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Joseph Ori, CFA
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Joseph Ori is founder and President of Paramount Capital Corporation, a real estate investment, financing and advisory firm that provides strategic advisory services, debt and equity capital financing, capital solutions, brokerage, corporate finance and work outs and restructurings for the... More
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Paramount Capital Corporation

    Many public companies have substantial sums invested in commercial real estate that it owns and uses in its business. The real estate can be a headquarters office building, industrial warehouse property, retail store site or restaurant building. Dillard's and Sears, two department store operators, own many of their own stores. Cracker Barrel, Bob Evans Farms and Ruby Tuesday, three restaurant chains, also own a large number of their restaurant buildings and sites. Zynga, the online game maker that went public in December 2011, recently agreed to acquire their headquarters building in San Francisco's South of Market Neighborhood for $228 million. Google, a technology company, bought its 2.9 million square foot New York headquarters building in 2011 for $1.9 billion.

    Commercial real estate is considered a capital intensive asset and includes four main property types, office buildings, retail centers, industrial warehouses and apartment buildings. Each type of property (except apartments) is subject to a lease contract that typically has a base rent, additional rent for the property operating costs like real estate taxes and maintenance, a term of 3-10 years and options for renewal. The base rental rate varies depending on the location and age of the building, lease terms and credit of the tenant.

    Does it make economic and investment sense for a public operating company to sink large amounts of capital in its own real estate? Should an operating company own or lease its real estate? From a return on capital perspective, the answer is no. A public company should not tie up capital in commercial real estate whether it's used for office, industrial or retail purposes. Companies with large real estate holdings should sell the assets or do sale/leasebacks unless the assets are of strategic investment value. Some companies do need to own real estate for strategic and marketing purposes. Examples are a retailer buying a building on Fifth Ave. in New York or Rodeo Dr. in Beverly Hills, CA for a new, high profile store location to advertise its business or a company buying a suburban office building for a national headquarters. In most other cases, the capital tied up in real estate should be reinvested into the company's core business where the rate of return is greater than in a real estate investment.

    The expected return from investing in an operating business is higher than a real estate investment. This is because of risk. Operating business investments are riskier due to the volatility of the business, EBITDA (earnings before interest, taxes, depreciation and amortization) or cash flow, profits and competition. Commercial real estate investment is less risk because properties are encumbered by leases, as stated above, which can deliver a more reliable and steady income stream and the ability of the lease income and asset to be leveraged.

    Two proxies for operating company investment returns are the returns from private equity and venture capital investments. A Pepperdine University Private Capital Market Study in November 2011, stated that the expected return for private equity investments in 2011 was 25% and for venture capital, 28%. The expected return from investing in commercial real estate can be viewed through data provided by the National Council of Real Estate Investment Fiduciaries, (NCREIF), and a nonprofit provider of institutional real estate investment data. NCREIF provides a quarterly property index which is a time series composite total rate of return measure of investment performance of a very large pool of individual commercial real estate properties acquired in the private market for investment purposes on an unlevered basis. The NCREIF unlevered average annual return for the last thirty years was 8% and the comparable levered return with 60% debt is 14%.

    Therefore, if the expected return in private equity at 25%-28% is greater than the 14% in commercial real estate, then companies should dispose of their real estate and reinvest the proceeds in their business. Operating companies should be able to increase their investor return by selling real estate assets and redeploying that capital into their core business. As an example, a hypothetical operating company, ABC Digital, manufactures circuit boards and disc drives has delivered an average annual return of 22% since going public in 2000. It owns a headquarters office building bought for $60 million with a book value of $50 million and a market value of $100 million. If the building is sold for $100 million the net proceeds after a 35% tax rate are $82.5 million. If the company has a weighted average cost of capital of 12%, but can earn a 22% return (the company's historical return on equity) on reinvesting the $82.5 million in its business, the company will add $18.1 million in value annually to its shareholders. This will result in a higher stock price and enterprise value. The value of a company is the present value of its cash flows discounted at its weighted average cost of capital. The incremental cash flows generated from the above investment will increase this intrinsic value. If ABC Digital decided to keep the real estate, it would have a slightly higher net income because the deprecation would be less than a comparable rent, however, it would not have the capital to reinvest and earn the incremental 22% return.

