Are buildings a capital idea?

Posted On Tuesday, 23 April 2002 10:01 Published by eProp Commercial Property News
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Should companies own the real estate they operate from or are they better off renting?

Jonathan PriceFor companies in a wide range of services from telecommunications to transport, the corporate instinct seems to be suggesting that capital tied up in bricks and mortar is capital wasted.

David Church, head of real estate corporate finance at Deutsche Bank, says that companies are increasingly realising that they can earn higher returns by selling assets and leasing them back, redeploying the capital in the business.

'If you sell a business at a capitalisation rate of 8%, can you reinvest it in your own business at a higher rate? Most businesses can,' he says.

But for a range of companies whose activities lie at the junction between real estate and some type of service, the answer has been less clear.

In particular, two types of operating businesses - internet hotels and serviced offices - have been at the centre of this debate and two distinctly divergent business models have emerged.

The first model, articulated most clearly by serviced offices providers such as US-based Global HQ and MWB Business Exchange and by internet hoteliers such as Global Switch, favours direct property investment.

However, this week it emerged that Digiplex, an internet hotels provider that also owned its properties, is close to receivership.

In late March, Global HQ sought protection from creditors under Chapter 11 of the US Bankruptcy Code, while MWB Group announced £91.5 million in asset write-downs for the half to December 31, most of them relating to its Business Exchange division.

Does owning the property assets give an edge to investors in asset-based property companies? The answer can hardly be an unequivocal yes.

Jonathan Price, head of Close Brothers Serviced Offices, argues that owning real estate outright offers no advantages over renting. While those who chose to lease pay rent, those who own pay interest on the borrowings they use to buy the buildings.

The theory behind the decision to own operating company assets, rather than rent, is that ownership allows greater control over development, delivers collateral for lower-cost secured financing and, should the business proposition not work out, leaves an asset.

The alternative, exemplified most starkly by Regus, the international serviced offices provider, is not to own property at all.

This means Regus, unlike many others, is not at the mercy of its bankers. Last year, as its shares tumbled more than 90 per cent from their 260p flotation price, the company announced swingeing write-downs, terminated its opening programme, cut staff by 25 per cent and mothballed surplus rented space.

Although its shares are still only 20% of the flotation price, Regus looks like it is going to survive.

Consider, by contrast, the condition of MWB Group, which owns all its UK business centres. For the six months to December 31, it wrote off £91.5 million, of which £61 million reflects 'a diminution in the value of property and property-related assets'.

How could MWB's value have shrunk so much in just six months? The company's avowed strategy, after all, was to 'acquire undervalued assets and build operational businesses underpinned by prime property'.

The business itself did not appear to be suffering too badly. In the six months to December 31, pre-exceptional losses were a relatively modest £7.9 million while earnings before interest, tax, depreciation and amortisation were £6.8 million, down from £8.5 million six months earlier. Some £41 million has been deducted from the revaluation reserve, wiping out much of the uplifts in value of earlier years.

Perhaps some inkling of how such losses could have been incurred lies in the valuation report from DTZ Debenham Tie Leung.

MWB Business Exchange, along with some other MWB businesses, has not historically been valued like other property company assets. Instead, DTZ relied on estimates of the ebitda of each property, then applied a 'multiplier' to establish an exit value to determine net cash flow. DTZ then applied a market discount rate to calculate the net present value of each asset.

However, for freehold properties, DTZ also valued buildings using a traditional basis relying on open market rents and investment yields. Where these produced values higher than that generated by the ebitda approach, the higher value was used.

In assigning the new, lower value to the Business Exchange division, DTZ is understood to have roughly halved its estimate of ebitda for each centre.

It may be argued that using property valuation methodology is inappropriate for an operating business in the first place.

But no matter what the valuation methodology, one thing is clear: owning property assets offered no buffer for shareholders when the serviced offices business turned down.

On the other hand, renting for some internet hotels companies has proved little better as a strategy and several of these have gone into receivership.

Byrne Murphy, co-founder of the BAA/MacArthur Glen company, which has developed and managed a Europe-wide portfolio of factory outlets, says that it is not enough simply to opt for one model over the other.

'The first question is whether your business actually requires ownership,' Mr Murphy says.

'The next question is whether you really possess ownership expertise in addition to management expertise.'

Conversely, those with ownership expertise need to be sure they have management expertise as well.

Otherwise, straying beyond the role of landlord is a risky proposition.


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