how location decisions affect tax position are decisions to locate facilities overseas to significantly-lower tax-regime nations – Singapore and Hong Kong come to mind – particularly if the plan is to never bring the profits back to the U.S.

There are also everyday financial-type decisions being made in corporate real estate departments that affect income taxes. In these departments, it is convenient to assume that all cash flows and all P&L statement numbers would be affected by taxes similarly so that an an after-tax analysis would simply echo that of the before-tax analysis and be unnecessary – but this is not always true. Consider for example, the decision to purchase Bldg A or Bldg B which are priced identically. Before-tax, the economics of both seem identical. If, however, the allocation of price between land and building differs between the two buildings, an after-tax analysis would show them to have different costs. The one with the lower land value and higher building value would be less expensive because the deductible depreciation expense would be higher.

There are many other situations where before-tax and after-tax analysis point to different courses of action – from big decisions such as own-vs-lease to common decisions such as whether to accept a landlord’s offer to pay for tenant improvements. It is unfortunate that so much effort often goes into fine-tuning before-tax financial analysis when it leaves out such a weighty thing as tax. Before-tax analysis is ok as a preliminary, quick-and-dirty, back-of-the-envelope calculation based on WAG’s, but …. for a final decision?

Do you have your SOX-compliant portfolio plan yet? April 5, 2010

Posted by Bob Cook in Alternative Workplace Strategies, Financial Planning & Analysis, Lease Accounting.
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I’ve been writing about the impact of the new lease accounting standards to be set by FASB and IASB.  By June of this year the Exposure Draft outlining the standards will be in place with compliance likely to be required in late 2011 or early 2012. Corporate real estate – both strategy and process – is going to be mightily affected.

One aspect of the standard, in particular, is going to have far-reaching consequences – namely the accounting for leases with options to renew. This accounting is going to force corporate real estate departments to have documented portfolio plans. And these are going to have to be diligently created plans, created with SOX-compliant processes, that pass muster with auditors.

Here’s the background: The present value of future lease obligations will be going onto balance sheets. Most companies won’t like this because it will spotlight their financial obligations to landlords and negatively impact some measures of profitability such as Return on Assets. But here’s the interesting wrinkle on the present value calculation: the amount of lease obligations has to be based – not just on the present term of the lease but – on the likely lease duration, taking into account optional renewal periods.

Impact on strategy and process: That means that each quarter, corporate real estate departments are going to have to state what they think will be the likely lease durations for those leases with options to renew. Upper management is going to be pushing to make non-renewal assumptions, where legitimate, particularly for large leases. Auditors, though, will be scrutinizing any assumptions that renewal options will not be exercised and are probably going to require that formal portfolio plans, supported by the affected business units, be in place to substantiate renewal assumptions. And they’re going to want to review the processes used to create those plans.

How Corporate Real Estate Execs lives will change: Real estate planning is going to have to look ahead more than it typically has. This is going to be a challenge for corporate real estate departments in terms of staffing, but even more so in terms of getting business units to work with them on developing longer term plans.

For corporate real estate departments, this is “good news / bad news”. The “good news” is that they will gain CFO support in their efforts to get business units to do longer-range real-estate planning with them – something which many corporate real estate execs would like to do, but which business units are usually loathe to do.  The “bad news” is that corporate real estate departments are going to be in the “hot seat.” They’ll have responsibility to prepare a plan, but they’ll be dependent upon the cooperation of others across the enterprise to prepare them. Not an enviable situation.

So what can corporate real estate execs do? As always, starting early will help. Corporate real estate execs have to start tackling this issue now. They can lay out their process for developing portfolio plans, identify the major leases or collection of leases that deserve scrutiny, understand what options to renew exist, educate themselves about the new accounting standard, begin to educate their internal clients about it, and in general, get on with the business of portfolio planning.

 Other posts on lease accounting:

Beware new lease accounting guidelines coming

IASB confirms June 2010 date for lease standard exposure draft

Cisco’s Real Estate Valuation Dilemna: How much is enabling face-to-face collaboration worth? April 5, 2010

Posted by Bob Cook in Alternative Workplace Strategies, Financial Planning & Analysis, Real Estate Markets, Silicon Valley.
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Last week the San Jose Mercury News reported that the State of California is moving along on its efforts to sell the last large parcel of the Agnews Development Center property – 86 acres in north San Jose. See “Last of Agnews property up for grabs”.

While other state agencies, county government, local government, and school districts have first dibs on the property, if none of them bite, it’ll be offered to tech company Cisco which has an option, dating back to 1996, to purchase the land for $90 million. If Cisco doesn’t bite, the property will be made available to the public.

Cisco might very well bite. The property is adjacent to its giant, sprawling headquarters campus and would fit Cisco’s modus operandi which has been to consolidate virtually all of its 11,000+ Bay Area employees on this campus. If it thinks it might want to expand its employee population in San Jose at some point in the future, the Agnews site might offer the last chance to expand its campus with contiguous land.

