Real Estate Trends and Strategies for Manufacturing Leaders

The pandemic highlighted a number of supply chain issues for companies around the world and exposed various business risks. For a period of time some businesses had minimal inventory and excess warehouse capacity. However, as fears arose for businesses not having product available, companies purchased additional inventory often at inflated prices and pushed the warehousing space to its capacity, all of which had a significant impact on the cost of real estate.

While our focus will be on the manufacturing and distribution industry, the real estate concepts we will discuss are also applicable in various ways to other industries. Joining me today to discuss real estate challenges and strategies in the manufacturing and distribution industry is Andrew Zezas.

Andrew Zezas is a corporate real estate advisor and real estate subject matter expert. As founder and CEO of Real Estate Strategies Corporation, Andrew leads a team that solves the operating and financial needs of public, private, private equity, and tax-exempt clients, enterprise, and middle market companies. Senior executives have relied on Andrew to provide business and real estate guidance, create strategy and lead sophisticated acquisitions and dispositions of occupied corporate facilities regionally in the Americas and globally.

Real Estate Strategies Corporation advises CFOs, management, and boards, in achieving greater operational and financial excellence in buy-side M&A, in maximizing enterprise value in sell-side M&A, in transformations and turnarounds, in devising intelligent portfolio strategies, and in planning and executing facility acquisitions and dispositions nationally and globally. Welcome, Andy.
Andrew Zezas:Travis, thanks very much for having me today. This is a very exciting program. I appreciate EisnerAmper inviting me to participate and looking forward to chatting with you.
TE:Andy, my first question to you is, as a corporate real estate advisor, what challenges are you encountering in the manufacturing and distribution sector?
AZ:Travis there's an awful lot going on for that particular sector. We don't need to talk about what transpired in the pandemic, but what's going on these days from pending recession to inflation to supply chain issues that most leaders thought they had encountered by adopting a more robust inventory style that, based upon a receding economy, is not working. There's an awful lot going on.

From a real estate perspective, however, those business challenges create facilities and real estate management challenges as well. Those companies that are involved in distribution manufacturing are seeing very significant constraints in the supply of warehouse distribution and manufacturing facilities with prices increasing steadily and the trajectory expected to continue. Those very same companies are seeing just the opposite when it comes to their office space, given the changes in work styles and employee work demands, whereby most of those companies have very significant surplus facilities in the office sector. So the dichotomy between the two is creating a lot of havoc for a lot of great companies.
TE:How have recent real estate supply and demand affected the growth and stability of M&D companies?
AZ:Well, it's a similar answer to the question I just answered in that with some more complications in that from a growth perspective, when you're dealing with a recession and inflation and should we have just in-time inventory or less inventory, how do you figure out how much warehouse you need? How much distribution space you need? How much manufacturing space you need? It's a very, very challenging environment.

Moreover, the very basic principles of real estate and the fundamentals of real estate, whether a company owns or leases, is that real estate tends to be a long-term business. And with the very rapid changes that business and industry, specifically in manufacturing distribution, has seen over the last few years and what's expected, especially over the coming three or four quarters long-term in concrete transactions is a term that's very used very often when talking about long term leases and purchases over real estate. Very difficult when your company has to be nimble. When a company needs flexibility to grow and react and take proactive steps to ward off challenges associated with a recession, inflation, and the other things we mentioned, it's very difficult when you're required to hold a building for a long term, and sign very long-term leases.
TE:And you mentioned concern about the next three or four quarters, and with the recession looming, what steps can M&D companies take to redeploy their facilities to stabilize themselves so they can withstand what's about to happen?
AZ:That's an excellent question. Looking back at those sectors again, even though we're talking about M&D companies, those companies typically occupy multiple types of real estate. And when it comes to inventory management, it's tough to empty a warehouse when you're having challenges moving your product.

So from the perspective of managing warehouse and manufacturing space, the answer really comes from whether management is taking a short, intermediate, or long-term view of their business. If they anticipate that they'll come out of this recession intact, probably changed, but intact, then the recession is a short-term thing that needs to be managed in one manner. If the anticipation is that the recession will materially affect the company, then they'll need to manage their inventories as well as their warehouse and manufacturing space much more aggressively. And that'll be different for every company.

