As the financial and economic crisis slows growth, hits corporate profitability and puts pressure on margins, companies have increasingly sought to focus on their core competencies and offload specialized and expensive support activities. For many corporates, real estate forms a central part of their asset and cost base and inevitably the hunt to deliver savings in this area has intensified: outsourcing has been the principal beneficiary of this trend.
"We have seen a three-fold increase in RFPs [requests-for-proposals] for real estate outsourcing in the past year and the increase has accelerated in recent months as the financial crisis has intensified," says Robert Bonwell, head of corporate solutions at Jones Lang LaSalle. "In an environment of unprecedented uncertainty, corporates want to consider every available option to remove costs from their P&L." Practitioners at rival firms confirm a similar increase in the scale of enquiries over the past year.
Outsourcing has been a central theme in many areas of corporate business life over the past two decades. Starting with information technology and human resources, successive departments of corporates – once deemed integral to their existence – have been outsourced to third-party providers. The outsourcing of real estate, which began in the early part of this decade, was just a question of time.
Property outsourcing typically involves a corporate transferring responsibility for its real estate portfolio to a specialist real estate company based on three- to five-year contracts. Unsurprisingly, there are numerous models of outsourcing but it can include facilities management, delivery of property either through transactions or projects, transactions and advice and estate strategy and asset management.
The rationale for outsourcing is straightforward. "It is driven by a need to reduce costs, improve governance, increase flexibility and open new options in terms of how the real estate portfolio is structured," says Bonwell. Jones Lang LaSalle typically sees cost savings of 10% to 20% over the first two years of a contract and continuing savings on operational costs of 5% to 10% compared with a corporate running its own services. "On a €1 billion run rate that’s a considerable saving," says Bonwell.
Stepping stones
Corporates interested in outsourcing might dip their toe in the water with service-level roles. But ultimately it can result in a real estate outsourcing company taking full responsibility for running that corporate’s portfolio, including interfacing with customers. In order to fulfil such a role, a provider of outsourcing services requires not just experience of real estate management, governance and financing but also specialist knowledge of health and safety, business recovery and other issues relating to the specific use of premises.
| "The most important part of outsourcing is finding the right people"
Robert Bonwell, Jones Lang LaSalle |
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Only a few companies are able to provide such a breadth of services. Often property specialists from corporate clients transfer to work with real estate outsourcing companies as part of outsourcing contracts to ensure that the specialist knowledge of the assets and services being outsourced is retained. "The most important part of outsourcing is finding the right people," says Jones Lang LaSalle’s Bonwell. Real estate outsourcing started in the US – aided by the centralized nature of many corporates there – and initially focused on the financial and information technology sector. Interest in the financial sector derived from its mature and results-driven nature and the desire to cut costs. In contrast, the IT sector embraced outsourcing because of the relative immaturity of the market: with little legacy infrastructure it was easier to consider new business models.
"Now almost all sectors – from oil and gas to pharmaceuticals – have recognized the benefits of outsourcing," says Bonwell. "Geographically interest has expanded from the US, where outsourcing began, to Europe, where the more decentralized nature of corporates has meant it initially took longer for them to adopt outsourcing. Now more have grasped the opportunity. The concept of outsourcing and its benefits are now deeply embedded among CEOs."
Tailored strategies
Outsourcing models vary enormously between companies as no two corporates have identical business strategies, operational structures and requirements.
"As the business has expanded into Europe the flexibility of outsourcing has become increasingly important," says Bonwell. "Whereas it is possible to describe a generic model for centralized US corporates, such a structure is rarely seen in Europe for both operational and geographic reasons. The decentralized nature of Europe means it’s about finding the right solution to maximize opportunities for corporates."
Nevertheless, in order for a corporate to gain the maximum benefits from outsourcing it is crucial to take as high a level view as possible, notes Bonwell. "Ideally, a corporate should be considering outsourcing its real estate requirements at a global or regional level in order to maximize the value benefits," he says. "However, a large portfolio in one country is capable of achieving substantial benefits."
