In both business and real estate, spinoffs can unlock hidden value and increase investment returns. On the business side, you’ve seen private equity firms acquire businesses only to break them up and sell them off in parts. They do this because the whole is less valuable than the sum of its parts. In real estate, you’ve seen entitlement specialists subdivide a parcel into many lots and sell those lots to housing developers (or develop them and sell them off to individual home buyers). When it comes to retail real estate, you can implement a similar strategy to potentially increase the value of a shopping center.
A “breakup” or “spinoff” strategy can be used by investors or developers to both de-risk the investment and juice its returns. In this post, I’ll talk about what a breakup strategy is, how it is executed, and how it can create additional value. This strategy involves some risk and potential challenges, so I’ll touch on those as well.
Breakup Strategy Summary
First off, what is a breakup strategy? It’s when an owner of a property sells the property in parts, rather than as a whole. Aside from single family home development, the most common example occurs in retail shopping centers. Picture a typical grocery-anchored shopping center with shop space, a drive-thru restaurant in front, a drive-thru coffee shop, and another three-tenant building with a drive-thru on the other side, and a pharmacy on the corner. The owner, oftentimes the developer, will break it up by selling the drive-thru restaurant and the three-tenant building to different 1031 private investors in separate transactions. Then, the owner/developer will sell one of the anchors to a net lease REIT, and sell the remainder of the center to a mid-sized private real estate company. This is just an example of how a breakup strategy could be implemented. Note that owners can execute a partial breakup strategy: selling off some of the buildings but not all of them.
Aristotle is Wrong
Aristotle said “The whole is greater than the sum of it’s parts.” This is true, sometimes. It refers to the synergies associated bringing different business units together. This is one reason for business mergers and acquisitions. The breakup strategy is employed when the opposite is true. Now each situation is unique, and in many cases, the whole is greater than the parts–for example, when an investor might assemble several parcels to build a large multifamily project where economies of scale create a scenario when more units equates to higher profits on a per unit basis (and total)–but shopping centers defy this old axiom. In general, the execution of a successful breakup strategy can result in cap rate improvement of anywhere between 75 to 125 basis points. Check out this post for a refresher on cap rates.
Old logic assumes that the whole is greater than the sum of it’s parts. A breakup sales strategy makes sense when the sum of the parts is greater than the whole.Greg Barrett
Example of a Breakup Strategy
Lets use this hypothetical shopping center for our example. You can see that it is anchored by a grocery store. We will assume that this grocery store is on it’s own parcel and can be sold separately from the adjacent in-line shop buildings. Note that there is in-line space on both sides of the anchor. Along the street, you can see there are four pad buildings. From left to right, we have: a 3-tenant building, a coffee shop with drive-thru, a quick serve restaurant, and a pharmacy on the corner. Let’s also assume that we’ve taken all the steps outlined below to prepare for the breakup sale.
Now that you have a visual representation to work off, I’ve summarized in the table below, the basic back of the envelope comparison between what a sale of the entire shopping would look like, versus, what a break up strategy would look like.
You can see from the table above, that selling the whole shopping center would result in a value of $18.62 million; the equivalent of a 7.20% cap rate based on the in-place NOI. If you were to break up the asset and sell each of the buildings separately, your total value is $22.197 million; the equivalent of a blended cap rate of 6.08%; or cap rate compression of 112 bps. That’s a significant pop in value!
You don’t always have to pursue a full breakup strategy. Oftentimes a partial breakup strategy can be all that is necessary to de-risk the investment by reducing your basis and lowing your debt service. By only selling off a few of the buildings, you maintain more control over the center. See the table below to see the comparison between your debt risk when pursuing a partial breakup strategy.
