Letter number 50 of April 2010
- QUESTIONS & COMMENTS
Over the past 20 years, a number of firms have decided to sell off all or part of their operational real estate, while continuing to occupy these premises as tenants. Their reasons for doing so are varied and include the need to pay down debt, to speed up development using cash generated by the disposal, the desire to pay an exceptional dividend, etc. Other firms have preferred to hold onto their real estate. So, Printemps has sold, but Galaries Lafayette hasn’t, Odeon has, but Pathé hasn’t, Accor has but Concorde hasn’t, Santander has, but Société Générale hasn’t, Tesco and Casino have sold some of their real estate, but Auchan hasn’t, to name but a few examples.
In this article, we won’t be looking at the reasons that might prompt a given group to externalise its operational real estate.
However, in our view, it is a mistake to use the same multiples or the same discount rates to value a group that owns its operational real estate in the same way as one that does not.
To illustrate this point, let’s take the example of a company which records EBIT of 120, that is valued on the basis of an EBIT multiple of 10, which works out at an entreprise value of 1 200.
This company decides to buy its operational real estate which is worth 100 and on which the market rental return is 8%. The capital employed of this company is now worth 1 300 because it has been inflated by real estate which has a market value of 100. There is no reason for this not to be the case, as the operating real estate can be let to a third party or owned. If this real estate is amortised over a period of 50 years, the company’s EBIT will increase by the amount of rent that is now saved, and reduced by depreciation and amortisation.
Which works out at 120 + 8 % × 100 – 100 / 50 = 126.
The EBIT multiple should now be 1 300 / 126 = 10.3. If it stayed at 10, the capital employed would be worth 10 x 126 = 1 260 and 40 worth of value would have disappeared. Whether the company finances the acquisition of its operating real estate using bank or financial debt or though a capital increase makes no difference to the case and to the loss of value (in this example), due to an incorrect approach to valuation!
It is only if the rate of return on the real estate minus the amortisation rate on this same real estate is inversely equal to the EBIT multiple that we would avoid this loss of value, which here works out at 16.7 (1/(8%-2%)). This, of course, is very unlikely and could only be the result of chance.
When the inverse of the EBIT multiple is higher than the difference between the rate of return and the amortisation rate, the real estate is undervalued. This is the case in our example (1/10 is greater than 8% - 2%). When the inverse of the EBIT multiple is lower than the difference between the rate of return and the amortisation rate, the real estate is overvalued.
It can be shown that the new EBIT multiple for a group that buys its operational real estate (regardless of the means of financing) is higher if the EBIT multiple without the real estate is smaller than the inverse of the difference between the rate of return on and the amortisation rate of this real estate. This is the case in our example: 10.3 is greater than 10 as 10 is smaller than 1 / (8% - 2%) = 16.6.
Finally, all of this is quite logical as the new EBIT multiple is the average, weighted by the EBITs, of the EBIT multiple of the industrial or commercial activity and the multiple of the EBIT of the commercial real estate:
10,3 = 120 × 10 + 6 × 16,7
Similarly, the EBIT multiple of a group with two distinct divisions is the weighted average of the EBIT multiples of each of these two divisions, as long as there are not any major holding company / conglomerate expenses.
If the industrial activity is experiencing strong growth, which would justify a high EBIT multiple, the acquisition of the operational real estate would logically reduce the level of this multiple as real estate generates earnings that are growing at a slower pace.
On the other hand, if the industrial activity is highly risky and not experiencing much growth, and accordingly valued with a low EBIT multiple, the acquisition of operational real estate will result in an increase in the multiple.
But just to make sure that we have made ourselves clear. In neither of these cases is the increase or decrease in the EBIT multiple synonymous with the creation or destruction of value (1). It is simply the observation of a more or less major modification in the risk and growth profile of the company's capital employed.
