Finding A Cure For Your Real Estate Blues

By Karen M. Kroll, July 28, 2008

Conseco, Inc., the Carmel, Ind.-based insurance company, used to be known for its high-flying ways. In 1998, the company purchased Green Tree Financial Corp., a mobile home mortgage lender, for about $6 billion. As Green Tree's loan portfolio deteriorated, the company brought on GE alum Gary Wendt to help turn things around, enticing him with a $45 million signing bonus. In 2000, several board members were given the boot; according to reports, they had been loaned more than $100 million by the company. Finally, Conseco filed for bankruptcy protection in late 2002. The company had about $6.5 billion in debt and its stock was trading for pennies.

Today, a different culture can be found at the firm, which emerged from bankruptcy in 2003. Everyone is paying greater attention to costs. In 2004, several hundred staffers in Conseco's Bankers' Life and Casualty Company division moved from the Merchandise Mart in Chicago to a suitable -- but lower-profile -- office in the River North neighborhood of the Windy City. "We looked at what we needed to run the business," says Todd Hacker, senior vice president of finance and operations and treasurer. "It was clear that being in a marquee building like the Merchandise Mart wasn't needed."

Still, the move wasn't easy. In addition to leaving a high-profile landmark, employees' workspaces were downsized. Everyone up to the manager level now works from a cubicle, says Jeff Groth, vice president of facilities. And, rather than the larger, often extravagant, executive offices of old, today's are standardized at about 10 by 15 feet and are "very average," Groth says.

The changes have paid off. Lease costs are lower by about 30 percent, Hacker estimates. Moreover, the new space sets the tone for the company's approach to business today. "You need quality office space, but it needs to be reasonable," Hacker says. "We want to grow the business, and fancy offices don't compute with that goal."

The focus on corporate real estate costs by Conseco's management team illustrates a change under way across corporate America. "Real estate has more significant visibility higher up in the organization than at any time in the past," says Mark Costello, a New York--based managing partner with the construction and real estate advisory practice at Ernst & Young. Executives around the country are keeping a closer watch on the dollars consumed by their companies' facilities. Whether they're structuring real estate deals to conserve cash, deploying new technologies to analyze locations and streamline processes, or taking steps to reduce operating costs, at many companies they have real estate at the top of their minds.

One driver is the sheer amount of dollars flowing to many companies' real estate holdings. For most, it's one of the three largest expenses, experts say. Also, today's software applications allow managers to better aggregate the amounts they're spending on real estate. Previously, these costs often were scattered across several accounts, such as rent and maintenance. "They're quarters and nickels, but they add up," Costello notes.

At the same time, many leading-edge companies are rethinking the design of their operations, which impacts their workplaces. The growing popularity of "hoteling," in which employees who spend most of their time on the road reserve a desk just for the days they're in the office, along with shared services centers and telecommuting, all affect real estate needs and costs.

The upshot? Organizations are doing more with less space, says David Worrell, an Atlanta-based managing director with Cambridge Consulting Group, a real estate consultancy. "Companies are squeezing to the nth degree. Everyone's offices are small. CFOs are in cubes. There's one conference room versus four."

Announcements of office closings and consolidations are coming frequently. Conseco, for instance, has sold four office buildings in Carmel and has a fifth on the market. With head count down from a decade ago, employees are able to fit into the company's remaining facilities.

Decisions on where to locate offices and plants also reflect today's cost-consciousness. After years of flocking to the 'burbs, with their massive parking lots and easy highway access, companies are showing greater interest in downtown office space, which tends to be better served by mass transit -- a key attribute with gas at $4-plus per gallon, says John Tobin, president of TenantRep.com and an expert in office tenant representation, based in Cleveland. In fact, Americans made about 85 million more trips on public transportation during the first quarter of 2008 than in the year-earlier period, reports the American Public Transportation Association. "If gas prices climb to European levels, we're going back to the 1950s model with an office downtown, where it's central for everyone," Tobin adds.

Office vacancy rates in central business districts declined from 9.9 percent in June 2007 to 9.6 percent in March 2008, according to the CoStar Group's "Office Report Mid-Year 2008." Conversely, vacancy rates in suburban office campuses crept up from 11.4 percent in June 2007 to 12 percent as of March 2008, the report notes.

