Journal of Corporate Emerald Article: Optimising real estate financing Greg Krzysko, Claudia Marciniak

Article information: To cite this document: Greg Krzysko, Claudia Marciniak, (2001),"Optimising real estate financing", Journal of Corporate Real Estate, Vol. 3 Iss: 3 pp. 286 - 297 Permanent link to this document: http://dx.doi.org/10.1108/14630010110811643 Downloaded on: 08-11-2012 Citations: This document has been cited by 1 other documents To copy this document: [email protected]

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Optimising real estate financing

*Greg Krzysko and Claudia Marciniak Received (in revised form): 30th March, 2001 *Equis Corporation, Corporate Headquarters, 321 N. Clark, Suite 1010, Chicago, IL 60610, USA; Tel: ϩ1(312) 424 8143; Fax: ϩ1(312) 424 8080; e-mail: [email protected]

Greg Krzysko is Vice-President of the Financial The corporate real estate manager can most Consulting Group at Equis Corporation in effectively arrive at an optimal decision by Chicago. He provides for Equis clients, in- considering three perspectives: the corporate real cluding Ameritech/SBC, DaimlerChrysler, Delphi estate market, business unit needs, and investor Automotive and Xerox, creative financial struc- preferences. After gathering the relevant infor- turing strategies that achieve the best overall mation and evaluating the pros and cons of the business outcome. Greg has been successful in full range of financial structures, the real estate providing real estate solutions that enable manager can make a sound recommendation to clients to pursue new business ventures, to the business unit and the finance department. expand existing real estate assets and to reduce The manager knows that the solution is cost in existing client portfolios. He received his acceptable to the marketplace, can provide degree of Master of Business Administra- flexibility in the event of a changed business tion majoring in Finance and Strategy from model, and provides the space at the most Northwestern University’s J. L. Kellogg School reasonable cost. of Management in Evanston, Illinois. Keywords: finance, capital sources, Claudia Marciniak is Director of Portfolio financial structuring, financing alterna- Services at Equis Corporation. She provides tives Equis clients with analyses to administer and align their real estate portfolios with business and financial strategies. Claudia has significant THE MANAGER’S DILEMMA experience in financial structuring and strategic Financing real estate projects can be a planning, as well as project, construction and vexing experience for even the most risk management. She received her degree of seasoned corporate real estate manager. Master of Business Administration majoring in Corporate hurdle rates, capital budgets, Finance and Accounting from Northwestern discount rates, weighted average cost of University’s J. L. Kellogg School of Management capital, cost of debt, residual value in Evanston, Illinois. estimation and changing operating needs — the considerations are many, but no single approach helps corporate real estate ABSTRACT managers understand how to structure This paper discusses ways that corporate real financing for a given project. Corporate Journal of Corporate Real Estate Vol. 3 No. 3, 2001, pp. 286–297. estate managers can use creative financial struc- real estate managers often evaluate a Henry Stewart Publications, 1463–001X turing to optimise their real estate portfolios. project for the business unit merely by

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Figure 1 Commercial real estate funding — traditional model

Corporation Capital Sources Figure 2 Commercial real Treasurer or CFO - Corporate Bonds - Stock estate funding — Corporate Financial Structuring strategic model Real Estate - Asset-backed Lending Individual Business Units

determining the present value in an Landlords represent the creditworthiness own-or- scenario. Their analyses of the business unit’s tenancy to asset- rarely address the financial, market and based debt and equity capital sources, real estate factors that corporate finance a situation that creates inherent com- professionals need to develop a broader munication and agenda obstacles. range of financing alternatives in order to In addition, corporate real estate determine the best solution. managers commonly encounter transac- Corporate real estate managers essen- tional barriers. Given inconsistent finan- tially face two types of impediment to cial parameters and business unit demands, optimising their real estate: organisational how does a corporate real estate manager and transactional. Organisational barriers identify the best financing option? Banks are inherent in the way in which com- and corporate financiers have their own mercialrealestateistypicallyfinanced in agendas and typically do not provide this the USA. The usually acts as the high level of analysis. Treasury profes- middleman between the individual busi- sionals are most familiar with corporate ness units’ real estate needs and the capi- level capital sourcing and have little tal sources. In this situation, the capital expertise in real estate funding. sources underwrite the landlord, and the In recognising the need to fulfila landlord therefore acts as the middleman financial structuring role, the real estate between the corporate real estate manager manager can make decisions by bridging and the capital sources. This situation these traditional barriers. By changing leaves the needs of the corporate busi- the landlord role, corporate real estate ness unit subject to multiple levels of managers can directly access the best capi- interpretation, as depicted in Figure 1. tal sources, as shown in Figure 2.