All in all, when using the multiples method to value a company that does not own its operational real estate, valuation professionals should be sure to restrict their samples to comparable companies, not only in terms of size, but also in terms of real estate policy. If this is not the case, they should extract, from the multiples of those companies that own their real estate, the impact of this situation on the multiple by using the following formula:
Multiple Multiple EBIT EBIT of Multiple
with = without × excl. real estate + real estate × real estate
real estate real estate EBIT EBIT
Similarly, to value a company that owns it operational real estate, only companies with the same real estate policy should be included in the sample. If not, multiples should be corrected using the above formula.
The reasoning behind this is the same as for the P/E ratio – it can only be validly used if the capital structures are the same. If not, the reasoning is biased.
We will not conceal the fact, however, that this rational approach can be ignored when the amount of operational real estate is low when compared to the value of the company's other assets. The error made is not significant. In our example, the operational real estate was only worth 8% (100 / 1 200) of the company’s industrial and commercial capital employed. Using the same multiple of 10, before and after the acquisition of the commercial real estate, will result in an undervaluation of 30 out of 1 300, or 3%, well within the bracket for even a well conducted valuation, and low compared with the uncertainty of future EBIT.
However, there are some sectors such as the hotel industry, the cinema, department stores, retail stores, banks etc. where operational real estate can account for a large percentage of the industrial capital employed. In such cases, this approach is certainly necessary.
Some analysts have already identified the issue and we see in certain valuation notes the inclusion of the EBITDAR multiple (Earnings Before Interest Taxes, Depreciation, Amortisation and Rent). The multiple is then calculated by applying a modified enterprise value to EBITDAR. The modified enterprise value is the value of the firm plus capitalised rent (2). The idea is thus the same: reason for all companies as though they owned their real estate (we then have EBITDAR=EBITDA and modified enterprise value = enterprise value).
What about valuation using the DCF method?
When a large amount of operational real estate is involved and / or when the situations of landlords and tenants is similar in the company’s sector, we believe that an ad hoc methodology should be used – the Opco / Propco method. Opco is the operational company and Propco the owner of the real estate.
What is the Opco / Propco method?
In the Opco / Propco method, the actual facts are taken into account. The company owns its operational real estate but it could rent it, and the assumption is made that the operating activity pays the real estate division a rent at market rates, calculated on the basis of the value (as expertly appraised) of the property. The value of the operating activities is then calculated by discounting the free cash flows from which this rental charge is deducted. The market value of the real estate is then added in to obtain the total value of the company’s capital employed.
Similarly, for a DCF, it is assumed that all the free cash flows are paid out to shareholders after the creditors have recovered what is owed to them. These two assumptions are at the same time, paradoxically central and indifferent
Central for both the DCF and for the Opco / Propco because this is how the calculation is done. Indifferent for both the DCF and the Opco / Propco because it makes little difference whether the company has paid out all of its free cash flows or not or that it has effectively set up two analytical centres within the company (for operations and real estate), which invoice each other.
Let’s continue the parallel with DCF as it is very revealing. Twenty years ago, when DCF started to make its way from the pages of financial text books and into practice, there were many who claimed that it was a method for valuing a majority as only the majority shareholder had the power to decide on the allocation of free cash flows. This type of criticism has long since disappeared. Analysts would not use the DCF method for valuing shares if this had not been the case! Nobody would automatically suspect that majority shareholders systematically mismanage free cash flows. Free cash flows do not have to be paid out in full in order to make the DCF method relevant. They simply need to be invested (3).
Similarly, for the the Opco / Propco method to be relevant, it is not absolutely necessary for the company to carry out a legal or even shareholding separation of operations and real estate. It is sufficient simply to ensure on a regular basis that the real estate assets could not be put to better use than their current use, in other words, that the operational part of the company is able to pay the theoretical rent for the property it is using. Market practice is that the rent should not exceed 50% of EBITDA before analytical rent.
In the same way that the DCF method was not a revolution, but an evolution compared with the dividend discount model, the Opco / Propco method is not a revolution either. It is a progression of the DCF method that makes it possible to factor in the real estate component of companies, just like the DCF method makes it possible to factor in their debt component.