That’s a big “if”, though, because in recent years, Cisco has been expanding its R&D efforts considerably oversees — most notably in Bangalore where it has 6,000 employees and aims to have a total of 10,000 employees in a few years. This overseas expansion has, arguably, been at the expense of growing R&D and other jobs in San Jose, and might be an harbinger of where job growth would be for the company in the future.

Assuming, though, that Cisco wants the land, the issue it needs to deal with is price and bidding strategy. While it has an option to purchase the site at $90 million, the California General Services Administration estimates the value of the land to be only $60 million. If Cisco were to exercise its option, it seems, on the surface, that it would overpay.

But if Cisco doesn’t exercise its option and chooses, instead, to try to be the successful bidder in an open bidding process so it can get the property for something closer to $60 million, it risks not being the successful bidder at all. This is particularly true because price won’t necessarily be the State’s only criteria for selecting the winning bidder. It might, for example, give preference to bids from developers who would convert the site to housing, the promoting of affordable housing being one of the State’s goals.

So that’s going to make Cisco think long and hard about passing on its option to buy. Some might say that the 50% premium it would have to pay above the site’s estimated value is too high, but that estimate of value does not take into account that this property is probably a lot more valuable to Cisco, if it thinks it needs the expansion space, than to anyone else.

As one of the world’s most profitable companies (with net income of $6 billion per year, equal to 17% of revenue), Cisco could, and probably should, look at the value of that land differently than would others. If, in fact, the aggregation of so many employees near one another so as to maximize face-to-face interactions is an important feature of what makes Cisco tick (and it seems that the company’s decision to aggregate so many employees in one place indicates that it does see this as an important feature — and if it wants to provide for future growth — then its valuation of the land should be based on an evaluation of the incremental profit that the company would derive from expanding jobs in San Jose. It should not be based on any of the traditional land appraisal techniques. In fact, this methodology of basing value on what incremental benefit the property would bring to the company would be in line with how companies typically evaluate whether their owner-occupied properties are impaired and should be written down on their balance sheets. Companies typically do a test to see if the cash flows likely to be generated from the enterprise substantiate the property values on their books. If it does, then there’s no write-down — even if the aggregate of all the “market values” (using traditional appraisal techniques) of the properties is less.

Cisco’s high level of profitability would, I guess, easily allow it to justify “overpaying” for the Agnews site. By how much is difficult to judge, but for a company with net income of $6 billion per year, a $30 million premium would not seem too much to me. What Cisco would have to do is think through the value of being able to expand its campus onto contiguous land. Ultimately, that’s a judgement-call on the value of face-to-face communication – a big picture question if there ever was one. Be sure it’s not just a calculation of how much time would be saved in getting people together because they don’t have to drive very far. Instead, the true value would be based on the benefits of the face-to-face meetings – some serendipitous – that just wouldn’t happen at all if folks were not so proximate to one another. These may be just the type of interactions that may be at the core of Cisco’s success.

The irony of all this, of course, is that Cisco makes networking gear that facilitates virtual meetings, remote work, electronic communications, etc. It advertises how it supports “The Human Network” through other-than face-to-face communication (although it’s telepresence product, I suppose, sort of supports face-to-face encounters for those who can afford it.) These analogies aren’t quite on target, but: Cisco’s placing a high value on “face-to-face” would be like McDonalds serving only health food in its company cafeteria, like Nike not allowing employees to exercise at lunchtime, and like the State of Kentucky outlawing smoking.

Earthquakes and Enterprise Survival February 2, 2010

Posted by Bob Cook in Business Continuity Planning, Financial Planning & Analysis, Silicon Valley.
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A number of blogs have posted a news report that an earthquake was “overdue” in Port-au-Prince – and oh, by the way, a quake should be expected in many American cities not typically associated with earthquakes: St. Louis, Seattle, Charleston, Memphis, Salt Lake City, and Boston. A FEMA report from 2001 cites additional high earthquake-risk cities (beyond the well-known ones in California): Albuquerque, Anchorage, Atlanta, Honolulu, Las Vegas, New York/Newark, Philadelphia, Portland, Provo, Reno, and Tacoma.

New York, an earthquake risk? Who new?

It makes me wonder how much business continuity planning has been done by companies dependent on at-risk locations. And more generally, to what extent vulnerability to earthquakes plays a part in company stock valuations. If it is very little, as I imagine is the case, it seems like there is a lot of room for arbitrage by the Black Swan artists. Going short on stocks of companies vulnerable to earthquakes would likely eventually pay off. Better yet, there seems to be scope for some negotiable instruments to be invented that allow investors to invest on both sides of whether an earthquake hits or not.

While facilitating such bets might seem immoral to some, in fact, such an instruments would allow a company faced with earthquake risk to hedge against this risk by buying a position that profits if an earthquake hits. Then, in the event of an earthquake, they would be able to offset their business-continuity costs (or is it incontinuity costs?) with the profit gained from the instrument.