I’ll deconstruct what I’ve done above. For simplicity, we will assume our basis in the property is equal to the full shopping center value. If we sell off pads 1-3 (highlighted in grey in the BOE analysis table) then we are left with the results in the right column. Typically, the loan will have a release provision that will require you to use all the net sale proceeds to pay down the loan principal. When we sell those pads and use the proceeds to pay down a portion of the loan, we arrive at a principal of $4.8M. Our NOI has decreased because we are no longer generating income from those pads, but we’ve reduced our debt service payments significantly, which has reduced the riskiness of the loan.
Benefits of Pursuing a Breakup Strategy
- Reduce basis and de-risk the investment. The disposition proceeds go toward paying down the debt. This deleverages the project and improves the loan-to-value ratio, the debt service coverage ratio, and the debt yield. This means your debt service payments become less burdensome.
- Accessing a larger and more motivated buyer pool drives up value. Private investors are plentiful and will pay more (lower cap rate) than firms that would buy the whole project. There are more buyers seeking properties in the $1MM-5MM dollar range than the $15-30MM dollar range. On top of that, buyers attracted to the pieces are generally exchange buyers who are willing to pay more for an asset to satisfy their exchange requirements. The buyer pool for full shopping centers continues to decline as REITs, PE firms, and other institutional investors move away from multitenant retail. More on this below.
- Improved IRR and ability to make distributions to investors sooner. Since IRR is sensitive to the timing of cash inflows and outflows, the sooner you can sell the properties the better the IRR could be. Additionally, if you’ve sold enough assets to pay down your debt (which isn’t the case in this example until you either sell the anchor box or everything but the anchor), then you could make larger distributions to investors.
Challenges & Risks of Pursuing a Breakup Strategy
The breakup strategy doesn’t come without its own set of challenges. Don’t be persuaded that the risks outweigh the benefits simply because I’ve listed more of them. Whenever executing any CRE strategy, it is vital to consider every potential risk before executing.
- Loss of stable revenue. The revenues you’ve lost when you sell off the high-quality parts of the asset mean that you are left with more risky tenants and more challenging real estate. In other words, you are getting rid of your consistent cashflow by spinning of high-value pieces at low cap rates. This will leave the asset less secure and stable.
- Inability to dispose of last parcel(s). Generally, the quality parts of the center sell quickly and at high prices. The challenge lies with the portion of the center that is less attractive to potential buyers. This is typically the shop space in the back or land parcels that have flaws. If your goal is to complete a full breakup of the asset, then be sure that there is a buyer pool for each of the parts. The last thing you want is to sell everything off but be left with a few parts of the asset that don’t generate much or any revue that linger unsold for an extended period of time.
- Loss of Control. When you are no longer the owner of a property you lose control over it (e.g. how it is maintained and operated) and you lose a sense of cohesion with multiple property owners. The more individual owners at the shopping center, the less control you have over what happens.
- Entitlements. You will need to go through an entitlement process to create separate parcels for each building you wish to sell. This process can be relatively easy, but can become very complex and expensive in other cases. You’ll also need to pay venders (architects, civil engineers, etc.) to help you with the process. It can take several months to a year to complete the process. For example, you may have to convert water from public to private, which can be lengthy and costly.
- CC&R Challenges: It also get’s messy when you have to figure out the CCR’s with multiple owners. You’ll likely have to form an association at some point–meaning that you will outsource the common area management to another organization. If you still own parcel(s), then you are no longer in control even though you can typically still be the declarant. More on this below.
- Accounting Challenges: The accounting associated with multitenant retail properties is complicated enough. Add in multiple dispositions, multiple owners, and the transfer of CAM budgeting/accounting to another entity: you have a lot of accounting work to be done. In one instance, I formed an association and transferred the budgeting and accounting to an association that was formed. I had to work with their accountants and answer their questions up to a year after the association was formed!
- More work and expenses. Since a breakup strategy involves a lot of steps that require the expertise of attorneys, accountants, brokers, asset managers, property managers, etc., it creates a lot more work than simply selling the property as a whole. I delve into some of the steps required to effectuate the breakup strategy below, which will give you a better understanding of the common steps involved.
