1. Real estate financed using equity capital

Real-estate assets have the advantage, as a general rule, of maintaining a high value that is unrelated to the operational process and that is relatively not very volatile (compared with intangible or financial assets). Accordingly, they are, in theory, attractive and can be used to back financing through borrowing. Even if real estate is financed using equity capital without it explicitly constituting a guarantee for lenders in one way or another, it is still a source of comfort for the group’s bankers. It is also important to bear in mind that raising debt backed by real estate may seem like the easy option, but it could handicap the company at a later stage when it is seeking to raise ordinary debts, since the lenders will know that the real estate has already been pledged to third parties.

Financing real estate using equity capital means keeping room for manoeuvre in the future (with the possibility of selling it or renting it) and providing comfort to shareholders and lenders, but also suppliers, customers and staff vis-à-vis the solvency and thus the long-term success of the company.

2. Real estate as backing for standard loans

A mortgage, i.e. a pledge of a real-estate asset to a lender, is the most direct way of backing a debt with a real-estate asset. What happens in such cases is that the proceeds of the sale of the asset are used to reimburse the creditor directly. Nevertheless, in countries where it is a cumbersome and expensive process, this type of financing is generally only used by very small and small to medium-sized companies, which do not necessarily have access to other forms of financing. With a mortgage loan it is possible to easily raise up to 50% of the value of the asset (the loan to value ratio is called “loan to value”, LTV). In Anglo-American countries, mortgage loans on commercial assets are more common and the loan to value ratio can be up to 70%.

But there are other less formal ways of securing a loan with real estate. These assets may be covered, under a loan agreement (or a bond), by a so-called negative pledge which prevents the company from using its real estate as a guarantee to other lenders, or selling it. Additionally, banking covenants (see Section 39.2) may oblige the company to keep a minimum amount of real estate on its balance sheet. Such covenants are significantly more flexible than taking out a direct guarantee on a property, as they enable the company to carry out arbitrage on its real-estate assets.

Finally, securitisation of real-estate assets (see Section 21.3) is only an option for real-estate groups or for very large industrial groups which own a lot of real estate.

3. Finance lease

A finance lease is a common tool used for financing real-estate assets over a long period (up to 15–20 years). For a company, this means having a real-estate asset acquired by a specialised financial institution (which must either be a bank or a lending establishment) and then leasing it (see Section 21.3). At the end of the finance leasing agreement, the company can either acquire the asset for a small or symbolic amount, or leave it to the financial lessor or possibly continue to lease it (at a reduced rent as it no longer covers the amortisation of the asset). The financial lessor remains the owner of the asset for the duration of the agreement, which ensures liquidity in the event of the company defaulting, since it can re-let it to a third party if there is no secondary market for the real-estate asset, which would be too specific.

Property leasing generally covers 80% of the value of an asset, which is more than for a standard loan and at a lower interest rate. Additionally, financial lessors are often prepared to finance more than 90% of the value of necessary renovations.

In most countries, property finance leasing presents a marginal tax advantage as the rent reflects an accelerated amortisation of the property. Even if this surplus amortisation must be taken up when the option is lifted, the company would have benefited from postponement of the tax paid.

4. Operating lease

For ordinary rental, the company only makes a commitment for the duration of the operating lease. This may vary widely depending on the aims of the company and the lessor, but also in line with the type of property and the country.

Rents can be indexed according to activity either to a commercial rents index or consumer prices, new construction price changes in retail sales or the change in GDP, or any other index the parties agree upon. Indexing rents to an independent index of the company’s economic activity results in the risk of a negative scissors effect over which the company has no control. So some groups have opted for rents that are totally or partially indexed to the activity of the site exploited (e.g. rent indexed to the turnover of a hotel or a cinema box office). Some groups have even succeeded in forcing the property owner to agree to a rent cap in line with earnings of the activity exploited.

We refer to the capitalisation rate to designate rent divided by the value of the asset. The rent to turnover ratio is the ratio between the rent and the turnover of the business in question (we note that some companies calculate a rent to turnover ratio in proportion to EBITDAR (and not turnover), i.e. earnings before interest, tax, depreciation, amortisation and rent).

5. Sale and leaseback

Sale and leaseback is an implementation method and not a type of financing as such. This operation enables a company to change from an equity capital financing to a rental. Some use the term leaseback to refer to the sale of a real-estate asset and its subsequent rental with an option to buy (usually though a finance lease), others do not draw a distinction and refer to a sale and leaseback whether there is an option to buy (finance lease) or not (operating lease).

The sale and leaseback system enables the company to free up cash and also to unlock the market value of the real estate with the pros (strengthen equity capital in the event of capital gains) and cons (possible tax to be paid on capital gains) that this brings.