Since a large number of groups externalise their real estate, Opco / Propco methods are becoming indispensable for correctly valuing enterprises with real estate policies that are increasingly different. Opco / Propco methods are no more linked to the real estate boom than the DCF method was linked to the debt boom of the early 1990s. If this weren’t the case, the DCF method would have disappeared from the face of financial analysis by now.
Around 15 years ago, EBITDA multiples and EBIT replaced the P/E ratio, and the DCF method replaced the dividend discount model for valuing industrial and commercial companies. Similarly, the Opco / Propco method looks set to become the method that will enable analysts to correctly value companies with large amounts of real estate, both in absolute terms and by comparing one with another.
From a practical point of view, the valuer should be sure to discount the flows of capital employed, after deduction of rental payments, at a higher discount rate than that used for a company that owns its operational real estate. The rental payments constitute a fixed cost on the cash flow statement (they have to be paid in reality or as a calculation assumption!), and accordingly raise the breakeven point.
In practice, we see that companies that have sold their operational real estate have a higher cost of capital and a higher β. However, this does not mean that they have destroyed value. It simply means that they have a slightly higher risk profile. They would only have destroyed value if they had sold their operational real estate at a price below its market value.
Our illustrated approach for real estate assets could also be duplicated for all assets that the company could use on a rental basis. So, for companies with a large fleet of vehicles, aeroplanes, ships, etc., the same issue could arise and could be dealt with in the same manner, allowing for a few minor variations.
(1) For more information, see chapter 31 of the Vernimmen.
(2) The rent multiplied by a coefficient of (7 or 8x).
(3) For more details see Vernimmen.net Newsletter n°35.
Unsurprisingly, the largest European companies stopped buying back their shares in 2009, not because they thought their share prices were not low enough but more likely because:
• they were in dire needs of cash (car and steel companies);
• they were more cautious than greedy (one never knows);
• they wanted to pile up cash to seize potential opportunities in the future.
Indeed, on average, members of the Eurostoxx 50 actually sold back treasury shares more than they bought back for around €0.8bn. What a contrast with 2007 when they bought back shares worth close to €47bn!
Some sold back treasury shares to buttress their balance sheet (Unicredit to the tune of €2.8bn), others did it because some treasury shares were hedging stock option plans which matured with share prices below exercice prices.
Some groups have cut their dividends sharply such as Daimler (divided by nearly 4), ING (divided by 6), Crédit Agricole (by 2). The 2 Italian banks (Intesa San Paolo and Unicredit) have reduced their dividend to 0 and they are the only ones on the Eurostoxx 50 index to have done so.
2009 dividends are down 29 % but are still the same percentage of the average market capitalisation as last year, i.e. around 4.5%.
Taking into account share buy-backs and dividends, these European groups have reduced by 50% the cash distributed to their shareholders in 2009 by 50% compared to 2008 or 2007.
For more on dividends and share buy-backs, see chapter 38 of the Vernimmen.
Over the past ten years, a lot has been written about the relationship between law and finance. In 2000, La Porta et al. (1) showed how minority shareholders are paid the highest dividends in countries where their rights are the most firmly guaranteed. In a similar vein, two recent articles look at the consequences of creditor rights for dividends (2) and the features of bank loans (3).
The first article relies on an empirical study to show that dividends paid to shareholders are higher in countries where creditor rights are the most firmly guaranteed.
When rights are weak, two counter-effects on dividends come into play:
• a “revenue effect”, according to which dividends paid will be higher because the negotiating power and influence of creditors is weak;
• a “substitution effect", according to which dividends will be low in order to guarantee creditors a certain amount of security by providing a substitute for the legal environment.
The study shows that in terms of creditors’ rights, the substitution effect comes out top (while La Porta et al., for shareholders rights, come out in favour of the revenue effect).
So, in countries like the UK or Australia, where creditors enjoy stronger rights (4), dividends are 2.8 higher than in the USA or Canada where these rights are weak (for comparable companies).
