The Real Estate Development Game

Back in the 1980s, corporations were enticed into diversifying into real estate development, primarily because of the buoyant commercial real estate markets at the time. The most popular approach was to enter into a joint venture between the corporation and an experienced real estate developer. A favorite joke at the time was characterizing a joint venture as one where the developer brings all the expertise to the venture at the outset and the corporation brings all the money. At the end of the process those roles are reversed. These deals worked because corporations could contribute their tenancy as a way to anchor a major development.

In the early 1980s I proposed a joint venture with Homart, the development subsidiary of Sears. Homart’s primary mission was the  development of retail projects for Sears, but it also did traditional office development. In 1981, Xerox Realty and Homart developed Xerox Centre, a 1.2-million-square-foot office complex in Las Colinas, Irving, Tex., near Dallas.  This was the first development of the newly formed Xerox Realty Corporation and would be the new headquarters location of the Xerox Southern regional office. Over the next several years, Xerox entered into a number of joint ventures with projects in El Segundo, California,  Hartford, Connecticut, and New Orleans, Louisiana among others.

There were several key rules that we had to conform to. First, we had to limit our participation to less than 50% of the over-all project to maintain off balance sheet treatment of the asset. We basically utilized equity accounting  to cover the basic elements of the joint venture. The Xerox business unit entered into a conventional operating lease with the joint venture. In actuality, Xerox leveraged its lease position to secure development profits, realized from refinancing or sale back to the joint venture partner.

We deferred to the development partner to execute the various phases of the project including market studies, environmental impact analysis, traffic studies, etc. With Xerox as an anchor tenant and a guarantor of both construction and mortgage financing, the joint venture enjoyed very favorable lending terms and rates.

So how did this program work out in the end? The economy turned sour in the later 1980s. And many of the Xerox ventures suffered lower tenant demand resulting in project deficits. Xerox disbanded its real estate development effort as well as its broader financial services initiative. Many companies learned the bitter lesson of straying from its core mission by diversifying into financial services including real estate development.

This is not to stay that many companies enjoyed real estate gains from its core business. Retailers like Sears and J C Penney maintain vast portfolios of valuable store inventory. Fast food operators like McDonalds and Burger King enjoy substantial rental income from its franchise operators. And hotel chains also benefit from their property portfolios.

But in general I would caution CRE managers to resist the siren call of real estate development, unless the projects align with corporate strategy and core mission. Only through rigorous strategic analysis, can the CRE manager take on development risk and stray from their primary corporate mission.

Michael Bell

Author Michael Bell

Read posts by Michael Bell from Visual Lease, including accounting for leases under the new standard, lease management solutions and IFRS 15 intercompany lease.

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