Roundtable Participants: J. Thomas Benek, IBM (East Coast); Glenn Kelly, R.R. Donnelley & Sons; Dan Busch, EDS; Richard Kennett, Xerox; Mike Ewing, Union-Pacific Resources Co.; Harold Mapes,EDS; Gerald Gant, Countrywide Funding; Kourosh Panahy, Fidelity Investments; David Homsher, PageNet; R. Gary Pletcher, Xerox; Loren Houchen, Great Western Bank; Thomas Quinn; Lockheed Martin Properties; Tom Karst, DSC Communications Corp.; Clifford Van Handel, Great Western Bank; Marilyn Kasko, EDS; Tammy Daley Walston, Fina Oil and Chemical Co.
Our second annual meeting of top corporate real estate executives brings to the light the issues of the day.
Editor's Note: Corporate real estate executives face a number of key issues that will ultimately determine their fate in the coming years. Chief among them are a new variety of "metrics" to measure performance, creative financing vehicles including synthetic leases and sale-leasebacks, global challenges, and effectively working with outsource service-providers.
Recently, Jones Lang Wootton invited National Real Estate Investor to sit in on an all-day roundtable discussion in North Dallas at EDS's new corporate campus with several top corporate real estate executives to spotlight these issues. The following story details the highlights of that discussion.
J. Michael Dow, managing director and chairman of Jones Lang Wootton USA, opened the conference along with Peter Aberg, director of JLW's corporate real estate group in Dallas.
Metrics & impact on the bottom line By now, shorthand performance measures for business EVA, TQM, etc. have creeped into nearly every psyche. But what is best for corporate real estate? Does it depend on variables like corporate culture and strategic goals?
Debra Moritz, director in the corporate and advisory services department of JLW's Chicago office, led a discussion of metrics, beginning with an overview of the corporate landscape.
"In the last decade there are three major observations," said Moritz. "The CFOs are taking a more active interest in and playing a larger role in real estate itself within corporations. Second, the changes in the capital markets themselves are influencing directly the real estate units. Not only are senior managers under more pressure to perform and are getting a sense of urgency from Wall Street and shareholders, but oftentimes today their incentive is actually tied to the company's performance. Thirdly, traditional measurements aren't really doing these corporate real estate strategists justice in how they perform their particular responsibilities."
"There's clearly becoming a closer bond between the office of the CEO and the CFO and the real estate group itself. But there's clearly a new need for both financial and nonfinancial metrics that more effectively can accommodate the real estate strategist who is ultimately responsible for performing and monitoring the company's strategy itself," said Moritz.
While most companies historically have concentrated on earnings per share, the shareholder rights movement came forward, and with it corporations were forced to look at performance on a business unit by business unit basis. Investors are now looking inside the company to understand the strategic direction of the different business units, understand management's strategic decisions and resource allocation practices. The focus of the CFO is shifting from short-term earnings per share to more longer term value creation. Today, the most commonly reported metric is "return on equity."
CFOs are paying more attention to real estate, primarily because it is the second- or third-largest expense item on corporate balance sheets. In response, real estate departments have adopted the new genre of performance-fixed metrics EVA, cashflow return on investment, balanced scorecard.
"We went through a re-engineering back in late-1993, which was really the first time that people in the organization had communicated effectively with one another and started using a common language," said Loren Houchen, first vice president at Great Western Bank in Chatsworth, Calif. "We understood the operating expenses, but we had to work with our business partners to get them to understand that. We made another major shift fairly recently to say, 'Let's go from just taking all the real estate costs and allocating them out on some basis,' to saying, 'Anything you do now is going to be directly allocated to each individual business.' We had to demonstrate to Wall Street that getting control of the real estate, which for us is a nine-figure expense, we have to make sure that we drive that down and demonstrate that we're going to push our earnings per share up."
David Homsher, director of real estate at Plano, Texas-based PageNet, also considers Wall Street to be a major influence.
"We've experienced firsthand the wrath of Wall Street when both an industry segment and a particular business within that segment fall out of favor with securities analysts, which is frankly what's happened," said Homsher. "We are looking carefully as a company right now what is core to our business and what is not core, and that is where the whole metric discussion as it relates to real estate really ends up. Real estate by and large for most of our businesses is a raw material that helps to fuel the growth and the operating performance of our companies but it really isn't what our companies are about. And so to the extent that that expense can be minimized or used more productively, our respective enterprises are positioned in much better shape. We're looking at metrics these days such as number of subscribers per employee, certainly square footage per employee, occupancy cost per employee."