The success of Land Securities Trillium – one of the largest companies operating in the outsourcing and public-private partnerships sector (which involves private money in public sector capital procurement) – with a number of UK-centric clients is testament that outsourcing can work in a single country provided an organization’s portfolio is large enough.
In addition to government bodies such as the Department for Work and Pensions and the Driver and Vehicle Licensing Agency, Trillium – the £1.5 billion demerger of which from Land Securities was delayed in November but is still expected to complete within a few months – has the Post Office and Accor Hotels as core clients. Trillium manages more than 2,000 properties across the UK, some 4.64 million square metres of accommodation.
Trillium’s focus on government clients – it won the £600 million Building Schools for the Future programme in Kent in October and is part of a consortium that won a £80 million contract in Inverclyde in Scotland also in October – is important to the company’s success. Nevertheless, a number of other outsourcing companies have opted not to work with the public sector and say that while government real estate and outsourcing are a natural fit, the bureaucracy that goes with contracts make them more trouble than they are worth.
Financial modelling opens other windows
Outsourcing provides an opportunity to improve a corporate’s P&L and its balance sheet by driving down costs and releasing capital through opportunistic buying or selling of assets to reduce operating costs. "For corporates the two objectives are intertwined," says Bonwell.
Most important, the thought processes that accompany outsourcing inevitably result in greater visibility and control of the real estate portfolio. By financially modelling assets there is the opportunity to create a strategic plan that informs what it makes sense to own. One possible consequence of such financial modelling of assets is sale and leaseback.
"Contrary to the concerns of some people, outsourcing isn’t about losing control," says John Wilson, head of corporate strategies in CB Richard Ellis’s global corporate services unit. "It’s about gaining control." He says that sale and leaseback is the next stage in outsourcing following facilities management and other real estate services.
Wilson notes that sale and leaseback is also an extremely effective alternative to other traditional forms of debt finance, which are at present in short supply. A recent report by CBRE notes that traditional alternatives to bank funding such as equity capital markets funding and debt issuance are both in a historically weak state.
Equity capital markets in Europe have been largely closed to new issues since the summer. Windows of opportunity in the debt markets are sporadic and borrowing is extremely expensive. The iBoxx index average redemption yield for UK AA-rated bonds with 10-year to 15-year maturities ranged between 5.5% and 6.5% from 2001 until mid-2007. Since then, however, yields have risen to more than 9% as risk aversion has increased and the economic slowdown has become more entrenched.
The principles of sale and leaseback are straightforward: by selling real estate assets corporates receive a capital boost and improve their cashflow. "In addition to the obvious benefits of sale and leaseback it is also often driven by tax management considerations," says Wilson. "The market has been made possible by a growing cultural acceptability of selling corporate real estate assets." Of course, a corporate also gains the flexibility of a lease structure.
Sale and leaseback started in the UK in the early part of this decade in response to the private finance initiative, which injects private finance into public sector projects. It first became established commercially in the office space sector, then warehouses and retail premises and finally industrial premises – a pattern that has been repeated in each new geographical market that has opened.
Figures from CBRE shows that in the first half of 2008, retail disposals (€4.2 billion) were almost equal to those in the office sector (€4.7 billion), reflecting changes in retailing – including moves toward larger average store sizes and the public listing of retail companies – that have made retailers look more favourably on real estate disposal strategies.
In recent years the sale-and-leaseback market has grown far beyond its roots in the UK, which accounted for 21% of the market in the past 18 months, down from 42% in 2005. France, Italy, Spain and Sweden have each enjoyed more than €2 billion-worth of sale-and-leaseback transactions since the beginning of 2007, contributing to the overall growth of activity in Europe.