Meanwhile, as corporate bankruptcies climb by more than 40 percent annually, real estate transactions continue to play a central role in company restructuring strategies.

"The issue that we're finding -- and it's a big challenge for anyone in the marketplace today -- is whether there is equity in the underlying real estate, because so much real estate has been overleveraged," says Matthew Bordwin, managing director and group head at KPMG Commercial Finance LLC. "Right now, we're seeing this in the home building industry in particular, where it takes only a little due diligence to realize that a property's worth may be just a fraction of the debt on it."

Sale-Leaseback Transactions Attracting Interest

Corporate executives also are rethinking the conventional wisdom that says they need to own their own buildings.

"Usually, real estate is a necessary evil," says Richard Ader, chair of U.S. Realty Advisors LLC. "Now, companies are looking to convert it to cash." As a result, his firm's sale-and-leaseback transactions are attracting interest, he says.

While the volume of sale-and-leaseback transactions is down, it hasn't dropped as dramatically as that of other real estate deals, according to "U.S. Investment Market Report Spring '08" by Jones Lang LaSalle, a Chicago-based real estate firm. While overall real estate transaction volume declined 69 percent in the first quarter of the year, sale-leasebacks dropped by 62 percent. They likely will play a more prominent role in the coming months, the company says.

As the term suggests, in a sale-and-leaseback, one company sells its facility to another and then turns around and leases and occupies the same building. The company gains cash and removes the facility from its balance sheet. This helps sellers that need liquidity, given the tightening in the capital markets, says Dan L. Werry, managing director with 1031 and TIC Investments, LLC, in Minneapolis. In June, DineEquity, Inc., the franchisor and operator of Applebee's and IHOP restaurants, completed a sale-leaseback of 181 Applebee's locations. The transaction netted about $300 million after taxes, the company announced, adding that it will use the money to reduce debt.

Just a handful of companies should own their own real estate, Ader says. One example would be firms that boast ample checkbooks but lack immediate opportunities to deploy their cash; some high tech firms are in this category. Most other companies can snag a higher return by putting their cash to work within their operations, he asserts.

However, sale-leaseback transactions need to be structured carefully, as Uncle Sam can take a big bite out of the proceeds, particularly on buildings that the company has owned a long time, Ader says. Say a building sells for $1 million, but has a basis of just $100,000. The $900,000 difference may be considered ordinary income and taxed at up to 35 percent.

Also, if the lessee wants to include a purchase option within the lease, so that it can acquire the facility at the end of the lease term, the lease is considered a form of debt. This means that the obligation will appear on the company's balance sheet, Ader adds.

Another caveat: Most investors in sale-leaseback transactions are looking for a long-term commitment, notes Peter Mavoides, president and chief executive officer with Sovereign Investment Co. If management thinks that the company will be in the building for five years or less, a sale-leaseback may not be suitable. In addition, companies that need control over their space -- say, manufacturing firms that routinely invest in new equipment and redesign their workspaces -- may find that it makes sense to own their facilities outright.

Zeroing In on Real Estate Operations

As real estate has consumed larger chunks of companies' budgets, more organizations are turning to technology to more effectively manage their holdings. Until recently, many processes associated with the real estate function were largely manual, says Andrew Rains, vice president of global sales and marketing with Intuit Real Estate Solutions in Cleveland.

This is in contrast to most other functions within an organization, notes Andy Thomas, chief operating office and president of Virtual Premise, a provider of real estate management software based in Atlanta. For instance, accounting and human resources processes have been automated for decades.

Real estate, however, has held on to paper-based processes. Lease administration often tops the list. Companies usually maintain separate files or spreadsheets for each lease that outline such details as lease rates, termination dates, and the company's right of first refusal at renewal time. Assembling this information within a single database and automated system allows companies to better manage their properties.

Tween Brands, Inc., in New Albany, Ohio, is the company behind several retail favorites of girls ages 7 to 14, including Limited Too and Justice. Between the two brands, the company operates nearly 900 stores, almost half of which have been built or remodeled in the past three years, says Peter C. Krier, senior director of real estate law and asset management.