Preparing for a Breakup Strategy
Investors considering a breakup strategy need to think through the steps required to successfully execute the breakup disposition process.
Lender Requirements. Make sure your loan allows you to sell off individual parcels. Many loans, especially CMBS debt, will not all you to sell off a portion of the collateral.
Entitlement. The owner of the shopping center must go through a parcelization process in order to sell off each of the buildings individually. You need to make sure that each of the buildings you wish to sell are on individual parcels. You cannot sell buildings individually if they are on the same parcel. Bring in an experienced entitlement specialist to help with this process. It can take several months up to a year (or more) to complete the parcelization process; so start early.
CCR Modifications. You may need to amend the CCR’s to allow for parcels to be sold. You want to be sure that you bring in competent legal counsel to review these documents, and modify them if necessary.
Get the Property Sale Ready. Before you put properties on the market, you want to make sure you’ve done everything you can to enhance their value. This includes making cosmetic repairs like new paint, new LED lighting in the parking lot, seal and stripe the parking lot, and improved landscaping. You also want to make sure you have a strong merchandising mix, occupancy rate, and that you’ve renewed the major tenants in the buildings you wish to sell so that they are on long-term leases.
Once you’ve done this, you can put the properties you wish to sell on the market. If you are pursuing a full breakup strategy and intend to divest of the asset, then you will need to transfer management to a new owner or form an association.
Transferring Management Responsibilities to an Association
Real Estate Associations
One of the consequences of performing a break-up strategy is the requirement to transfer management of the shopping center operations and finances. Typically, shopping center owners are responsible for overseeing the operations related to common area maintenance, capital expenditures, budgeting and financial oversight. When an owner sells off all or most of the shopping center, he will not want to continue to be responsible for managing the center’s operations and finances. As a result, the original owner of the shopping center will typically form an association and transfer management of the shopping center over to all of the owners.
CCR’s & the Formation of an Association
The purpose of the association is to operate and manage the common areas, common area improvements, manage the finances [including budgeting, collecting CAMs (common area maintenance charges), paying expenses, and otherwise enforcing the CCR’s]. CCR’s (covenants, conditions, and restrictions) is the document that lays out the rules and regulations of the shopping center and how it is to be managed. Typically, the declarant (the owner of the shopping center) will relinquish control of these rights responsibilities to the association. To properly set up an association, the owners generally need to do the following before the transfer takes place: (a) nominate members to the board for appointment; (b) appoint officers; (c) obtain a Tax ID number for the Association; (d) open bank accounts; and (e) if desired, hire a management company.
The shopping center owner (declarant) will reconcile accounts of income and expenses as of the date of the transfer. This is called the “reconciliation”. Surplus funds are paid to the association for its operations moving forward. Oftentimes the final CAM reconciliation will be done after the books have closed for the last period of time the owner managed the operations of the center. Note that this transfer from declarant/owner to the association is very similar to what would happen in a disposition, from an accounting perspective. Always hire a competent attorney experience in these matters when forming and association and transferring rights and responsibilities. Not only should you consult them to stay protected, but you will need an attorney to draft the proper documentation in order to legally effectuate the action.
CAM Management & Declarant Rights
You can bifurcate the CAM management (aka association) rights and responsibilities and the declarant rights. Typically, even if you have just one parcel left, you will want to have as much control over the center as possible; therefore, you will want to retain your rights as declarant. Therefore, you will often want to form the association and transfer CAM management rights and responsibilities. As part of the association formation, a director will be appointed to manage the association. You will then typical transfer your declarant rights when selling the last building; this will then completely remove you from involvement in the operation of the center. Many times the association will hire a property management company to handle the management of the property common areas and finances.
Simply Assigning Responsibility
Sometimes the transfer of rights and responsibilities is much more simple. On one retail breakup I was involved with, the CCR’s indicated that the rights and responsibilities of declarant would automatically be deemed assigned to the owner of the lot(s) which contained the most floor area. The most important thing to do is review the CCR’s because they will govern how an assignment of declarant and CAM management rights is to take place.