There is also increased activity in central and eastern Europe, where €291 million of sale-and-leaseback transactions were completed in the first half of 2008 compared with €178 million in all of 2007. The UK and Germany still dominate activity, accounting for more than half of all sale-and-leaseback deals in the past 18 months – with Germany alone accounting for 34% of that total, up from 18% in 2005.
Overall, the growth of the sale-and-leaseback market has been phenomenal: CBRE estimates that corporate sale-and-leaseback transactions rose by 585% between 2004 (€6.7 billion) and 2007 (€46 billion), and expanded from 6% of the European investment market in 2004 to 21% in the first half of 2008.
Back to the future
Early on, the sale-and-leaseback market investor base was a mixture of high-net-worth individuals, pension funds and other investment institutions including syndicated funds – all of which were attracted by the prospect of a steady income flow.
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| "Contrary to the concerns of some people, outsourcing isn’t about losing control. It’s about gaining control"
John Wilson, CB Richard Ellis |
"The focus of the market changed a few years ago to be more centred on high-net-worth individuals who typically leveraged their investments to levels that other investors were uncomfortable with or couldn’t achieve and consequently lowered yields to levels that were no longer attractive," explains CBRE’s Wilson. "That two-year bubble has burst and now the original investors have started to return to the market as yields have started to increase and a number of highly geared individuals have left the current market." In contrast to the 90% gearing that was common during the bubble, current sale-and-leaseback investment is now geared to about 60% to 70%, according to Wilson. "There is also an increased focus on tougher covenants and the quality of the name on the lease – everyone wants A-rated names nowadays: the focus is on improving investors’ risk profile."
Another consequence of the changed financial climate is that leases have begun to lengthen. When the market started six years ago, 20- to 25-year leases were most common. "Sarbanes-Oxley and changes to US GAAP and IFRS accounting rules made it difficult to justify an operating lease over 23 years," explains Wilson. Under US GAAP rules, the net present value of the lease has to be less than 90% of the money received upfront: under IFRS 80% is generally seen as the benchmark.
As the market became hotter, leases got shorter, coming down to 15 years. This change also occurred as the market expanded in continental Europe, where 10-year to 15-year leases are more common.
"Things are changing again and the long-term investors that now dominate the market want longer-term investments," says Wilson. "Twenty years is now the market standard again."
Investors have financing flexibility
While the seizing up of the credit market has made sale and leaseback more attractive to corporates it might also be thought to have stifled appetite among investors. Wilson at CBRE says that the investors currently dominating the market have significant flexibility in their financing options.
"The sort of investors now in the market are capable of warehousing deals if they need to," he says. "Moreover, debt is still available either from banks or the capital markets for these sorts of investors."
However, while pension funds and other investors are taking part in transactions, the sweet spot of the market is for deals below £100 million ($148 million). "It’s possible to find buyers for £200 million-plus deals, but it’s a lot tougher than for smaller deals or compared with a year ago," he says.
On the supply side, there is plenty of interest from corporates, according to Wilson. "The quality of companies considering outsourcing and sale and leaseback is much higher than it was five years ago," he says. "The market is now more educated and it is seen as a real alternative to debt or equity finance for corporates – it has become a part of their mainstream financing toolbox."
Wilson notes that despite the rapid growth of sale and leasebacks in recent years, owner-occupation remains dominant in most parts of mainland Europe. "With the total value of corporate owner-occupied property probably exceeding €2.25 trillion, the scope of future sale-and-leaseback activity is significant," he says. "As supply increases, the real question is whether demand can keep pace."
While the sharp fall in commercial real estate values has clearly been negative for property landlords, for corporates considering sale and leaseback it is less of an issue.
"Firstly, it may be the case that the property asset has historically been undervalued by the company," says Wilson. "More importantly, the corporate can simply offer a longer lease and a strong covenant in order to create value. When a corporate considers sale and leaseback, it is compared to other traditional forms of financing – and from that perspective it is attractive, despite falls in property values."