Before a real estate software application was implemented last year, most real estate--related tasks were completed through spreadsheets, Krier says. "All functions were on their own and disconnected." This made it difficult to compare sales and expenses with store attributes across locations.

The company went live with a real estate management system from Virtual Premise in the spring of 2007. Now, all reporting is fed from a single database. Krier and his team can sift through the data and see how sales vary, depending on the size of the store or the market. They can perform "what if" analyses to identify the bottom line impact of closing underperforming stores. "It's difficult to make a strategic decision without a single point of data," he says.

In addition, while lease terms used to be manually transferred from each lease to the financial system, the real estate system now is electronically linked with the financial system, eliminating the data entry work.

Altogether, the amount the company saves each year by analyzing rent invoices jumped from about $400,000 to $1.1 million. For instance, the company's lease might state that if a shopping center's occupancy falls below a certain level, the store's rent is adjusted. When they were reviewing paper leases, the analysts didn't have time to dig into each lease calculation. Now that all leases are electronically accessible, spotting inconsistencies becomes much easier. "We identified savings opportunities that we weren't aware of," Krier says. In addition, Tween Brands chopped 15 percent off the time it takes to get a new store sourced, built, and open.

It's not just software and deal structure that impacts real estate costs. On a day-to-day basis, running a building can take a tremendous amount of energy and money. So, execs are looking at ways to cut energy use and trim expenses. This is where LEED, or Leadership in Energy and Environmental Design, can come into play. LEED certification by the U.S. Green Building Council is a nationally recognized, third-party benchmark for the design and operation of "green" buildings. While LEED usually is associated with new construction, LEED for Existing Buildings (aka LEED EB) covers the operation of existing buildings. Going through this process prompts companies to identify sources of energy and cost savings that otherwise tend to get overlooked.

At 4.2 million square feet, the Merchandise Mart in Chicago is the second largest building on Earth; only the Pentagon is larger. It covers two city blocks, houses five miles of corridors, and host 20,000 visitors daily.

Management began looking into LEED certification in 2005, registered in 2006, and achieved certification in late 2007. To get there, employees installed motion-activated lighting in restrooms, along with lower-wattage lights where possible; replaced older lavatories with more efficient ones; and began using "green" cleaning products and paints. They also installed tools that allowed more precise measurement of energy consumption, says Myron Maurer, senior vice president.

Energy use dropped by about 5 percent during the certification process, after having declined 10 percent between 2002 and 2006, Maurer says. Water consumption plummeted by about 30 percent in 2006. There's another benefit, as well. "Because of our LEED certification, we can offer something others can't," Maurer notes. "It gives us a leg up in a competitive market."

Another firm reaping the benefits of energy efficiency is Adobe Systems Inc., which in 2006 obtained LEED EB certification for its three headquarters towers in San Jose, says Randall Knox III, senior director of global workplace solutions. Knox and his colleagues took what were fairly efficient buildings to the next level. For instance, they replaced high-pressure sodium lights in the parking garages with fluorescent ones. The price tag of $157,000 was partially offset by a government rebate of $41,000 and annual energy savings of $86,000.

Knox also programmed the fans in the parking garages to run just 15 minutes out of every 60 during the morning and evening commuting hours. This $200 investment for time and labor reaps a whopping $98,000 in annual savings. (The fans are equipped with carbon monoxide sensors and will start up if the amount of CO reaches unhealthy levels.) Nearly two dozen lighting initiatives, such as switching from incandescent to fluorescent lights and installing motion sensors, generate annual savings of about $350,000.

In total, Abode's headquarters buildings cut their use of electricity by 35 percent, natural gas by 41 percent, and domestic water by 22 percent, racking up annual savings of $1.2 million and quickly recouping the $1.4 million spent in obtaining LEED Certification. In fact, the 34 projects that comprised the LEED initiative boast an ROI of 140 percent, Knox says.

No matter which direction the economy heads, efficient and effective deal structures, office locations, and operations will remain one key to companies' success. Says Krier of Tween Brands: "Whether or not there's a downturn, there is constant pressure on real estate to become more efficient, because occupancy is one of the largest expenses that's controllable."