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This process employs strategic thinking tion to achieve its business objectives at that links corporate goals to real estate thebestpossiblecost. and directly accesses capital sources. Cor- Without embracing the opportunities porate real estate departments can place a and the dynamics of the real estate invest- quantifiable monetary value on the wide ment community, corporate real estate variety of financing options available for managers often create a ‘stock’ or ‘one- each transaction, turning real estate into a size-fits-all’ approach that results in a competitive asset. single answer or decision for all For example, corporate finance and of a particular type. For example, a com- real estate departments commonly pany assumes that office buildings ap- struggle when evaluating single-tenant preciate and that the company needs them buildings in an own-versus-lease scenario. for a very long time. The company then Typically, a business operating unit will performs an analysis that compares 100 budget for a lease at market rates and per cent debt ownership and selling the expect corporate real estate to secure that appreciated asset at the end of 15 years lease. When corporate real estate can with just leasing the office for 15 years. instead purchase the asset and still meet In this scenario, owning is clearly the thebusinessunitneedsinlieuofalease, best option because the company assumes a debate ensues as to how to consider an increase in value and continued oc- the project —financing of an asset that cupancy. Alternatively, a business may will be discounted at an after-tax cost need a call centre for ten years, over of debt, or a project to be discounted which time the company believes that the at the weighted average cost of capital? industry will change dramatically. The Corporate finance and real estate company then performs an analysis that departments further consider and debate compares a ten-year lease to a purchase whether the will increase or with 100 per cent debt and no residual diminish in future value, how much value. In this scenario, leasing is clearly decrease can be tolerated, the length of the better of the two options because of time for which the business will need the the lack of value at the end of ten years. property, and whether the capital budget In all likelihood, the corporation will can accommodate a change from a leased pursue its next office as a purchase and its into an owned property. next call centre as a lease. However, the corporation’s financing options are influenced by a number of A LOOK AT THE FULL SPECTRUM other factors, including shifts within the By focusing on the internal corporate company (such as a merger or acquisition) evaluation criteria only, corporate real or in corporate debt rates. Additionally, estate managers often miss real estate in- with the dramatic swings in office demand dustry perspectives; a sub-optimal deci- and building valuations resulting from sion results. Industry concerns include the business cycles and local economic condi- amount of leverage a typical real es- tions, the corporation’s financing options tate capital source allows; whether the may be affected in response to supply project is financeable; and what residual and demand for a particular space type. value assumption is acceptable to a lender The aforementioned lease–buy analysis ig- and/or investor. Managers who incor- nores the fact that both properties operate porate the industry point of view into within the context of a larger, dynamic their decision making help the corpora- universe of real estate and that alternatives

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Table 1: Lease-versus-own considerations

Leasing Ownership

Advantages • Generally off balance sheet • Long-term control • Market/residual risk left to • Facility specially designed for developers/investors business needs • Flexibility for expansion/ • Provides mechanism for financing contraction. (if needed) • Participation in upside of market risk

Disadvantages • Usually most expensive • Illiquid and less flexible. option. • Balance sheet impact. • Loss of control. • Residual real estate risks borne • Long-term can affect by company. balance sheet/financial ratios. • Existing facilities may match business needs.

