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Opportunities for Action in Infrastructure and Real Estate Building Flexibility into Corporate Real Estate

Building Flexibility into Corporate Real Estate - BCG · PDF fileBuilding Flexibility into Corporate Real Estate Corporate real estate was once straightforward: identi-fy good locations,

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Page 1: Building Flexibility into Corporate Real Estate - BCG · PDF fileBuilding Flexibility into Corporate Real Estate Corporate real estate was once straightforward: identi-fy good locations,

Opportunities for Action in Infrastructure and Real Estate

Building Flexibility into Corporate Real Estate

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Page 2: Building Flexibility into Corporate Real Estate - BCG · PDF fileBuilding Flexibility into Corporate Real Estate Corporate real estate was once straightforward: identi-fy good locations,

Building Flexibility into Corporate Real Estate

Corporate real estate was once straightforward: identi-fy good locations, negotiate long-term leases, and cutoccupancy costs. Those days are over. New conditionsnow apply.

Managers find that steady-state projections of theirfacility needs are quickly made obsolete by new tech-nologies and organizational changes. Executives rec-ognize that occupancy decisions, once seen as ancil-lary to the core business, can have a significant impacton a company’s financial performance. Boards arebecoming aware that if their company’s footprint ismisaligned with its operating needs, harsh penaltiesmay ensue through asset write-downs and space short-ages that impede competitiveness. Investors, who havegrown skeptical of the idea that companies can simplygrow their way out of suboptimal sites, are favoring amore cautious approach to managing assets, margins,risks, and returns on invested capital. Accordingly,companies must abandon their traditional approachto managing real estate holdings as fixed assets.

The quick pace of change and the high cost of faultypredictions dictate that companies build more flexibil-ity into their real-estate portfolios and decision proc-esses. They can use a variety of financial and physicaltools to increase flexibility, such as shorter leases, fre-quent lease breaks, options on adjacent space, andmodular build-outs. However, flexibility always comesat a price—usually in the form of higher lease rates,build-out costs, churn rates, and the like. Moreover,the pricing picture is clouded by a complex, deal-driv-en real-estate supply chain that rewards transactionsmore than long-term value creation. To achieve flexi-

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Page 3: Building Flexibility into Corporate Real Estate - BCG · PDF fileBuilding Flexibility into Corporate Real Estate Corporate real estate was once straightforward: identi-fy good locations,

bility that lasts beyond the lease, companies must takea strategic approach to both evaluating their currentchoices against inherent real-estate risks and calibrat-ing the appropriate degree of additional flexibility.

In short, companies would do well to think of realestate as a flexible resource and—in the mode offinancial strategists—as a financial option that can beused to hedge against future adverse scenarios. Thisconversion presents a twofold challenge: for corpo-rate real estate (CRE) groups, it means revising theirportfolio strategies; for senior management, it meansreevaluating the strategic and financial significance ofthe company’s real-estate holdings.

To fashion a flexibility-based strategy, CRE andfinance executives should

• focus on building flexibility into all decisions about CRE

• understand that flexibility comes at a price

• recognize that flexibility is rooted in probabilitiesand life cycles

Focus on Building Flexibility into All Decisions About CRE

In negotiating for new office or commercial space,real estate executives should prepare for unexpectedgrowth or contraction in the business units and cor-porate functions that will occupy the facility. In TheBoston Consulting Group’s 2005 CRE benchmarkingstudy, 41 percent of real estate executives said thatbusiness unit projections of space demands are typi-cally off by more than 100 percent. Such discrepan-

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Page 4: Building Flexibility into Corporate Real Estate - BCG · PDF fileBuilding Flexibility into Corporate Real Estate Corporate real estate was once straightforward: identi-fy good locations,

cies result from a combination of new businesslaunches, shifts in underlying market demand, andinaccurate forecasting methods.

The value of flexibility in CRE depends on howquickly changes are carried out and how much of a company’s real-estate portfolio is affected. (SeeExhibit 1.)

Traditional

Limited useof such techniques

Primary techniquesto createflexibility

LowValue of flexibility

Incremental growth

Little divergence betweenminimum and maximumneeds

Specialcharacter-istics or catalysts

Timing: very predictable

Amount: very predictable

Predictability Timing: unpredictable

Amount: very predictable

Timing: very predictable

Amount: unpredictable

Timing: unpredictable

Amount: unpredictable

Requiredregulatoryapproval

Pendinglawsuit

Plannedacquisition

Technologicaldisruption

IncreasedM&A activity

Offshoring and outsourcing

Upcomingcost-reductioninitiative

Most in line withtoday’sbusinessenvironment

High High Very high

Expansionoptions

Multipleexpirationdates

Modulardesign

Short leases

Early leasetermination

Expansionoptions

Maximum ability to sublet

All availabletechniques

Timevariable

Amountvariable

Time andamountvariable

SOURCE: BCG analysis.