For the purpose of measuring creditor’ rights, Brockman and Unlu constructed an index from 0 to 4, which factors in creditors’ power in the event of debt rescheduling, their ability to appoint new management in the event of bankruptcy, and the priority granted to secured loans in the event of liquidation. When the index goes from 4 (high level of protection) to 0 (low level of protection), the likelihood that the company will pay a dividend is reduced by 41%, and the size of the dividend paid is reduced by 60%.
One possible explanation is that weak protection of creditors goes hand in hand with poor development of financial markets. In these countries, firms pay low dividends because they have to finance their operations themselves. Brockman and Unlu reject this assumption, showing that a rise in dividends in these countries does not lead to an excessive decline in the valuation of the firm, which should result from an intention to seek external financing.
They prefer an explanation based on agency theory. Since creditors have little power in the event of default, they only agree to lend to firms that undertake to pay low dividends, which minimises their risk of default.
The second article looks at the differences between the features of loans, according to the legal environment. It distinguishes between creditors' rights in the strict sense of the term (measured on the basis of criteria that are comparable to the previous article) and the guarantee of the contracts being executed. This guarantee factors in the level of corruption, the risk of expropriation and the risk of contract repudiation.
Bae and Goyal show that this execution guarantee has an even greater influence than the rights of creditors in the result of loan negotiation. Going from the lowest level of protection (index 0) to the highest level (index 10), the amount of loans increases by 63%, the maturity increases by 2.5 years and the spread is reduced by 67 base points. On the other hand, when the contract execution guarantee is taken into account, the factoring in of creditors’ rights has little impact on the loans (better rights reduce the spread by a little more).
In the same article, Bae and Goyal offer an interesting observation on the Asian crisis of 1997. They show that the legal system plays an even more important role in the case of a financial crisis. Since returns on investments fall, majority shareholders are more likely to expropriate creditors. In return, the latter require and obtain shorter maturity periods and bigger spreads.
After shareholder rights, of which the impact on the financing of firms has been heavily studied, researchers are now looking at creditor rights.
These two articles provide a major contribution to the literature on this subject.
(1) R.LA PORTA, F.LOPEZ DE SILANES,A.SHLEIFER and R.VISHNY (2000), Agency problems and dividend policies around the world, Journal of Finance, vol.55, p.1-33.
(2) P.BROCKMAN and E.UNLU (2009), Dividend policy, creditor rights and the agency costs of debt, Journal of Financial Economics, vol.92, p.276-299.
(3) K.H.BAE and V.K.GOYAL (2009), Creditor rights, enforcement and bank loans, Journal of Finance, vol.64, p.823-860.
(4) See chapter 45 of the Vernimmen.
ETFs (Exchange Traded Funds) are funds that replicate the performance of an index. They are also referred to as index funds or tracker funds. EFTs can be bought or sold on a market like individual shares.
The indices replicated are generally share indices, but some ETFs also cover bond indices or even commodities indices. EFTs are theoretically also more varied than the indices that may exist. For example, there are ETFs that follow short indices (index that goes up when the underlying drops) or the price of food indices.
Accordingly, ETFs make it possible to invest, in a simple manner, on a market without having to set up a portfolio of shares, which can be complex and expensive to do.
One of the keys of the success of ETFs lies in the liquidity that they offer. Investors wouldn’t be interested in this type of product if they were not confident that it would be possible to trade (buy or sell) these funds in large quantities at any time. The narrowness of the listing bracket is an important sign of this liquidity.
In practice, the funds can use several techniques to replicate the index. The most simple is the effective reconstitution of the index, by buying all of the shares that comprise it. Alternatively, the fund managers can look towards the interbank market and use swaps to constitute their portfolio. It should be noted that the funds then run a counterparty risk vis-à-vis the bank with which it contracts (and it became clear during the 2008 crisis that this risk could prove to be very real, even for top ranking financial institutions).
The growing success of ETFs, which are playing an increasingly important role in international fund management, seems to indicate that managers are shifting more and more towards simplicity, and … towards financial theory! The CAPM comes to the conclusion that each investor should acquire a portion of the market portfolio and “adjust” his/her level or risk by financing this investment by more or less debt, or by investing a part of his/her funds in risk-free assets.