Bean-counting: a core skill for CRE executives?

Despite all the value-added corporate performance models, cost still seems to be the key performance monitor in virtually all aspects of business, including property decisions. And a core skill require­ment of all CRE executives is to be able to think and communicate in financial terms. The first challenge for the non-accountant CRE professional is to understand the differ­ence between accounting and finance. Simply stated, accounting is about the past and the historic performance of companies. Finance is about the future and the projected perform­ance outcomes and the risks of investments – whatever these investments may be.

Accounting is all about the past

Accounting is all about the history – that’s generally the case, although there is an ob­ligation to report on future liabilities. The focus is on recording the past actions of the company and reporting strictly in accord­ance with accounting standards to provide the stakeholders with indicators of past performance of the company. Accounting is all about double entry recording, debits and credits, timing of transactions, cash or accruals, disclosure and materiality, and ad­hering to Accounting Standards. Tax impli­cations should not be ignored, but probably fall outside the realms of this discussion.

The accounting back-bone is made up of three financial statements:

• The Profit and Loss Accounts – indicat­ing whether the company’s income for the year exceeded its liabilities
• The Cash-flow Statements – showing how the company has financed its opera­tions
• The Balance Sheet – showing the com­pany’s net position in terms of assets, li­abilities and the owners’ equity.

These statements are generated and audited by teams of young accounting grad­uates and audit clerks doing the prescribed checks and balances to ensure the account­ing principles and standards are maintained.

The importance of the process cannot be under-estimated. The entire capital markets sector relies on these audited accounting results of businesses to give them the confi­dence to provide equity and debt finance to the corporate world. This process provides the liquidity and investment capital needed to keep the world economies running. Real estate transactions – be they invest­ments in leases or freehold ownership pur­chases – can have a significant impact on these financial statements. Given the size of most of the property transactions – real es­tate assets are still often the largest assets on and leases, the longest term liabilities in the balance sheet in most companies – the im­pact of these should not be under-estimated. Any real estate changes, be they relocations, sale and lease-backs or developments, will tend to make noticeable impacts on the fi­nancial statements.

Of all the accounting terms and princi­ples, depreciation – which is a non-cash ac­counting expense and the tax implications, always seems to be a challenge for non-ac­countants and is usually significant in real estate deals, particularly as it relates to ten­ant fit-outs. Many a transaction that may ap­pear to be great in terms of the deal param­eters has come unstuck with the impact of depreciation provisions applied in accord­ance with accounting rules

The CRE executive who is not familiar with accounting terminology, the process and impact of transactions on financial state­ments, cannot expect to gain the confidence of the CFO or, for that matter, the Board. The CRE executive trying to motivate a ma­jor real estate change or relocation without clearly showing the overall financial impact – both from a cash flow and profit & loss perspective – in the business case should not be surprised if the CFO gives the idea the short shift. And the oft-used excuse that the financial team will do the modelling and determine the impact is a cop-out. How can the ideal transaction be negotiated if there is no in­trinsic understanding of the impact of the subtle changes to the deal terms?

Finance is all about the future

Financial analysis is about the future – in­vestments, projected profits and associated risks. The language of finance is all about compounding, discounted cash flow, dis­count rates, risk premiums and future val­ues. Concepts such as the weighted aver­age cost of capital (WACC), risk betas, net present value (NPV), hurdle rates, and capi­tal structures are the vernacular of corporate finance junkies and should not be mysteries to CRE executives. Investment bankers and financiers salivate on these concepts and the riches that can result.

Besides the past and the future, the other major difference between accounting and fi­nance is the treatment of risk. Accounting, because it generally looks at the past only, does not account for future risk. However discounted cash flows are focused on the uncertainty of future cash flow projections. The pricing of the resultant risks of these un­certainties is the back-bone of financing.

Besides making best-possible estimates of future cash-flows, the key challenge in discounted cash flows is selecting the dis­count rate. Usually the risks of the projec­tions are encapsulated into the discount rates – these may be different for the various cash flows in accordance with the associated risks. Selection of the most appropriate dis­count rate tends to be influenced by a variety of inputs such as real estate returns in the market, prime lending rates, bond rates, re­quired returns on shareholder equity, oppor­tunity costs and the weighted average cost of capital.

Most large companies have their own fi­nancial directives which dictate the discount rates that are to be applied. Without a clear understanding of the implications of direc­tives, incorrect pricing for real estate risks may result. Too often, the company WACC is applied to highly risky speculative assump­tions about real estate values in the future – often leading to erroneous decision-mak­ing unchallenged by the CRE executive.

Many CRE executives have cut their teeth in the real estate valuation and supply side of the property market, and are now on the other side of the divide. They are usually adept with these concepts and calculations, although it should be noted that methods as applied have usually been adapted. Quite of­ten a CRE discounted cash flow analysis pro­vides NPV results that are all negative. Surely this is a strong case to reject all options under consideration? But many CRE decisions such as buy-versus-lease, alternative leasing and incentive options seldom modelled the in­come – and thus the decision rule reverts to the NPV that is least negative.

Ratio analysis is the benchmark

Pulling together the accounting and finance sides of bean-counting is ratio analysis. These ratios are the benchmarks of the fi­nancial and accounting fraternity. Included are:

• Market value ratios such as earnings per share, and price/earnings ratios
• Profitability ratios such as gross profit margin and return on assets or equity
• Liquidity ratios such as the current ratio.

These financial benchmarks are often the key to constructing defendable business cases for major real estate decisions.

Besides understanding the workings of accounting and finance and how real estate transactions might impact these, it is also important for the CRE executive to under­stand the financial priorities of the company, and the CFO in particular. For example, a significant sale and lease-back at the top of the market may appear to be a great real es­tate transaction, but is hardly likely to be ac­ceptable to a CFO trying to reduce recurrent operating costs. A once-off capital boost may be ignored by market financial analysts, whereas a sustained reduction in the recur­rent costs of the company may result in a positive re-rating.

Understanding the corporation’s financial statements and the impact that real estate transactions will have in the performance reporting of the company is now an essential part of CRE skills. Being able to communicate with the CFO in corporate finance terms, and under­standing the company’s primary financial imperatives, is critical in creating business cases in support of real estate transactions that are likely to be approved at Board level. Those CRE executives from a non-account­ing background should now be enrolling in night-school at business colleges to remain relevant and to be heard by the Board.