Exhibit 1. The Value of Flexibility in a CRE PortfolioDepends on the Time Available for Planning andExecution and the Amount of Affected Real Estate

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There are many ways to create flexibility, including

• acquiring options on adjacent land for possiblefuture expansion

• allowing for a higher vacancy level in order toaccommodate unexpected growth

• analyzing the downside risks to both the incomestatement and the balance sheet of various real-estate scenarios, such as leasing versus buying

• entering into shorter leases with more frequent and earlier termination, expansion, and renewaloptions

• coordinating the end dates of leases, subleases, andexit clauses of adjacent spaces

• designing facilities for reuse, subdivision, and sub-lease with minimal customization

• exploring alternative workplace arrangements,including home offices, telecommuting from non-company locations, and shared-office programs

One leading financial-services company is using acombination of these techniques. In 2003 its averagelease term was 17.5 years; it is now negotiating three-to five-year leases and adding lease breaks and exten-sion clauses. Longer-term leases can still work, provid-ed the facility is designed for easy subdividing andsubleasing. But when negotiating long leases, realestate managers must consider the probability thatthe company will need to replace one occupant withanother over time. They must also analyze the poten-tial volatility in real estate market conditions over thelife of the lease.

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Page 6: Building Flexibility into Corporate Real Estate - BCG · PDF fileBuilding Flexibility into Corporate Real Estate Corporate real estate was once straightforward: identi-fy good locations,

Understand That Flexibility Comes at a Price

Executives need to be prepared to pay more in orderto create flexibility. In corporate finance, options areoften used to achieve this goal. The price of an op-tion, according to the Black-Scholes model, increaseswith its anticipated volatility. The corollary for CRE is that the greater the uncertainty in real estate re-quirements, the more willing the company should beto purchase advance rights to change its footprint,build-outs, and financing terms. The idea is not tospend more on improving and converting a facilityover its life. Rather, much like buying an equity op-tion as a hedge, the CRE buyer pays somewhat moreup front to guard against unexpected swings in thefuture.

Higher costs are associated with shorter and non-standard leases, with build-outs that create easilyreusable space, with options for expansion space,and with higher near-term vacancy rates. For onecompany, lease negotiations are managed like newcar purchases: establish a base price and define awide array of options for which the company is will-ing to pay a premium, depending on the degree offlexibility it needs. By understanding the variabilityof a company’s needs, CRE managers can makeintelligent decisions about what they are willing topay. In volatile times, the up-front costs are small rel-ative to the hidden operational costs of having toolittle or too much space or the wrong type of space.

The challenge for real estate executives is to persuadesenior management that fixating on today’s costs oftenproduces much higher costs tomorrow. The task isdoubly difficult because the “savings” from avoidingadverse events in the future may not accrue during thetenure of a company’s current managers. But the tra-ditional approach to managing CRE as a fixed asset or

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a series of one-off leases has manifold hidden costs.For companies with too much space, lease terminationcosts often equal or exceed the full value of the re-maining lease. And the focus of many architects anddevelopers on creating “curb appeal”—expensiveembellishments intended to make speculative build-ings more marketable—can backfire if they skimp onfunctional elements that improve utilization and costeffectiveness. When the novelty of odd shapes andtrendy features wears off, new occupants may requiresubstantial reconfigurations as well as shorter leases,generating heavy expenses for the developer-owner.Those who later must sell or lease out such buildingsbecause of unforeseen changes in occupants’ spacerequirements may lose the excess amount spent onopulent headquarters and customized build-outs.

But the reverse can be worse. In a just-in-time, war-for-talent economy, insufficient infrastructure can causeserious business disruption, forcing divisions to relo-cate unexpectedly and individuals to work in subopti-mal sites. The sanctions for such inflexibility, whichcan run to hundreds of millions of dollars or more,may dwarf the gains from carefully managing occu-pancy costs across the rest of the portfolio—and alsoproduce unintended reductions in productivity,recruitment, or retention rates.

Flexibility is essential because structural changes fromM&A, offshoring and outsourcing, technologicalinnovations, and regulatory scrutiny can quickly over-whelm growth projections. A blue-chip companybuilds its state-of-the-art headquarters, only to mergewith its largest competitor. A financial institutionnegotiates a 15-year lease for a call center and thenshifts the entire function offshore. A retailer spendsyears shoring up its core business, only to be acquiredfor its real estate. And a high-tech manufacturerexpands its plant after winning a crucial contract,

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only to lose the business to a foreign competitor whenthe contract is rebid. Global competition can createor destroy carefully crafted product-market strate-gies—in months. Shorter business cycles—extendingfrom one to five years—are the “new normal.” Realestate strategies that assume straight-line growth rates,incorporate 10- or 20-year leases, and disregard exitclauses no longer match the businesses they support.