1. Maturity of the company

A young company, in its high-growth phase, will need large amounts of cash to develop its activity. Additionally, as its perimeter (and sometimes even its economic model) is not yet fixed, its real-estate requirements will vary sharply over time. In such cases, an operating lease seems to be the most suitable choice in order to provide maximum flexibility while not depleting supplies of cash, a resource that is very precious at this stage. There’s no point in buying premises only to find that they’re too small in a few months’ time. When choosing a lease, don’t be swayed by the immediate advantages that go with a longer lease (no rent for several months, reduced charges) instead of a shorter lease, and then a few years later find yourself stuck with a building but not enough business to justify it.

On the other hand, a company that has reached maturity could seriously consider investing in its real estate. In particular, it could secure its strategic operating assets by owning them outright. Owning a large chunk of real estate could also be a form of saving for a rainy day in the case of a major investment opportunity or financial difficulty linked to an economic downturn.

Midway between these two cases is the company that has reached maturity on its market and which externalises its operating real estate in order to finance growth on new markets. Once the commercial concept has taken hold on these new markets, the company then again has the option of externalising the financing of its operating real estate.

2. Shareholders

The role of shareholders is especially important in terms of a company’s real-estate policy when such companies are family owned, for both psychological and asset-related reasons.

Very often, a family will be attached to a building or a geographical area where the company took off or which marks a very important step in the company’s life. There may be reasons that are not at all rational why it may be reluctant to sell its property. For example, take the Publicis building at the top of the Champs-Elysées, which was destroyed by fire in 1972 and rebuilt.

It is, moreover, frequent to see a family-owned holding company or a family-owned real-estate investment firm holding all or part of the operating real estate that it rents to the company and that it finances using debt that is repaid with the rent received. This arrangement enables an entrepreneur who is approaching retirement age, and who wishes to secure his/her revenues, to be more exposed to real estate than to the operating activity. He/she just needs to increase the size of his/her stake in the real-estate company and gradually dilute his/her stake in the operating company. In time, real estate that is personally owned can then be sold to the company, thus constituting a larger retirement capital, all the more so when capital gains tax on real estate is regressive and falls to zero after a certain number of years of ownership.

In the same vein, the head of a family-owned company who has several children could leave the operational activity to the child who is best suited to carrying on the business and leave the real estate (and any other non-strategic assets) to the other children. This sort of arrangement will prevent the company from getting bogged down in fratricidal wars or incompetent siblings being left in top management positions.

3. Operational constraints and opportunities

A company’s real-estate assets do not all serve the same purpose and they can be classified into several categories:

• very specific assets, the location of which is key, e.g. the Harrods building on Knightsbridge or the Saks Building on 5th Avenue;
• ordinary real-estate assets which, if the company moved location, would not result in a significant impact. Office blocks fall into this category;
• non-strategic operating assets or assets of which the long-term usefulness is not apparent.

The first category of real-estate assets has a value for the company over and above the turnover generated, which is the brand value, the value of its image. Additionally, the company often wishes to retain the freedom to restructure the building, to choose its neighbours (co-operators), etc. Only full ownership and possibly capital leasing (which is deferred full ownership) allows it to guarantee this flexibility. Moreover, a decision by the landlord not to renew an operating lease cannot be excluded, which is why ownership is often preferred for this kind of asset.

Although in the 2000s a number of operations resulted in the splitting up of ownership and exploitation (asset-light strategy), today we are witnessing a reverse trend, with some industrial groups seeking to take back ownership of assets whose underlying activity is performing well (Accor). On the other hand, some real-estate groups that have acquired ownership of buildings are now seeking to take back the business and/or the operation. The reason for this is simple. In many sectors, a building only has value as a result of the rent that the tenant can pay. If the tenant improves its income statement substantially as a result of its commercial actions, management and renovation work, it will be able to pay higher variable rent to the owner. The latter benefits from the increase in the value of the building, even though it has played no role in achieving this increase. It’s a bit like getting a free ride (see Section 26.3). It makes sense for the manager of the operational activity also to own the building, so that none of this value creation is lost.

For ordinary buildings, operational flexibility is of little interest and the group can generally neglect operational issues in the choice of a holding system. In this case, the choice between ownership and a rental method is purely a financial arbitrage.

For non-strategic assets or assets that the group does not intend to hold long term, maximum flexibility is achieved by renting. This enables the group to decide more easily between locations and increases the number of potential buyers if the activity is sold (because the selling price is reduced). A game then sets in between the seller, who remains in the building as a tenant, and the buyer, which revolves around the length of the lease and the probability that the tenant will renew the lease or not. The new owner of the property will lose out if the tenant ends up staying for a shorter term than expected, because it will then incur costs for finding a new tenant, for upgrading the building and in lost rent.