    The capital companies have tied up in real estate is not earning a return other than the amount of rent being saved by owning the property. However, this amount is very small compared to the lost capital investment. Today, many public companies are evaluating their return on capital and asset utilization in a difficult economy. One way to increase these returns is to dispose of non-strategic real estate assets and reinvest that capital in the business operation to generate organic growth. Companies that reinvest this real estate capital into their core business can earn a much higher return on equity, which will result in a higher stock price and market value.

    Author: Joseph Ori


    Paramount Capital Corporation

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Apr 20 12:37 PM | Link | Comment!
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    Jun 15 4:36 PM | Link | Comment!




    The commercial real estate industry is the next big shoe to drop in the U.S. economy and may push the fragile economic recovery into a double dip recession. The commercial real estate industry is a $5 trillion dollar business and its health and vibrancy is critical to a strong and growing economy. The industry has been hit by the perfect storm of the great recession, an average decline in property value of forty percent, increase in risk aversion by investors, lack of new debt and equity capital and weakening fundamentals for rental rates, occupancies and operating costs.


    Currently, the industry is frozen and there are few investment, financing and leasing transactions. Transactions are the life blood of the commercial real estate industry. The banking industry is faced with mounting defaults and foreclosures and many financial institutions have been in the “pray and delay” mode wherein they have not foreclosed and recycled defaulted loans into the marketplace. There is virtually no financing available except for apartments through Fannie Mae and Freddie Mac. According to Foresight Analytics, roughly half of the $1.4 trillion in commercial mortgages maturing by 2014 are under water. If this situation continues, it will be very difficult for the economy to avoid a double dip recession.


    I believe that the commercial industry can be pulled out of this crash by Congress suspending the Passive Loss Tax Rules for 2010 and 2011. The passive loss tax rules were promulgated by the Internal Revenue Services in the Tax Reform Act of 1986 and further amended in 1994. These rules stipulate that losses from real estate and equipment rentals and investment transactions by partnerships, limited liability companies and S Corporations cannot be used to offset wages and investment income unless you are a material participant. A material participant is someone who works on a regular, continuous and substantial basis in the business. Most real estate investors are not material participants and hence cannot use real estate losses. Some investors who are considered active participants may deduct up to $25,000 in annual losses, however, this deduction is eliminated as the investor’s adjusted gross income reaches $150,000. Suspension of the passive loss rules will allow individual investors to deduct real estate losses, arising primarily from depreciation deductions, against wage and investment income. This will open the flood gates of new capital to the commercial real estate industry and a turnaround in the economy. 


    Suspending the passive loss rules for two years will help the commercial real estate industry tremendously as follows:


    1. Generate substantial new capital investment into distressed and troubled projects

    2. Allow overleveraged owners to reduce their debt and increase the equity funding

    3. Help financial institutions especially smaller community banks restructure their troubled real estate loans

    4. Increase economic activity and jobs through the development of new projects and new investments in existing projects

    5. Help stem the value decline of commercial real estate loans and investments

    6. Provide a tax benefit to real estate investors by allowing real estate losses to offset wages and investment income

    7. Increase the disposable income of real estate investors that can be used for other spending

    8. Reduce the number and amount of distressed and troubled projects owned by financial institutions thereby reducing the risk to taxpayers

    9. Help the economy grow out of this recession and a potential double dip

    10. Increase capital investment in low income housing projects


    Although my proposal has many benefits it does have a cost to the Treasury of lost revenue, however it may be offset by increased taxes from the boom in economic activity. It can also be implemented easily by Congress and the economic benefits will start to appear quickly in early 2010. 



    Author: Joseph Ori, is President and CEO of Paramount Capital Corporation, a California based real estate investment and advisory firm.

    Disclosure: None
    Dec 16 5:43 PM | Link | 1 Comment
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