When you buy a share of stock in a company, such as Microsoft, is your main consideration the company's people and products, or the building where it is based?
It's products and services, of course, which is why it is surprising more companies are not spinning off their real estate assets into real estate investment trusts. As there is more discussion about the virtual corporation, we are talking about corporations that have no fixed assets. Shouldn't we separate the operating company and the real estate assets entirely?
By separating the two, the corporation is, in effect, putting the operating company and its real estate assets into separate entities that can be valued differently. In the current capital market, one actually can create value for a company by disaggregating.
By disaggregating the real estate assets from the operating company, many shareholder-owned corporations, such as retailers and restaurant chains, have the opportunity to increase value, and even raise new capital.
After all, corporate real estate is often a nonearning asset. It consumes a large amount of corporate capital, yet provides no return to the shareholder.
DETACHING REAL ESTATE
Separating the operating company from its real estate asset base can be an opportunity to create value.
For example, a recent report calculated the cost of vacant property owned by IBM equals 27 cents a share.
Another example comes from the hospitality industry. Prior to Hilton's competition with Starwood for the ITT assets won by Starwood, LaSalle Partners Investment Banking Group estimated such a separation would have raised Hilton's equity value by 50% The operating company remains a C corporation, while the real estate is now owned by a REIT, which is valued advantageously by the capital markets. Each shareholder receives a share in the operating company and a share in the REIT. Now two separate entities, with overlapping boards and executives, can maintain similar interests. (This is different from the paired REIT structure being challenged by the Clinton administration.)
The operating company and the REIT structure leases with payments that equal the operating company's original depreciation charge. As a result, the operating company experiences no change in its pro forma earnings, while the REIT begins to generate cash flow from what has the opportunity to become an earning asset.
ADVANTAGE OF SPLITTING
The advantages of separating a company from its real estate assets are many. In a REIT, an entity is created that generates significant cash flow that is valued differently in a REIT context by shareholders than earnings of operating companies. By taking the real estate away from the company and going forward, the operating company turns the responsibility of investing in real estate to the REIT, whose specialty is real estate, which can then yield a higher return on assets, given its new employees' focus.
Disaggregation also clarifies the performance of the operating company and the contribution of the REIT. The shareholder now knows whether the real estate aids or detracts from its performance at the corporate level. The shareholder can own or divest; that is, the shareholder can own the Microsoft software operations and divest the Microsoft real estate if the shareholder wishes.
Unfortunately, many companies view real estate as a necessary evil. With the kind of separation we are talking about, a company is creating an entity that can cater to this operating company but can still grow outside that business. Theoretically, the REIT can acquire other real estate assets, can manage real estate assets for other companies, can go to other companies to take the real estate off the balance sheet and buy and lease back to them.
ADD OR SUBTRACT?
Once this is done, the REIT shines the spotlight on the real estate operations and strategy of the REIT entity. Without this separation, there is no way of knowing whether the real estate strategy aids, or detracts from, the corporate performance.
Now that the real estate assets are held by the tax-advantaged REIT, the REIT has a valuation based on cash flow. With a very low loan-to-value ratio, the REIT has access to capital at a potentially lower spread over Treasuries than the operating company can achieve.
The combination of more focused real estate management, real estate executives who can enjoy direct performance-related compensation, advantageous public market valuation and the potential for a lower cost of capital, means the corporate REIT is an idea whose time has come. We hope more companies will see the benefits and not be put off by the illusory loss of control and, therefore, pursue the strategy to its logical end.