Hopefully, this process appears simple and straightforward. At the end of the day, it is relatively simple, but each situation is unique and unanticipated issues often arise. Since it’s not something anyone does on a regular basis, things can easily be forgotten. That’s why it’s always important to have legal counsel guide you through the process.
Advice on Capital Structure/Debt
As I mentioned above, if you are purchasing a property, or refinancing a property, with the intent of implementing a breakup strategy, then type of loan you obtain is critical.
If you are going to purchase or refinance an asset and plan to implement a full or partial breakup strategy, then either don’t collateralize the parcels you wish to spinoff into the primary loan or ensure that your loan has a “Release” clause. The release clause will give you the right to release the parcel(s) from the loan.
Generally, the loan will indicate a specific release price that you need to hit for each building in the center you intend to sell. The lender will typically require that all of the sale proceeds go toward paying down the loan principal. Funds in excess of the release price either go into a reserve account or are applied against the principal balance. Generally, it is best to apply those funds against the principal balance rather than let them sit on the sidelines. When you have reached terms with the buyer, let the lender know that you are selling the pad and that you need a partial reconveyance. Note that you will typically have to pay for the lender’s legal expenses ($500-1,000+) and cover a loan exit fee ( e.g. 1.35%). The lender’s legal counsel will draft a partial deed of release and reconveyance document. They will also draft a “Partial Payoff Quote” which will indicate how much the total paydown is estimated to be based on the settlement statement.
The Bifurcation of the Real Estate Investment Market is Adding Fuel to the benefits of a Breakup
The private investment market in single tenant and multitenant pad buildings was very resilient in the face of COVID-19. Given low projected yields in stocks and bonds, easy to manage net leased properties are trading at a premium. I don’t see this trend changing anytime soon as there is a lot of dry powder and sizeable interest from both domestic and foreign buyers.
The investor/buyer pool for shopping centers, power centers, and neighborhood shopping centers has been in decline for several years. COVID-19 has only accelerated the shift away from investment shopping centers. Institutional investors are staying away from secondary and tertiary markets, except those poised for growth, due to their affordability and business friendly environments. Even though more and more institutional investors are allocating capital to CRE, they are only interested in the best shopping centers in the best markets when it comes to retail..
The simple laws of supply and demand play a role in the success of the breakup strategy. By taking an asset from a low demand environment, to one of high demand, you’ve just increased the value.
Current Market Conditions
10-20 years ago, while e-commerce was in its infancy, there was a large investor base for shopping centers. Right now, and likely into the future, the shopping center buyer pool is very limited. Cap rates for shopping centers will likely expand due to COVID-19’s impact on the sector, which as of this writing has not hit it’s trough. However, demand for net leased properties by 1031 buyers and private capital remains robust, keeping cap rates near historic lows. If you own a shopping center that you bought at a 7.5 cap, you could spin off the pads at 4 to 6 caps (depending on the tenant credit, term, etc.). That’s a sizeable spread. By doing so you can reduce your basis and deleverage the investment. As a result, the breakup strategy could be a good option for shopping center owners who plan to divest of shopping center investments. The challenge will be how you handle the remaining inline space. It could be difficult to find a buyer for the remainder of the center. This is one of the biggest risks.
Similar to many private equity companies that purchase businesses and then spin off various parts to achieve greater returns, real estate investors can do the same. Due to the shifting dynamics in brick and mortar retail, changes in capital markets, and the perception of shopping centers in today’s environment, a breakup play could be a viable exit strategy to maximize value. The primary reason shopping center developers and owners pursue the breakup of a property is because the sale proceeds can be greater than if sold together. In other words, by selling a shopping center in pieces, you can realize improved value and returns.
If you are considering a breakup sale strategy, feel free to reach out to me to discuss.