Tom Quinn, president of Lockheed Martin Properties in Baltimore, Md., has been focusing on disposition of surplus properties. Prior to the recent merger between Lockheed and Martin-Marietta (a stock transaction), he focused on space efficiency. After the merger, the company suddenly found itself holding about $1 billion of value in surplus properties as the defense industry continued its rapid consolidation.
"The people at the top remembered that number ($1 billion) so that gets reported on by me weekly," said Quinn. "When we get to a steady state situation there's going to be about $3 billion to $5 billion in free cashflow generated each year, but before we get there there's going to be two years of a struggle and it's during those two years that they're looking to real estate to fill in some of the gaps. So I get called down to Bethesda where our headquarters are more frequently than I used to these days."
So who uses EVA? Glenn Kelly, vice president of real estate at Chicago-based R.R. Donnelley & Sons, is in a similar situation to Quinn's. But about three years ago he started looking at EVA and CFROI (cashflow return on investment) and other measures to get his operating divisions to recognize the amount of operating capital that is tied up in their businesses. Two years ago, EVA was rolled out across the company, which capitalized operating leases for any facilities or buildings in which R.R. Donnelley leases a majority of space. "We're now saying, 'Recognize the full cost of your investment in real estate, and as a result we're having quite a bit of activity in terms of dispositions both in leased space and also in owned space," said Kelly.
"It's (EVA) driven a lot of very positive activity." Kelly and his group are now trying to dispose of 11 major manufacturing facilities and have 300,000 sq. ft. of office space to sublet or find alternative uses for.
Richard Kennett, director of strategic services at Rochester, N.Y.-based Xerox Corp., says performance measures must relate to the corporate culture. "For a business that's growing fast, it's worse to have facilities not ready, even if you're spending more per unit cost, than it is for us in a mature industry having a little bit too long. You have to recognize where your company is on that growth curve."
Xerox has managed a surplus property portfolio since 1986, and has shed almost 6 million sq. ft. worth $100 million in contingent liability. Now it has less than 200,000 sq. ft. left. "Those are numbers you can talk to the CFO about," said Kennett.
Is "portfolio theory" being used in practice? "A couple of years ago we looked at the leasehold versus the fee-simple and we were pretty much on balance, and I brought up the idea of a long-term lease because that was a factor that was totally missing in our portfolio, which we've adjusted for recently," said Marilyn Kasko, asset manager at EDS.
Richard McBlaine, a senior director based in JLW's Chicago office said more of his clients are applying portfolio theory to their real estate portfolios. "The markets have all been in significant decline and the tenant was king. So delivering year-over-year bottom line occupancy expense reduction to the CFO or to the controller was relatively easier. And as people look out now as markets tighten across the U.S. and they're seeing real increases in rents throughout their portfolio, they're beginning to look out a few years and it's going to be difficult to deliver those kinds of year-over-year bottom line improvements. So maybe it does make sense to map out the portfolio and combine some longer term leases with short-term leases with an ownership, map that against your demand and try to manage to some kind of risk-adjusted occupancy expense."
Creative Financing Alternatives The financial markets' imact on the nation's real estate markets has been swift and dramatic. This session, led by Stephen Olsen, senior vice president of the corporate services real estate group at JLW in New York, explored some of the latest trends, including synthetic leases and sale-leasebacks.
"The capital markets have recently become more relevant in the commercial real estate arena specifically because of the capital flows eminating from the capital markets which are basically creating new opportunities for real estate, that people a year ago thought was illiquid. Those capital flows are targeting single-tenant, net-leased facilities. There are pools of capital out there that are highly segmented by investor groups that are looking for different mixes of corporate credit risk and commercial real estate credit risk, put in some combination that achieves their objectives and the investors who are participating with them in their fund," said Olsen.
More major investment funds have big money to spend on single-tenant net-leased properties with corporate tenants. The goal for the corporation is to create cash, through sale-leasebacks for example, said Olsen.
Many corporations have been exploring synthetic leases, which is a relatively new financial restructuring arrangement that throws the traditional lease off the company's balance sheet. "The terms are just remarkably compelling in terms of financing new construction and acquisition," said Olsen.
"The whole idea is to create flexibility. Our basic assumption is having a fixed asset like real estate on your books, if you are good at what you do, why are you tying up 30% of your capital in fixed assets when you've got these new vehicles out there that you can take that capital out and put it into R&D or inventory which rolls three to four times a year." said Olsen.
Dan Busch, manager of international real estate at EDS, was cautious in approaching the synthetic leasing option. "Part of this ties back to the portfolio mix, because there are only certain things that you want to do in this. What we're trying to do is more long-term things."
