Companies should be looking closely at the role of real estate given the current worrying market conditions, because too much corporate capital is tied up in property.

Back in 2007 real estate was at the centre of a number of high profile corporate bids, such as that involving Sainsbury’s assets, and the arguments for separating real estate from a company’s operating business were regularly debated in the media.

Group finance directors and property directors alike are seeking greater flexibility at less cost. Operating company/property company structures and legacy estate disposals previously used by private equity are now commonplace in the boardrooms of the global businesses, with management increasingly exploring these mechanisms for unlocking equity and driving out cost.

There is an overarching desire among companies with property to reduce their lease cost base and transfer lease liabilities of their non-used properties, such as legacy estates, off the balance sheet.

One solution is to package up and sell-off lease liabilities, clearing up your property risk and reducing cost while maintaining flexibility. It is an increasingly popular option, with recent speculation suggesting that as much as £70m of legacy estate lease liabilities are about to be snapped up in a surge of activity in the property sector.

How it works

Legacy estate transactions see liabilities acquired by specialist property companies that can manage the leases, allowing corporate occupiers to focus on their core business.

The key objectives in disposing lease liabilities are to offload property risk, reduce the amount of management time spent on managing lease liabilities, and to reduce the ongoing cost to the business.

Although under IAS37 provisions are made for surplus leases, there is a concern that businesses are not making enough provision for leases and funding needs to be increased.

By disposing of the surplus lease liabilities during the year, the corporate is able to create a mechanism to remove the IAS37 provisions through a one-off portfolio disposal, ridding future property market exposure and future lease liabilities. These are structured to ensure that there is no greater financial exposure to the business than if they had dealt with the lease liabilities themselves.

There are a number of transaction structures available. A typical approach would be establishing a special purchase vehicle. The leasehold liabilities are then transferred into the SPV by way of assignment ­ meaning the SPV then has a negative value. The vendor then transfers a cash sum equal to that into the SPV. At the point of sale, the shares in the SPV would be sold for a nominal consideration.

Typically surplus lease liabilities are found in the financial services and retail sectors. These sectors have large property lease portfolios, which are increasingly redundant as technology or markets change. RBS is one of several banks to have disposed of surplus lease liabilities. CIS is another to do so as a result a restructuring of its business. A number of high street retailers have disposed of portfolios of surplus lease liabilities as part of the repositioning of their brand.

Property advisers work with such corporates to match-make their requirements with specialist legacy estate managers, such as Mapeley, Sparklestone (a joint venture with RBS), Legacy Portfolio, Land Securities Trillium, Asset Factor, Telereal and Burcott. The managers mitigate lease liabilities, through surrender, assignment or sub-letting. It is not the role of the businesses’ property team to act as letting agents for redundant property: specialists are far better at doing this.

Accounting for the change

Property specialists are working with clients to overcome accounting issues that might once have acted as barriers to the use of this answer to managing real estate.

For example, the transfer of lease liabilities could potentially leave a business facing a big hit on the profit & loss account if it has not adequately provided for the lease liabilities in the first place. Yet, in the event of under-provision, the disposal payment and management terms can be structured in such a way that the P&L is no worse off than if the business had managed out the estate. This is successfully achieved through deferral mechanisms.

Additionally, there is a perceived tax issue, as any payment to a third-party is deemed to be a capital payment and a reverse lease premium, which is not allowable for corporation tax, but this need not be the case. The SPV route ensures that there is no claw-back of previous tax relief. This mechanism is supported by legal opinion.

Finally it is possible to put in place safeguards so that the leasehold liabilities transferred to the third party will not revert back to the business. This can either be achieved via the deferred payment route or through so-called credit enhancements such as bank bonds and parent guarantees, and therefore need not be cause for
concern.

In the current climate effective and efficient property management is paramount. The SPV structure can eliminate exposure to the property market. It takes only a short-time to set up and enables the liabilities to be ring-fenced and therefore more easily checked. With property so often the second largest cost after staff, you must carefully examine whether your business should retain legacy estates, particularly when there are ‘buyers’ in the market with an appetite for these portfolios.

Stephen Clarke works in DTZ’s corporate finance division