UK: Surplus Real Estate Headaches – Is Outsourcing the Painkiller?

'First published in the PLC Corporate Real Estate Handbook, July 2005'

All businesses have real estate assets and liabilities, with real estate costs accounting for an estimated 17-20% of corporate operating costs, but many businesses fail to manage their portfolio in a focused and efficient way, driving up the cost of doing business and having negative knock-on financial effects.

In particular, surplus or legacy real estate (that is real estate that is surplus to requirements, whether sublet or vacant) is a growing phenomenon. In today’s fast-moving, flexible economy, the operational requirements of a business can change swiftly meaning that its real estate needs also do. Companies can be over optimistic and take on space to accommodate growth that never arrives, or find themselves with excess real estate capacity after cutbacks and rationalisation. Alternatively, they may have acquired unneeded property as part of a corporate acquisition. Accordingly, a business can find itself holding properties:

• That are surplus to its requirements, therefore not only representing an unnecessary cost, but also having a significant impact on a company’s annual accounts under FRS12 reporting requirements, or its international equivalent, IAS37, whereby businesses have to make a provision on the balance sheet for any liabilities arising from surplus leaseholds;
• That represent an unnecessary cost for the business, increasing financial ‘drag’;

• In which capital is unnecessarily tied-up;

• In locations that are far from ideal; and

• That are an ongoing management headache.

Real estate outsourcing has been the buzz-word of the property business for the last few years, in particular in the UK market where the concept has been adopted in a number of massive public sector deals, since it can address many of the problems outlined above. However, there is no one-size-fits all solution to the challenges outlined above. As the outsourcing concept evolves which solutions are the most appropriate for addressing specific challenges?

There are two common headaches for corporates with real estate portfolios: companies that have real estate they no longer need at all or that does not match their business needs, and businesses with properties they require but which are tying up funds and management time. Even if the real estate is needed it is still an asset that remains high on maintenance costs and low on returns.

To date, the real estate outsourcing solutions on offer have focused on providing a solution where the company has been able to raise capital, in much the same way as a straight forward sale and leaseback arrangement, but having the added advantages of flexibility (whereby the company can vacate a certain percentage or all of its properties) and alleviating the management headache of administrating a large number of properties.

The issue of surplus real estate has been left largely untouched, except by way of ‘bolt-ons’ to the total portfolio being outsourced. However, innovations have changed this and recent deals have now been completed where the main part of the transaction relates to surplus properties.

Research by Fraser CRE (Corporate Occupiers Report 2003) found that 55% per cent of UK corporate occupiers surveyed had surplus properties in their portfolio. Whilst no definitive statistics exist on a worldwide basis, there is no reason to suspect that surplus property ratios in other developed markets are wildly different to those in the UK. Surplus real estate and the leasehold obligations that go with it therefore remain a significant business cost for many businesses.

To date the solutions on offer to this thorny problem have all had their limitations:

• Lease surrender. Surrendering the lease to the landlord is likely to mean paying a premium and is also dependent on market conditions: the landlord has no obligation to accept surrender of the lease and will therefore only do so if market conditions mean that it would be to their advantage or it is financially worth their while.

• Lease assignment. Assigning the lease to another party is an alternative option, but is likely to require the landlord’s consent as well as the presence of another interested party prepared to pay the existing rent levels, neither of which is guaranteed. This is a particular problem in the UK where upwards-only rent reviews have left many tenants paying rents above the current open market rent for such premises.

• Subletting. In a market where commercial real estate rental costs are falling, subletting inevitably means the current tenant taking a financial hit since the property will have to be sublet at a rate below that of the current passing rent and may entail offering a prospective sub-tenant further incentives, such as limited repairing obligations or capped service charges. It therefore leaves the current tenant with an ongoing financial and administrative burden.

• Outsourcing. The outsourcing of surplus properties to a service provider remains an option and can provide a number of benefits such as: providing cost certainty, protecting against future upwards rent reviews and transferring to the service provider real estate risk and obligations such as repair, reinstatement and service charges. All these may aid effective business planning and outsourcing also has the advantage of being able to sweep up many surplus properties into one basket at the same time, without the management headache of having to deal with each and every property on a property-by-property basis. However, there are a number of hurdles to be cleared. Assignment or transfer of leases, even to a service provider under a property outsourcing, will require the landlord’s consent. If there is an actual transfer of the properties this will involve additional costs such as Land Registry fees, stamp duty and land tax. It is also likely that there will be both employment (TUPE) and tax issues to resolve. Whilst it may be viable to clear all these hurdles in order to outsource an entire corporate real estate portfolio to release tied-up capital, free-up management time and transfer risk, doing so to clear a number of surplus properties from the corporate balance sheet is less attractive.