J. Thomas Benek, director of real estate operations (East Coast) for IBM, said, "We do use sale-leaseback as a means of exit. I think it's a great strategy from an exit standpoint, but it depends on the market."
Olsen also mentioned the importance of the real estate investment trust (REIT) as a potential new driver for corporate real estate. "The REIT vehicle is increasingly moving into the corporate world. It would probably be structured as a private REIT initially, but the idea is to create a portfolio. A lot of you have huge international portfolios of real estate that creates a geographic portfolio that could potentially be attractive to investors, especially since those properties are integral to your business, strategically important to your business on a go-forward basis. To the extent that you align yourself with somebody on the asset management side in running that portfolio within the REIT, you basically can lower costs, structure flexible leases and you've created a separate investment vehicle that is very real in terms of its equity. This presents a significant opportunity. And it could be taken public at some point."
Over lunch, Jim Young, assistant to EDS' chairman, provided some sobering commentary on the state of technological change in the business world. For example, in 1943, Tom Watson, the chairman of IBM, said "I think there is a world market for about five computers." And in 1977, Ken Olson, president of Digital Equipment Corp., said, "There is no reason for an individual to have a computer in their home."
"The world is changing enormously," said Young. "It's going to require us to think differently and behave differently. It's going to require us to look at what has helped us be successful in the past, that will continue to help us be successful. I would contend that technology is going to be an even more important part of your world and your business, but it is only a tool."
New global challenges "The way we're having to think through our businesses going forward is looking at the world as a single global market, said Denis Kavanaugh, head of JLW's global corporate business based in London. "We no longer have to look at national boundaries or regional boundaries. We're looking at the changes which are taking place in the way we organize ourselves which have been brought about by the changes in technology and communication."
Kavanaugh said that globalization poses both a threat as well as an opportunity, because it allows competitors with a more efficient cost base to compete in local marketplaces.
For EDS, "Years ago we stopped saying, 'This is our U.S. holdings and this is our international holdings,'" said Dan Busch. "I equate what we're doing worldwide with what our company used to be 20 years ago. It's growing in very small pieces very far away and everybody's enthusiastic about opening our first office in Jakarta just like we were when we opened our first office in Detroit. Globally there's a lot more risk and uncertainty. The things we're doing haven't been done before."
Value seems to be an important element. "You have to demonstrate value on a continual basis. Internationally, demonstrating value from the get-go is difficult," said Glenn Kelly.
Kourosh Panahy, head of Fidelity Corporate Real Estate based in Irving, Texas, said his company has been reorganizing its international business and decentralizing it more to facilitate coordination. "We're in a business where the real estate follows a wide spectrum of product and location. We've also been looking at the strategic portion as being central, but we're putting more responsibility in the regions. We're also supplying a lot of information up to our headquarters with which to formulate the strategy," said Panahy.
Tammy Daley Walston at Fina Oil and Chemical Co. in Dallas said her firm's real estate function is similarly decentralized.
Measuring outsourcing performance That "O" word, outsourcing, has been both a blessing and a curse to corporate real estate professionals for years. Tom Freeman of JLW's Dallas office opened a discussion on some of the present-day techniques for determining whether outsourcing arrangements measure up to expectations.
Some of the key issues in outsourcing these days include mergers and acquisitions of brokerage firms, compensation issues and finding the right "fit" with a service provider.
Freeman cited three types of outsourcing relationships: 1. Preferred provider (transactions, no service); 2. Exclusive provider (several relationships for property management, transaction management, design and construction); 3. Strategic alliance (outsourcing everything but planning function, with shared information and financial reward).
"The relationships that don't work are the ones where the alignment is not there for what the expectations really are," said Freeman. "And this alignment process seems to be changing daily."
What is the best performance measure? "Part of the problem is that only in the last few years have we started to measure ourselves," said Dan Busch. "Just trying to develop some metrics for this are pretty tough. The service providers have the same problem because you're still holding them a little bit at bay and they're trying to figure out what's really going to add value for you. But there has to be that point where you can put these measurable things down in writing."
IBM's Benek said he looks for service providers to bring deals to IBM's table. "We make the decisions, they provide the data. The only thing you really measure is serviceability. I do it through a survey of my program managers, our real estate planners. I'm not really interested in whether you're bringing $30 a sq. ft. or $18 a sq. ft. because you're presenting to me alternatives based on criteria that I give you. We don't pay a commission, we pay a fixed fee, so I know the deal I'm getting is going to be good. You form those relationships, that's what outsourcing is all about."
A consensus developed that it takes time to hire the right partner. "If you want outsourcing real bad, that's what you'll get outsourcing that's real bad," said Xerox's Kennett.