beyond the standard lease-or-buy decision like Silicon Valley will constantly consider exist. For example, investors would never the current or future land value for purchase a building without addressing redevelopment, especially during any sale, local market conditions, the asset’s con- refinancing or tenanting of the space. figuration, the creditworthiness of the Corporations should take a similar ap- tenant and a historic perspective of values. proach and consider ongoing and regular Incorporating the real estate investors’ reviews of their portfolios or individual perspective can add a great deal of value projects. Otherwise they will routinely miss to a financing decision. opportunities to limit risk and realise Real estate investors are driven by appreciation. opportunities to capture value and wealth. They capture these by recognising or anticipating changes in the real estate REVIEW OF APPROACHES TO market, within companies or in financiers’ FINANCIAL STRUCTURING preferences. Developers routinely invest in A corporation’s decision to own or lease projects and systematically isolate and a building is rarely clear-cut. Factors such structure around the risk, while retaining as where the corporation is in its lifecycle, the upside — theveryessenceofarbitrage its financial status, its philosophy as to the opportunity. Real estate investors regularly use of investment capital, and its business review their property values and how value unit needs must be carefully weighed. changes under varying scenarios, then act Leasing and ownership each have distinct accordingly. For example, an investor who financial and operational advantages and owns a warehouse in a high-demand area disadvantages, as described in Table 1.

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Figure 3 The own-or-lease continuum

Because corporations view, account for it has limited credit history and needs and measure financial performance for to plough capital into business develop- real estate investment differently, the real ment. For many start-up companies, space estate manager, the business unit and needs will grow exponentially and there- treasury team should thoroughly consider fore cannot be accurately predicted. In the short and long-term earnings impact this case, leasing provides the necessary and the balance sheet results in addition to financial and space planning flexibility the business unit operational issues des- and fits ideally into the company’sbusi- cribed above. Because real estate can ness plan. By contrast, a utility company provide a competitive advantage through that needs a building to its trans- cost and location, the real estate decision formers — aspecialiseduseinavery should be included as an essential part long-term business — should own the of the corporation’s overall business and real estate. Ownership makes sense, be- financial strategy. cause developers will not be interested in Incorporating real estate into the busi- financing such a specialised activity, the ness and financial strategy can be difficult company has a predictable revenue stream because real estate usually competes with and it can pay for the property with other projects for investment capital. For minimal risk. example, a newly formed software com- Real estate needs, like business pany will probably have difficulty secur- strategies, are dynamic and may differ ing a loan to construct a building, since from one company to another and even

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Figure 4 The triple approach

within the same corporation. Unfor- cent of the portfolio square footage) tunately, most corporate real estate space are small and subject to variable busi- and financing decisions are not as ness needs. Clearly these properties are clear-cut as the examples cited above. best structured as leases; and When real estate is an integral part of the — The remaining 979 properties (51 per strategic business plan, the real estate cent of the portfolio square footage) decision becomes more complex. To are subject to changing internal cor- address these additional concerns and porate needs and widespread real issues, hybrid financing structures have estate industry investment, and so are evolved. As Figure 3 depicts, most not clear-cut lease-or-own decisions. corporate decisions fall in the middle of These are best addressed through the own-or-lease continuum, where the financial structuring. financing options are varied and confus- ing. In this area, financial structuring is The authors found a similar distribu- most valuable to the corporate real estate tion and trend across the real estate manager. portfolios of numerous other Fortune As a case in point; a recent examination 500companiessuchasDaimlerChrysler, of a Fortune 100 company portfolio with Xerox Corporation, Delphi Automotive, more than 10,000 properties, consisting of Ameritech Corporation and Square D. 50 million square feet, revealed that: Unique, long-term assets were generally owned; generic spaces were typically — More than 9,000 properties (48 per leased. However, large portions of the cent of the portfolio square footage) portfolios had real estate requirements that are considered ‘specialised’ in support- fall between standard and special (logistic ing business units whose real estate centres, call centres) and therefore were needs are stable. As a result, direct not straightforward decisions. In these ownership is clearly the best option; cases, corporations have sought out finan- — Only 228 properties (less than 1 per cial structuring assistance.