The lesson is clear: in CRE, form should always followfunction, and function should be defined with greatflexibility. One powerful way for real estate executivesto frame the discussion about flexibility and costs is totake a life cycle view, suggesting analogies to optionspricing, as discussed above, and creating net-present-value scenarios for real estate commitments (whichwe discuss in the following section). The challengefor senior leaders is to consider how the company’sreal-estate portfolio fits into its overall strategic plan.Much as business strategists increasingly embraceuncertainty and unpredictability in their planning forthe future, real estate executives must persuadesenior managers to support nimble choices for loca-tions, layouts, leases, and overall network configura-tions to fit the new competitive conditions.

Recognize That Flexibility Is Rooted in Probabilities and Life Cycles

More flexibility is intuitively better than less flexibility.But how much flexibility should a company buy—andat what price? Is an early termination clause worth a 1percent or 5 percent lease premium? What should thecompany pay for an option to purchase contiguousspace? The best way to answer these difficult questionsis to understand the financial and operational costs of both overestimating and underestimating real es-tate needs.

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Page 9: Building Flexibility into Corporate Real Estate - BCG · PDF fileBuilding Flexibility into Corporate Real Estate Corporate real estate was once straightforward: identi-fy good locations,

Economists and financial experts have developedmany tools to sort through uncertainty in other con-texts. Net present value, standard deviation, and prob-ability analyses can help shape real estate decisions.But even more than it needs such tools, an organiza-tion needs the strategic capability—and the will—tobreak from the past. By relentlessly decreasing operat-ing costs per square foot year after year, regardless ofhow the business might change in the future, realestate executives may be undermanaging one of thelargest assets on the corporate books. They may alsobe missing an opportunity to engage with top corpo-rate executives about the strategic importance of realestate decisions.

Exhibit 2 depicts four scenarios for a hypotheticalCRE portfolio and the significant differences in thetiming and amount of space required under each.The first scenario shows a traditional approach, inwhich the business plan projects increasing spaceneeds in a straight line over time. The other scenariosare more in line with today’s reality: businesses maybe uncertain of when their space needs will change,what space they will need at a given time, or both.The traditional approach builds in little flexibility,which can create problems if business projections donot come true. In the other three scenarios, recogniz-ing uncertainty allows a company to build in the flexi-bility it will need to increase or decrease space. Inessence, businesses with greater uncertainty in theirreal-estate needs should place a higher present valueon obtaining real estate flexibility.

* * *

To build sufficient flexibility into their portfolios, mostCRE organizations will need to devote a significantamount of time and effort to prepare for the unex-pected. Real estate executives should rely less on expe-

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Page 10: Building Flexibility into Corporate Real Estate - BCG · PDF fileBuilding Flexibility into Corporate Real Estate Corporate real estate was once straightforward: identi-fy good locations,

Traditional real-estate planning

Need varies by time

Need varies by amount

Percentagechangein spaceneeded

–20–15–10–5

05

101520

2006

2006

2006

2006

2015

2015

2015

2015

Need varies by time and amount

–20–15–10

–505

101520

–20–15–10–5

05

101520

–20–15–10–5

05

101520

SOURCE: BCG analysis.

NOTE: The shaded areas represent the potential flexibility of each hypothetical scenario.

Exhibit 2. The Need for Flexibility Depends on aCompany’s Space Requirements

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rience and intuition—honed as their instincts maybe—and more on portfolio visualization, life cycleanalyses, and the other proven techniques of long-range strategy. They should start viewing themselves asstrategists, collaborating with senior managers andbusiness unit leaders to understand and plan forupcoming challenges. Some real-estate organizationsmay need new people, from both inside and outsidethe organization, to institute these new principles.

In the days when real estate managers kept to a tradi-tional straight-line course, the message of “strategyover tactics” could be ignored with a minimum ofrisk. But that time is gone. The message has become amandate. If your organization is still resisting it, younow face substantial risk.

Sandy ApgarOrin Herskowitz

Sandy Apgar is a director, and Orin Herskowitz a formermanager, in the New York office of The Boston ConsultingGroup.

You may contact Sandy Apgar by e-mail at:

[email protected]

To receive future publications in electronic form about this

topic or others, please visit our subscription Web site at

www.bcg.com/subscribe.

© The Boston Consulting Group, Inc. 2006. All rights reserved.

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