An innovative solution to the issue of surplus properties is now available, with all of the upsides of outsourcing, and only limited drawbacks. Rather than transferring the leases on unwanted properties to an outsourcing service provider, an agreement can be entered into whereby an outsourcing provider can be appointed to manage the surplus portfolio as the exclusive agent of the tenant, coupled with an indemnity from the service provider to the tenant against future outgoings and risks of holding the properties. This can, in effect, transfer all of the real estate risk without transferring the properties. Fees and other costs and the need to seek the consent of the landlord, can therefore all be negated. In such a transaction, the lessee would make a fixed payment (either up front in a lump sum payment or spread over the duration of the contract) to the outsourcing provider for taking on all the risks – and the potential benefits – of its surplus properties. The benefits of such a structure to a corporate with surplus properties in its real estate portfolio are two-fold:

• It enables property cost certainty via the fixed payment mechanism; and

• It facilitates more certain provision within its accounts in order to comply with international accounting requirements (FRS 12 or IAS37).

When considering such a structure, there will be a number of key issues for corporates to consider:

• Number of properties. There is no minimum or maximum threshold, in terms of number of properties, for entering into such a structure. However, the key question is do the benefits of the transaction outweigh the cost of implementing it?

• The strength of the covenant. As always this is the keystone of the transaction. The covenant strength of the service provider is crucial if the indemnity route is important and the covenant strength of the occupier is key if payment is not going to be made up front.

• Payment terms. How should the payment be made to reflect the letting risk? A one-off or a fixed amount on a regular basis? Both entail different issues. For example, if a one-off payment is made, what happens to the provision in the accounts if the business then agrees a surrender of a property? The lump sum framework remains in place, but if the agreement had been based on the number of individual properties, rather than the portfolio as a whole, the removal of one property from the portfolio may cause accounting issues.

Most real estate outsourcing transactions to date have involved large public or corporate real estate portfolios, with the aim of "getting corporate occupiers out of real estate and into accommodation", enabling them to focus on their core business and realise better return on capital tied up in property. Example transactions include:

• The PRIME outsourcing contract between Land Securities Trillium and the UK government’s former Department of Social Security (now the Department for Work and Pensions), which outsourced the Department’s portfolio of approximately 800 properties covering 1.6 million square metres. According to the National Audit Office, the current estimated saving to the UK taxpayer achieved via the PRIME property outsourcing deal over its 20-year duration will be some GB£560 million or 22 per cent below the cost of continued public sector ownership and management. The contract has recently been extended to include a further 1,000 properties.

• In the private sector, British Telecommunications Plc (BT) negotiated a solution with Telereal (a joint venture between Land Securities Trillium and William Pears), primarily to reduce debt following its massive overspend on 3G licences. BT’s priority was to remove its real estate from the balance sheet, transfer property risk and ensure an earnings-positive effect in its profit and loss account. The capital release amounted to GB£2.38 billion (about US$4.4 billion) and BT’s share price rose 3.8% when the deal was announced. Three hundred and fifty staff from BT’s property division were also transferred across to Telereal.

A typical outsourcing contract involves the transfer of real estate from an occupier to a service provider for an agreed sale price. The service provider then assumes responsibility for the risk and management of the properties and provides fully serviced accommodation back to the occupier for an agreed period and for a single occupation charge. The occupier can pick and choose the level of services and flexibility it needs according to the price it is prepared to pay.

The occupation charge (otherwise known as a facilities price or unitary charge) is based on the cost of providing the accommodation and includes a margin of profit to reflect the risk borne by the service provider and, if requested by the occupier, the estimated cost of providing associated facilities management services, including maintenance, security and cleaning services (other facilities options may also be offered).

In return for paying a unitary charge, the occupier receives serviced accommodation that meets its business needs. The occupier therefore no longer has responsibility for looking after surplus properties or for the various management issues associated with its properties.

The unitary charge might be increased by fixed amounts each year, for example by reference to a retail prices index, to cover rent reviews and rising costs for a provider. An element of this charge is likely to be performance-related. This allows the occupier to make deductions from the charge for non-delivery or poor delivery of services. The outsourcing contract may also provide the occupier with the flexibility to reduce the amount of real estate that it occupies in a time of economic downturn or to expand the space, or the number of properties, it occupies in a time of business growth.

Setting the unitary charge. Cost reduction is not always the main reason for undertaking outsourcing transactions. However, in cases where cost certainty or on-going flexibility is the main driver, the ongoing cost of occupation to the occupier should be no more, and preferably much less, than the existing cost of real estate. Whether it is a public or corporate entity that is considering real estate outsourcing, and whatever the considerations and priorities might be, the most important factor will be financial. The unitary charge paid by the occupier to the service provider (the Price) will depend on a number of factors, including:

• The value and physical condition of the occupier’s property;
• The occupier’s ongoing requirements; and
• The degree of flexibility required.