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A THREE-PRONGED APPROACH location can greatly influence the range of Financial structuring of corporate real es- possibilities for structuring a project’s tate projects involves taking the best prac- financing without materially affecting the tices of real estate developers and investors cost or functionality of a and using them to control the risk and business operation. For example, say participate in the appreciation of real a corporation is considering a one- estate to achieve lower cost. An effective million-square-foot headquarters building evaluation process used to reduce cost with 250,000 square feet on each of and increase flexibility approaches the four floors. While this building would problem by examining three considera- meet the operating requirements, the tions. The first consideration is the real corporation could alternatively consider estate requirement itself: its uniqueness, four separate 250,000-square-foot build- adaptability, location, ability to be multi- ings with 50,000-square-foot floorplates tenanted, place in the broader market, and connected by bridges. The functional so on. The second consideration is the difference is probably minimal, but to an business user need and possible variability, investor the second scenario represents an including possible future expansions or opportunity to accommodate multiple contractions. The final consideration is 50,000-square-foot configurations. This the investors’ risk – reward objectives configuration would reduce the investor’s and their desire to buy, sell or benefit risk in the long term, and so the real estate from a particular corporation’stenancy.By wouldbepricedtoreflect a lower risk combining the information gathered from premium. these three areas, the real estate manager The next key is to understand the will have the right information assembled business use variability. If the business unit to evaluate all of its financing options is likely to decrease its space needs by half effectively and to achieve an optimal or expects to have the same needs for the decision (Figure 4). next 15 years, having a partial exit strategy Real estate managers can learn a great for a portion of the space is more cost- deal from the real estate marketplace effective over time, since only the re- about how to structure a deal. By quired amount of space will be utilised. gathering information about speculative With undergoing a large degree construction projects, considering the of uncertainty due to changing business amount of construction, financing and models, companies place a high value on investment activity and gauging reactions flexibility. from the investment community about a Finally, the last consideration is the proposed corporate real estate financing, investor’s desire to fund certain projects at the real estate manager obtains a big- any particular time. The corporate real picture perspective. These considerations estate manager must recognise the impor- reveal key information about the real tance of adapting the structure and design estate contemplated in the broader market of each real estate project to changes context. influencing investors. A broad range of To the extent possible, the real estate influences affect the real estate investor, manager’s goal should be to create real including taxation, sovereign risk, cur- estate opportunities that investors would rency exchange risk, global uncertainty, like to own, in places they would like to hostilities and securitisation potential. In own it (‘location, location, location’). the mid-1990s, REITs were active and Changes in concept, configuration or amassed large portfolios of properties

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based on specialisation, as Wall Street they must structure into leases a variety of allowed REITs to replace secured debt options such as purchase, termination, and equity with stock and corporate debt. expansion and various hybrid-ownership Because this recapitalisation of real estate options. firms progressed, REITs focused on After developing a market-appropriate projects which provided revenue growth physical and financial model, a corpora- and predictable capital requirements to tion can evaluate alternative structures to meet the Wall Street business model. Real provide the best circumstances for its estate projects that met these requirements tenancy. In the one-million-square-foot had good prospects for acquisition or example, the corporation can compare a financing by a REIT. Now that REITs lease with REIT pricing to straight are less active in the market, the corporate ownership, synthetic leases, amortising real estate manager must redesign for the off-balance sheet structures, joint ven- next investor market in vogue. tures, tax-free exchanges and traditional To demonstrate the importance of investors. evaluating business unit needs, real estate market concerns and investor preferences, reconsider the previously proposed STRUCTURING ALTERNATIVES project. It has now evolved into a product The real estate manager now has many that offers a REIT an opportunity to own structuring options from which to choose. a four-building, one-million-square-foot When evaluating each of the alternatives, project with annual rent escalations, with the real estate manager must synthesise the tenant retaining the ability to give the information gathered from the three back 250,000 square feet of contiguous arenas (business unit, investor and real space in year five of the lease. This project estate market information) before moving would be very attractive to the investor on to a structuring decision. Figure 5 pool, and would remain low cost to the depicts a representative sample of options business unit even if the latter’sspace available, from a build-to-suit to a single- needs dropped 25 per cent in five years. tenant facility; it reflects the continuum, Even after an appropriate structure with complete ownership at one extreme is implemented and the corporation and pure leasing at the other. Several takes occupancy, variations in investor hybrid alternatives are described and show preferences provide continuous oppor- the various options available to a real tunity for the re-evaluation of real estate estate manager in what was thought to be properties and portfolios. As investors a simple lease or buy decision. shift away from real estate, corporations Direct corporate funding is most ap- have opportunities to capture value by propriate for those properties that are repositioning their portfolio, by entering unique to a corporation’s operation and in into a long-term lease when markets are situations where no real estate investor soft or by purchasing leased properties. will value or assume the risk outside Since investors favour real estate, corpora- the corporation’s tenancy. Examples of tions again have the opportunity to this asset type are manufacturing plants, capture value by repositioning their clean rooms and telephone switch build- portfolio; for example, by exercising a ings. Leasing a specialised building is ef- below-market purchase option. For cor- fectively asking real estate investors to porations to take advantage of oppor- act as lender to the company, since the tunities in market conditions, however, lease would typically be structured to