4. Taxation

Of course, taxation has to be factored in – capital gains tax in the case of a sale and leaseback, during the exploitation of the asset (deductibility or real-estate charges) and the eventual sale of the asset (capital gains tax).

The revaluation of a relatively old building when it is sold generally results in capital gains taxable at the normal corporation tax rate for the company selling the asset, but makes it possible to create (at the acquirer) a tax base linked to the future amortisation of the asset. Taxation will generally be negligible for a newly constructed building.

Capital gains tax is a major issue in a sale to a third party and could create an obstacle for an internal restructuring without generating any cash with which to pay this tax. However, for a company that has tax losses carried forward, capital tax can then be reduced (or sometimes eliminated altogether) and will balance out with the present value of the future tax saving due to the tax base created by the revaluation of the carrying price of the real-estate asset.

It’s worth noting that many countries have a special type of real-estate company that provides tax transparency. So we get REITs (real estate investment trusts) in the US and the UK, SIIQs in Italy and sociétés d’investissements immobiliers cotées (SIIC) in France. The benefits of this regime are subject (most of the time) to certain constraints in terms of payouts (most rents received and most capital gains made are to be dividend out) and in terms of shareholding (a single shareholder may not hold more than a certain percentage of the share capital).

5. Financial constraints

When a company’s financial situation is strained, the sale (temporary or permanent) of its real estate may be a solution that can be implemented quickly. It’s a bit like having a nest egg. An example is the utility EDF, which in 2016 sold its historical headquarters in Paris. If the assets are very specific operational real-estate assets, with no secondary market, the investor will require a long-term commitment from the company to stay on as a long-term tenant. This operation is the “liquefying” of one of the company’s assets, i.e. the exchange of a promise of future flows (rent) for an amount of cash (the sale price of the property). Here, the real estate becomes a simple financial product. In such cases, the owner is generally a financial investor taking on the possible non-exploitation of the underlying site as its main risk. If the site is a sufficiently key element of the company’s industrial set-up, then this risk is limited. Often, the management of the building will remain mostly the responsibility of the operating tenant, which will also cover the cost of maintaining the site (triple net rent).

For example, in the 2000s, UGC sold its cinema theatres, which it continued to operate. A few years later, when it was back on its financial feet, UGC bought back its cinema theatres. True, the group had taken the precaution of holding onto a purchase option at the time of the sale, which guaranteed it the possibility and the conditions for buying back the property in time.

6. Financial criteria

For a purely financial manager, owning real estate (or another asset) means considering that unless one is the owner thereof, it’s a good idea to buy it. This implies thinking that buying this asset will create value for the company, either because it was bought at a lower price than its market value or because it enables the company to reduce its risk.

The assumption that an acquisition price is lower than the market price (or that a sale price is higher than the market price) assumes that the real-estate market is inefficient at a given time. Deciding to sell a property when real-estate prices are high, or to take advantage of a buoyant market to sell real-estate assets, is, if one believes in the theory of efficient markets, simply speculating on the evolution of real-estate prices, which means taking a risk.

Although the acquisition of real estate usually enables the company to reduce its risk, this is not a good enough reason in itself to acquire property. This reduction in risk is only followed by an increase in value if returns decline at a lower pace than the risk. But let’s not deceive ourselves, if real estate is less risky than the company’s capital employed, it will also be less profitable. Here, this ends up being just a type of diversification for the company. And we saw in Section 26.2 that diversification only reduces the specific risk, which is a non-remunerated risk, and that financial synergies do not exist. So most often, it’s naïve to believe that value can be created in this way.

A first step in deciding whether a company should own its real estate or not could be to compare the cash flows of the different options. At the end of this chapter there is an exercise involving such a simulation.

This comparison will require you to determine a discount rate which must differ in line with the methods for owning the property. Since it is often difficult to put an exact figure on the impact of difference in risk on the required rates of return in each situation, we often see people using the same discount rate. Do not be deceived – this is financial heresy.

The problem is often turned the other way round by looking at the difference in yield to maturity between renting and a loan or between a bank loan and real-estate leasing, in order to make a choice.

In the 2000s, capitalisation rates (see Section 51.1, part 4) were lower than the interest rates on loans of some groups, encouraging them to sell their real estate. Today, the situation is generally the other way round in Western Europe: we see capitalisation rates of 5% to 7% compared with interest rates of 2% to 3%.

Accordingly, it is better now to buy real estate (and borrow at 2%–3%) rather than to externalise real estate (and pay rent at 5%–7%), which explains why today, externalisation operations have become increasingly rare. Unless, of course, you believe that there will be a substantial drop in the value of real estate in the future.