Commercial Investment Real Estate

NOV-DEC 2012

Commercial Investment Real Estate is the magazine of the CCIM Institute, the leading provider of commercial real estate education. CIRE covers market trends, current developments, and business strategies within the commercial real estate field.

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A principal goal of corporate management is to make a business worth more than the cost of its underly- ing assets. To create such shareholder wealth, management has three levers at its disposal: asset effi ciency, operating effi ciency, and capital effi ciency. Asset effi ciency is the ability to limit the amount of assets that have to be funded with shareholder equity. It primarily entails managing fi xed asset costs and working capital levels. Operating effi ciency is the ability to improve operating profi t margins, which is accomplished by fi nding ways to increase sales, raise prices, and control expenses. Capital effi ciency is the ability to reduce the weighted cost of debt and equity capital. Managers must harness equity in concert with various forms of outside capital to lower corporate costs of capital. Combined, the three effi ciency levers work together to generate shareholder returns. Companies that can produce the highest returns with the least fi nancing drag on cash fl ows tend to create the highest percentage gains in shareholder wealth, not to mention higher cur- rent equity cash fl ow yields. The Role of Real Estate T e decision to lease or own real estate is centered on capital effi - ciency, which is measured by pretax rates of shareholder return. To be sure, there are tax implications to real estate fi nancing decisions. T e benefi ts of real estate depreciation, which can shield income from taxes, can be alluring. However, such benefi ts are nominal, since buildings are depreciated for tax purposes over a lengthy 31.5 years, and land has no depreciation. Moreover, the tax benefi ts are merely a tax deferral, since real estate sold aſt er a long holding period is subject to gains from the recapture CCIM.com of accumulated depreciation. T e many public companies that are shackled by the potential for severe tax consequences from imbedded real estate gains serve as a reminder that the better route is to focus on pretax equity return maximization. Equity rates of return cannot be properly computed from a fi nancial statement: T ey are a fi nancial, as opposed to an account- ing, concept. If a company invests $1 million into a building and fi nances 70 percent of the cost, then the percentage of equity is 30 percent. T e equity percentage never changes unless the debt is paid down, in which case the mix of debt and equity shiſt s. T is is what happens when real estate is owned and related mortgage debt is repaid. As the percent of the real estate funded with loans declines, the amount of equity rises, which has an adverse impact on shareholder equity returns over time. Apart from depreciation, there is a second allure to real estate ownership, which is the potential for appreciation. Without question, this is a subject worth considering, but not in concert with the proper means of corporate capitalization. Business leaders are rewarded fi rst for focusing their attention on optimizing the three corporate effi ciencies. Real estate appreciation, which is a part of real estate returns, is not a business activity; it is an investment activity. T e attractiveness of real estate as an investment for companies will be addressed later in this article. Computing Equity Returns T e V-Formula is a simple shortcut to compute current pretax equity returns. T e formula harnesses all three of the corporate valuation levers. T e fi nancial model based upon the V-Formula illustrates the November | December | 2012 33 Digital Vision/Getty Images

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