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Figure 5 The 9 9 No Off Yes

own-or-lease Low Stepped High cost Traditional continuum – Traditional medium offices Operating Lease Regional small to available options Operating Lease 8 8 long term No Off Yes only Low – building lessse Flat or Stepped Bond Net Lease Bond Net Lease need to be a full Wholly occupied facility Limited flexibility & – 7 7 No Off Yes Stepped term only Moderate Leaseback Leaseback Directed Sale/ Directed Directed Sale/ Directed of some control moderate to long occupied facility Wholly or majority Renewal risk & loss 6 6 long term No No Off only – of asset Moderate Long-term appreciation Flat or Stepped Leverage Lease Wholly occupied Leaverage Lease facility commitment & loss 5 5 No Off Yes complex Moderate structure & structure Relatively new Flat or Stepped facility long term Wholly occupied Amoritising Lease Amoritizing Lease 4 4 short term Off Yes Yes – a period Moderate risk, & complex Synthetic Lease Synthetic Lease Wholly occupied term interest rate term interest Floating-Fixed for facility Residual risk short- 3 3 Partial – Varies Varies Majority interests Moderate Partial On Yes Yes Joint Venture Joint Venture Partners may have opposing occupied facility 2 2 No No On N/A term High short to long – Non-Recourse Non-Recourse Wholly occupied Phantom Income Leverage Borrowing Leverage Borrowing facility Owner of real estate Owner of real Leveraged Borrowing Leveraged Borrowing 1 1 No On Yes N/A High estate Facility Funding Funding Special Use residual risk residual Owner of real Direct Corporate Direct Direct Corporate Direct Flexibility: Rent Structure: Balance Sheet: Renewal Risk: Residual Risk: Issues: Common Uses:

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amortise the cost fully over the initial The corporation therefore assumes rate, term at an interest rate substantially above residual and renewal risk while also fully the company’s borrowing cost. Any con- benefiting from appreciation. The main tinued occupancy beyond the initial term attraction of synthetic leases is that they would enrich the investor, as would any allow off-balance-sheet ownership of an residual value if the corporation vacates asset. Analysis of synthetics tends to the facility. ignore the cost of a reduced residual value Non-recourse borrowing is similar to until the property is actually vacated and corporate borrowing in that it accesses the company faces a potential write-off. low-cost funds and the company benefits In order to mitigate risk, the corporation from appreciation and/or continued oc- should amortise a portion of the principal cupancy, yet avoids residual risk. The balance in a synthetic lease, in preparation property must be fairly typical and not for dramatic changes in rates or un- specialised, because the lender is most favourable renewal terms at the end of the concerned with the underlying real es- lease. tate security for the loan, in addition An amortising off-balance-sheet lease to the mortgagee’s ability to service the structure offers a lower lease cost than mortgage. traditional leases, is fixed over the term, Joint ventures provide a way to share in and matches cost closely with the residual value while controlling residual property’s utilisation. At term end, risk. Real estate with good upside potential residual risk is eliminated, renewal risk is is best suited for this financial structure. controlled and appreciation is captured at Development projects where the corpora- varying levels. These off-balance-sheet tion controls the opportunity for a larger- structures are most effective for long-term scope project with high return potential properties with the potential for substan- over time are ideal for this type of transac- tial residual value but a history of value tion. Examples include an office user pre- volatility. For instance, a good application leasing over 50 per cent of a speculative, of these structures is a Fortune 500 multi-tenant project that will not proceed company leasing a single-tenant suburban without the company’s tenancy. Obtaining office building. a share of development profits realised upon Leverage leases provide a low rental completion and also participating in the cost over a long period, often with low income can be a prudent way to lower cost renewal options. A major drawback of while controlling risk. this structure is that any acceleration, Synthetic leases are often used to termination or reduction in the lease provide a low lease cost during the term is exceedingly difficult to achieve, be- but require a corporate guarantee to cause of the accounting and tax treatment ensure that the residual real estate value is by the . The corporation cannot greater than 90 per cent of initial cost. participate in any property appreciation, This structure essentially acts as an but completely avoids residual risk. This interest-only loan for up to seven years; it structure is best suited for long-term assets canbeutilisedforanytypeofproperty, involving business units whose needs are but is best suited to properties that will very unlikely to change. In today’sbusi- consistently maintain a high level of value ness environment, the ability to say confi- and are only required for a relatively short dently that a requirement will not change period. Synthetics are priced to indexes for a long time has diminished — and so such as which regularly fluctuate. has the use of leverage leases.

