Fri, Dec 18, 2015

Real Estate Monetization and Development; the Rationale for Third-Party Capital

Whatever your business, real estate is likely a meaningful component of the organization’s balance sheet. In today’s hyper-competitive environment, capital is the key enabler (or constraint) to capturing market share. Combining these notions, one could conclude the means of elevating your business to the next level is literally all around you. It’s not a coincidence that market leaders such as DHL, Malkin/Empire State, Hackensack University Medical Center and Walmart utilize third party capital to fund their real estate needs, and rapidly scale their respective organizations. When assessing viability of third part capital, it is instructive to consider the following components: review of strategy, operational and regulatory environment, and financial objectives. The sections below explore in further detail these considerations and highlight key areas warranting further analysis.

Real estate is often one of the last strategic priorities; however it often traps the largest amount of capital.The mission of any successful organization is to maximize operating income. Without profits to redeploy into the core business, an organization might shrink or bow to competition. Also central to one’s strategy are growth plans. What factors are necessary towards achieving growth, how will these achievements be measured, and in what time-frame can they be realized. Once these factors are fully analyzed, it becomes much clearer how the other pillars of operations should be aligned toward achieving success.

Think of owned real estate as potential source of capital
Through ownership of non-core real estate assets, an organization has allocated a precious resource to the real estate business, away from its primary operations. By owning distribution centers or office space, many companies miss financial opportunities to redeploy capital to margin-generating projects or advance growth imperatives.

In the retail sector, the increasing power of the consumer is pressuring retailers to invest scarce capital to drive volume and build customer loyalty. Some of these operational challenges include creating an omni-channel experience through high-touch, personalized shopping, and reworking the supply chain for delivery of instant gratification. These measures require significant capital investment, and there are heavy penalties for late adoption. To relieve some of the capital pressures, many retailers including Home Depot have extracted capital from their real estate for reallocation into their core business functions.

Virtually every industry faces increasing regulatory scrutiny, which impacts operations and compliance. Most poignant of these is in health care, whereby anti-kickback statutes between referral sources and the hospital are particularly important in negotiating leases. Millions of dollars paid in fines by leading health systems have resulted in apparent violations of these fraud and abuse laws. In many cases, dual objectives can be realized upon third party ownership of real estate as it takes the hospital out of the rent negotiations with the physician tenants, while providing liquidity.

Taking advantage of real estate returns
Do the returns of non-core real estate exceed the organization’s own operating margins? Penn National Gaming was able to create additional value to its shareholders of almost 20% by spinning off its real estate ownership, creating Gaming and Leisure Properties Inc., the newly formed REIT.  In this example, a proxy casino indexreturned an EBITDA margin of 25.4% in 2014, compared to the average return for REITsof 44.7% in 2014. Given this disparity between real estate returns and an operating business3, leveraging third party capital makes compelling financial sense.

Sale Leasebacks can create liquidity, flexibility and value
Non-core real estate can carry a fair amount of debt. This debt can have a meaningful impact to an organization’s balance sheet, credit rating, and corporate debt covenants.  Through a sale/leaseback transaction, not only will an organization be able to pay off debt with sales proceeds, but this additional liquidity will enable future borrowing at materially lower interest rates, and more generous financial covenants.

There are numerous ownership options commonplace with real estate transactions, including direct sale, sale/leaseback, joint venture and co-investments.  In a direct sale, the real estate is monetized without future leaseback obligations to a third-party, most popular for companies desiring to relieve itself of non-core or obsolete space.  Real estate investors are most interested in sale/leaseback transactions whereby the seller becomes a tenant to a new landlord, agreeing to a long-term lease at market rates. This affords the seller immediate liquidity, while maintaining ownership-like controls through covenants in the space lease. The lease can be structured as an off-balance sheet or operating lease with consultation of a company’s auditor, further enhancing the flexibility afforded to an organization’s corporate capital structure. Finally, real estate investors can co-invest or formulate a joint venture agreement for long-term financing of a company’s real estate through an ownership or developer agreement.

Dr. Richard Becker, former CEO of Brooklyn Hospital Centersays "As [we] continue to expand our outpatient presence through expansion of urgent care sites and other ambulatory facilities, we are considering a number of financial alternatives, such as a lease versus own model that utilizes third party capital for the ownership of the real estate and allows us to reallocate our capital into the core business of providing health care."  Third-party real estate capital should be the opportunity you can leverage to fuel corporate growth. 


1.The public casino index includes Penn National Gaming, Boyd Gaming, Caesars Entertainment, Churchill Downs, Las Vegas Sands, MGM Resorts, Pinnacle Entertainment, and Wynn Resorts.
2.MSCI US REIT index is used to capture the return of REITs of all property types.
3.The returns for 2014 by the S&P 500 Industrials Sector Index, Publicly-traded Hospitals, and the S&P 500 Retail Composite Index were 17.57%, 15.72%, and 8.40%, respectively.
4.Dr. Becker is now CEO of New Found Health LLC, a portfolio company of Blue Wolf Capital Partners LLC.

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