The price will then be built up according to the facilities management services being purchased into the contract.

Service providers are very experienced at pricing risk. However, pricing uncertainty is less straightforward. If required to do so, service providers will adopt a worse-case scenario model, but this will increase the cost to the occupier. If the occupier’s portfolio records and documents are incomplete, the service provider will charge a premium for the unknown, or exclude certain risks or even properties from the outsourcing contract.

Any occupier considering real estate outsourcing should, therefore, invest time in gathering together all relevant portfolio information to enable the bidding service provider to quote a competitive price.

The unitary charge price may also take into account any warranties the occupier is prepared to give to back-up the information disclosed to the bidding service provider. The more robust the warranties given and the more complete the information provided, the lower and more certain the price will be.

Above all the calculation of the unitary charge must be easily understood and ascertainable by the occupier so that it can establish the real cost savings and be comfortable that it is receiving good value.

Structure of the agreement. The legal structure of an outsourcing agreement will largely depend on the size of the real estate portfolio concerned.

If the portfolio is large and contains many long leasehold interests then "virtual assignments" may be used. The virtual assignments structure enables the outsourcing provider to assume liabilities under the lease (for example, to pay rent) in consideration for a unitary charge but also authorises the provider to act as agent on behalf of the occupier. It is, in effect, an agency and indemnity agreement whereby the service provider is appointed as sole and exclusive agent for the occupier and in return the service provider indemnifies the occupier against all outgoings and liabilities for the properties. The effect is that the leases between the occupier and the landlord remain in place but the provider assumes control of the leasehold interest.

If the virtual assignment route is not adopted, it is likely that the occupier would need to approach nearly every landlord for permission to assign or transfer the leasehold interests to the provider. This invariably takes time and money. Landlords are likely to want their legal and surveyors’ costs met and some landlords may even refuse permission to assign, which could jeopardise the transaction. Virtual assignments are not relevant for freehold interests as these can simply be transferred from a corporate occupier to the provider.

Creating a business plan. Outsourcing contracts usually cover long periods and will often include a flexible business plan that outlines the occupier’s anticipated real estate needs. The occupier is likely to have an idea of which properties are going to be vital for the business during the contract period. The contract may, therefore, categorise properties as being core, intermediate or surplus. This allows the occupier to produce a realistic forecast of its future needs so that the degree of flexibility required in the contract can be quantified.

The parties may also agree to procedures or rules that anticipate the possible need to vacate certain properties or acquire additional properties in the future, and price into the agreement any costs these changes would incur. This formula would initially have to be aligned to the occupier’s anticipated business strategy, but should also allow for changes to the strategy.

Payment mechanisms. The payment of the purchase price from the service provider to the occupier will be included in the outsourcing contract. This will represent the value of the freehold and leasehold interests transferred. As an alternative to taking payment for properties upfront, the occupier could opt to have the value taken into account in order to reduce the annual unitary charge. Although the latter option may make financial sense, it is not often done, for commercial reasons (corporates do not wish to be seen to be giving away their properties).

The unitary charge referred to above will also be stipulated in the contract together with mechanisms allowing for it to be varied, should the occupier exercise its rights of flexibility or require the provider to make improvements to the portfolio. Corporate occupiers, particularly those with large portfolios, will find it very difficult to accurately predict their long-term real estate needs. However, they must go through this process to determine the level of flexibility they will require from an outsourcing contract and, consequently, the level of unitary charge. A carefully balanced solution is, therefore, required, which takes a realistic account of future business needs and, ideally, will be at a unitary charge level, which is lower than the occupation costs paid before the outsourcing contract is entered into.

The "full" outsourcing scenario described above is different from the more straightforward process known as sale and leaseback. Sale and leaseback is a mechanism where one party sells a property to another and the latter simultaneously grants the former a lease over the premises. The mechanism differs from the "full" real estate outsourcing solution in that it does not include the facilities management element. It is, however, a relatively inexpensive way for corporate owner-occupiers to release capital for their core business in a tax efficient way. Sale and leaseback transactions are already being carried out in many parts of the world and in various property sectors.

However, sale and leasebacks often bind the occupier into long leases with "upwards only" rent review provisions. Responsibility for the management of the property also remains with the occupier. The occupier will, therefore, continue to have limited flexibility and will continue to carry the risk for its real estate.

As a result of these limitations, a more sophisticated "structured" sale and leaseback alternative to owning corporate real estate was developed. This is based on the standard sale and leaseback model, but, in addition, has the benefits of flexibility and frees the occupier of real estate risk.

Where significant growth is to be expected is in ‘partial outsourcing’ deals of surplus properties where there is no transfer of Title but where there is the transfer of real estate risk. The structure is expected to be attractive to any business – whether small, medium or large – that has surplus leasehold properties on its books.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.