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Table 2: Cost of financing alternatives to secure four 250,000 sq. ft buildings*

Present value of cost discounted at after Structure tax cost of debt

$ Developer-provided lease 111,609,683 Direct placement with long-term investor 101,904,493 Synthetic (off-balance-sheet) structure 77,144,910 Secured lease (off balance sheet) 77,808,902 Ownership 80,517,185

*Assumptions: Building at a cost of US$125 per sq. ft for a total of $125m; cost of debt assumed at 7.6% with a 40% tax rate. 3% escalations on rent annually; purchase option 40% of original cost; value of residence ignored.

Corporations are finding directed sale- This structure should be utilised for any leasebacks to be increasingly rewarding. substantial lease as a vehicle to lower As the markets have tightened, more cost. companies are faced with build-to-suit Finally, traditional leased facilities are requirements. Rather than enter into a best used when properties that meet the lease, a project is built for the corporation business unit’s needs are generally avail- directly and then sold off to inves- able in the market and when the corpora- tors, allowing the company to capture tion requires flexibility. Leasing is best the profit associated with entrepreneurial used when markets are soft due to exces- risk as well as that from the long- sive supply and lease rates are below term investor’s desire for the company’s replacement cost for existing properties. tenancy. Properties best suited for this The real estate manager has many op- approach are those that are most in tions as part of the real estate finan- demand by long-term investors, in situa- cial structuring strategy. The supply and tions where the company needs the demand of financing products varies with property delivered within an accelerated real estate and economic conditions. As a timeframe. Examples include office build- result, pricing, viability and financial im- ings, warehouses and call centres in major pact will vary among the options at any urban office markets. given point in time. In order to manage Bond net leases improve the lease rates the risk of focusing on just one strategy, charged to the company, since the tenant’s the manager should consider at least two credit is used directly to obtain borrowing alternatives. Revisiting the example of a capacity with little regard to the real corporation contemplating a one-million- estate. When reviewed at a portfolio level, square-foot headquarters, the requirement the incremental cost of entering into a has now been reconfigured into four traditional lease rather than bond leases is separate buildings to match local inves- very high for most major corporations. tor requirements more closly. Table 2

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shows a sample of some structuring op- CONCLUSION tions and the associated resulting costs for In order to capture opportunities within this hypothetical project. a company’s portfolio, financial structuring While the present value cost can vary must be an integral part of the approach dramatically, as the results in the table to corporation real estate solutions and demonstrate, cost should not be the portfolio strategies. When integrated, the driving factor alone, because the business number of unique assets requiring di- unit needs to evaluate the cost in the rect corporate funding can be reduced broader context along with operational, dramatically by using real estate market accounting and financial impacts and knowledge, investor preferences and busi- flexibility. ness unit utilisation as a road map. It is imperative, however, that the real estate manager and business unit are prepared to THE DECISION modify their space requirements to en- After gathering the relevant information sure financial and investment community and evaluating the pros and cons of each marketability. In a portfolio, opportunities solution, the real estate manager can make can be captured by studying shifts in the a sound recommendation to the business real estate market over time and convert- unit and the treasury department. The ing that knowledge into lower real estate manager knows that the solution is ac- cost. Using this process, a corporation that ceptable to the marketplace, can provide routinely re-evaluates its portfolio can flexibility in the event of a changed optimise the portfolio’s effects on the business model, and provides the space at corporation’s balance sheet and income the most reasonable cost, both initially statement. and over the corporation’s long-term oc- cupancy. ᭧Equis Corporation

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