Over the last decade, companies have become more aware of the risks posed by natural calamities, and as a result business continuity planning has arisen as a discipline. From my observations, though, those doing business-continuity planning have only been able to chip away at the edges of catastrophic risks. They’re able to do things like make sure they have redundancy in their own facilities, have multiple supply chains, and enable employees to work from home. These things are valuable, but don’t deal with the real problem of a major catastrophe in a large city which is that the surrounding area – physical and social – becomes broken, non-supportive, dysfunctional. Government services aren’t available; transportation and communication systems are broken; civil disturbances erupt; people focus on survival and stop working; residents eventually leave town.

For a company located in a hazardous zone – whether it be from earthquakes, hurricanes, flooding, etc – no amount of advanced corporate planning can overcome these challenges (except perhaps planning focused on relocation to a more benign environment). A company in the midst of a major catastrophe is stuck with negative consequences. They’re unavoidable. Business anywhere-near-as-usual, in fact, cannot continue. So, business-continuity planners have got to start thinking in different terms. Their ultimate goal needs to be, not business continuity, but rather “enterprise survival”. They need to ask questions like “how much revenue will be lost if there’s a quake and how can we make it up?” They need to think outside the box of their own organization and facilities and those of their suppliers. They need to find a way to mitigate the damages they will suffer because of what goes on outside these boxes. They need to go beyond IT engineering and civil engineering and focus on risk management and financial engineering. They need to look at concepts like markets in catastrophe-based negotiable instruments and large-scale insurance cooperatives.

This admittedly draconian view of natural catastrophes will not sit well with some, but only those who have been able to ignore the harsh reality of what has been on our TV screens: New Orleans, Chengdu, Port-au-Prince. Sure, the likelihood that your company will be hit by a calamity is low, but the consequences could be severe.

Beware: New Lease Accounting Guidelines Coming! February 2, 2010

Posted by Bob Cook in Lease Accounting.
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If the two accounting-standards boards stay on schedule, a new set of standards for lease accounting will be in place by mid 2011. The impact on corporate real estate will be BIG. And it will be SOON. Those corporate real estate execs who think these new standards are something just for the accountants to worry about risk being like a chef with his pants down stumbling around frantically trying to get his kitchen in order before the health inspector arrives.

The European-based International Accounting Standards Board (IASB) and the U.S.-based Financial Accounting Standards Board (FASB) are working together and plan on issuing a draft set of lease accounting guidelines within five months, with compliance required perhaps as early as a year later. They already issued a document last March that outlined their thoughts and which sets the general tenor of the standards.

You can see the status of the joint project, as well as links to the Discussion Draft, dated March 2009, here.

In a nutshell, each operating lease will go on the company balance sheet as both an asset and a liability, both valued at the present value of the lease payments to be made. The impact on company balance sheets will not be subtle. Many companies will have billions of dollars of new items on their balance sheet. There also will be an income statement impact as “rental expense” gets replaced with a “depreciation expense” and an” interest expense”. For corporate real estate portfolios, there will be a permanent ratcheting up of expenses related to lease payments. While the new standard is long overdue and is necessary to more accurately portray the financial condition of companies, it’s going to cause a lot of heartburn among corporate real estate execs.

The new standards are going to effect corporate real estate in four ways. First, it’s going to shine a spotlight on lease transactions and bring a lot of questions from upper managements, such as “who is responsible for negotiating these large financial obligations?” “Do they have finance backgrounds?” “Do they have a financial strategy?”

Second, at some companies, the new accounting is going to precipitate change in the internal accounting used for budgeting, internal pricing, chargebacks, and even bonuses. There are going to be a lot of food fights to see who has to eat what part of the negative soup that oozes from the new standards.

Third, except for those few companies who are confident enough to not worry about their performance as expressed by their financial statements, the new standards will change real estate finance strategy, particularly as it relates to own vs lease and the length of leases. And, interestingly, there will be no grandfathering of leases; leases written today will be re-accounted for once the standard is in place. This means new lease strategies to address the new accounting are needed today — or, actually, yesterday.

Finally, in order to comply with the new standards, companies are going to have to establish a whole new set of policies and procedures to capture the information and make the forward-looking assumptions that will be needed to account for leases. These are going to have to be SOX-compliant; they can’t be cooked up overnight.

Last fall, JonesLangLaSalle published a report citing how few corporate real estate execs had begun making preparations for the new standards. Half a year later, I doubt that the situation has changed even though the kitchen timer is ticking. In future blogs I’ll look at the reasons for the accounting changes and discuss the implications in more depth.

Starting again… May 27, 2009

Posted by Bob Cook in Financial Planning & Analysis.
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I began a corporate real estate blog when I was with Sun Microsystems a few years ago. This was back in the dark ages of blogging. At the time, Sun Microsystems was one of the few companies that encouraged employees to blog, and I took advantage of the blogging infrastructure that the company provided. When I left Sun, though, back in 2006, I stopped blogging.

It’s time, however, to start-up again. Like many bloggers, writing helps me organize my thoughts and come to new insights. And if I’m writing anyway, why not share my thoughts?

So here it is. Starting again….

BTW, if you’re interested in my old blog, you can find it here:   http://blogs.sun.com/bobcook/