Feb. 21, 2023
All over the world business and governments are making cash flow decisions.
In the UK, public sector borrowing is remarkably high – so pay rises for nurses are “not affordable” and, as a result, basic emergency services are put at risk. Meanwhile, many businesses are laying off employees to manage short term cash - even if they will likely be fighting for new talent within months. These are all short-term decisions.
The longer-term need to invest for future growth is acute and, whilst being a core responsibility for government and business managers, without increased revenues (from tax or higher sales) or cost savings is simply not an option.
Yet within government and business balance sheets one line item (“Property”) offers a source of growth capital. Operational real estate is an overlooked, “old world” item which underpins delivery of a service or product. Hybrid working and the impact of technology make some of this real estate less strategic than might previously have been thought but, whilst the model may have changed, we still need offices, factories and shops. Furthermore, accepting that building use may morph in some cases, the location will almost certainly have multiple alternative uses in perpetuity and hence embedded value.
Operational real estate is seldom recognised as a hidden value item but its separation allows it to be valued for its risk adjusted future potential cash flow (typically at a premium to the accounting value). For many years sale and leaseback structures have sought to release cash for real estate owners in exchange for a long-term lease. These are binary decisions involving permanent loss of strategic control of the real estate and are therefore unacceptable to many entities.
A more compelling option which unlocks value and solves the control issue would be to IPO the real estate – either as a single (substantial) asset or a number of largely “fungible” assets (investors benefit from commonality of risk to know what they are actually buying and value accordingly).
The proposition is simple but new and deliverable today. The original owner releases cash in the IPO and retains a majority stake in the new public entity, meaning that it has influence over the future use alongside the protections it has from a lease on the property with the IPO entity.
The investors in the IPO benefit from an asset backed equity with public market liquidity and the covenant of the tenant. Assuming the IPO vehicle has REIT tax status then the minimum dividend policy is set at 90% of rental income. The valuation should reflect the quantum of net cash generated, its assumed longevity, the risk premium of the covenant and whatever embedded value is ascribed to the land or building. The issued shares have both equity and bond like characteristics.
The Investment Property Forum estimates the value of UK Commercial Real Estate Market at some £900bn of which some £400bn is owner occupied offering some £200bn of growth equity release (assuming a 50%+ retained stake by the original owner).
The mathematics for corporate shareholders on separating the real estate is compelling not just because it releases cash – but (for quoted companies) the retained shareholding in the new quoted PropCo would in most cases trade at a premium to the existing operating business (Tesco and Sainsbury both trade at some 6x EBITDA but the value of supermarket rent currently trades at a 6% yield - a multiple of 17x). If this was added to the existing market value of the operating company, it would result in meaningful market value increase which shareholders would presumably like to see rather than watch value disappear in an outright sale or inactivity.
And then on to the strange lack of government interest in its property holdings at a time when debt reduction can apparently only be addressed by increased tax and reduced spend.
Looking at the UK Government Estate, it seems logical to respond to the long term impact of the GFC, Brexit, the Pandemic, Ukraine and the cost of living crisis by releasing growth capital from the £160bn+ of central government real estate (and the extended local authority owned assets) with HMG covenant as the tenant.
With defence spend being re-appraised (£26bn of real estate), Health (£47bn), (overcrowded) Prisons (£7bn) and the Prime Minister’s recent focus on Science (£2bn) might this offer scope for wise investment for the nations future? Furthermore, this source of funding is not debt. If the nation’s balance sheet improves, there is no reason for the UK government not to buy back shares in the quoted companies even if many institutional and retail investors might like the idea of being offered a new, transparent, publicly traded, alternative investment.
Anthony Gahan is the founder of IPSX and an Executive Fellow at King’s Business School
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