When it comes to office space, the anticipation is that the changes that have occurred over the last few years in employee work styles in the office will not materially evolve to the point where a lot of that office space will be required. So given that the recession and what's going on today is really about weathering the storm, then battening down the hatches and reducing cost and driving toward greater efficiency will be really important to those companies. And in that regard, disposing of that surplus space in any cost effective manner will be of tantamount importance.
TE:So Andy, I'd just like to get you to elaborate a little bit. So we talked a little bit about a risk of companies, maybe on the downside, they have to get rid of some real estate. So for those privately held M&D companies and other companies that are considering divesting, selling, transforming, their businesses, how can management protect their ability to achieve enterprise value?
AZ:Well, when you're anticipating a divestiture or an out and out sale, first of all, it's important to understand the nature of the expected sale. Is management planning that their primary sale objective will be to a strategic partner or to a private equity partner or some other type of partner, respecting that each of those transactions has a whole different personality to it. And resultingly, the real estate and facilities component of those transactions will also similarly have a different personality, meaning the following.
If a company is planning on selling, again, either the entire company or just divesting of a business unit, for example, if the company's planning on selling to a strategic partner, well, that strategic partner may only be interested, may only be interested, in acquiring the IP and perhaps the sales list, the customer list, and picking up the operation and moving it out of its current facility back to the mothership in some other state, for example, or consolidating it into another facility that the company may occupy.
In that case, it's likely that the real estate that the seller occupies may not be needed. If a company, on the other hand, was planning that its primary sale objective would be to a private equity company, then there's a greater likelihood that the new owners would keep the company in place and therefore the real estate would be required.

So in the case of those two types of transactions, the real estate would have a very different effect on the sale. In the case of a sale where the real estate's not required, will it have a devaluing effect on the overall transaction by virtue of the real estate having to go along with the sale, it may derail a transaction. So a plan needs to be put in place, if that's the primary sale objective. A plan needs to be put in place in terms of how the sale can proceed, perhaps without the real estate, perhaps with the real estate at a deeper discount.

Or, is there an alternative that the seller can proceed through with respect to retaining that real estate? Is there a whole other business opportunity associated with retaining and possibly repurposing that real estate? In the case of the private equity acquisition, that's a whole different ball of wax because you want to make sure that if the private equity buyer is the likely buyer for the business or the divestiture, then it's important to make sure that the real estate that comes along with the sale, we'll in fact support that kind of transaction. And if the anticipation is that the buyer will likely want to keep the real estate in place for the long term and is only a short-term lease involved, well then perhaps a plan should be put in place for that lease to be modified post-acquisition or it maybe it's best to proceed to modify it before even going to market.

Similarly, if there's real estate associated with the sale that is owned by the entity that'll be sold, is it likely that the buyer will want to acquire owned real estate? So all these things need to be figured out before going to market so that the proper plan can be put in place to support the type of transaction and make sure that the transaction doesn't get derailed, but actually goes through and that the sellers can realize the greatest enterprise value on the transaction.
TE:Thank you, Andy. I think you addressed a number of areas that a potential seller has to consider as they go through a potential sales process. And while you were speaking, you alluded to a little bit about purchasers. So you and I both have a number of relationships with CFOs who, while there is a downside to a recession, there's also the opportunity for some companies to maybe enhance shareholder value.

So for those entities that have the capital to make an acquisition, whether it's a private equity firm, a venture investor, or any other company. For those people seeking to make strategic acquisitions, what risks might be hidden in the facilities that would come along with those acquisitions and how can buyers identify and mitigate those risks?
AZ:Travis, despite what's coming in the recession or what we're being told is coming, the private equity world still has what they call an awful lot of dry powder. There is an awful lot of money waiting in the wings for beneficial acquisitions. And given that a number of companies will be asking themselves if they should be divesting or selling, I think the opportunity for acquisitions will be tremendous.

It's important to recognize that when you're in an M&A transaction, irrespective of the state of the economy, most M&A deals move awfully fast. So it's easy to miss important aspects of a transaction and to overlook. And real estate typically does not get a primary focus, unless of course, it's a real estate acquisition. But in the average M&A transaction, real estate's thought of as a second thought at best. And in many cases, it's just kind of reviewed on a check-the-box kind of basis and considered as unimportant to an a buy side deal as desks and computers. It's just one of the assets of the company.

Well, in fact, real estate because of some of the reasons we mentioned earlier in the podcast, real estate can be rife with very substantial risks and even substantial opportunities that if they're not uncovered prior to closing, risk tends to linger and tends to stick around and very often gets worse over time if it's not identified and mitigated. Opportunities have the opposite, in effect, they tend to go away.

So from a risk management perspective, it's imperative that an acquirer in a buy-side transaction take a deep dive not only into the documents but into the physical real estate itself to identify whether the transaction structure is in fact an appropriate transaction structure to support the ongoing operational excellence that's intended for the transaction.

If you look at a lot of privately held companies, they are rightfully, during their growth, during their evolution leadership, if they're advised by good professionals, and many are, they're advised that they should own the real estate that they occupy. This is specific to privately held companies, and that's a, that's good advice.

Privately held company should consider owning its real estate and very often should own it. And what happens very often is the entrepreneurial owner will set up a realty company buy a building and lease it to his or her operations. And very often that structure will be a simple structure because it's an operating company leasing from a landlord, both of which are owned by the same entrepreneur. And those transactions tend to be very simple, and that transaction tends to be structured to the betterment of the realty company for tax and financing purposes and very often to the detriment of the operating company. But it's not unethical, it's not illegal. In fact, it's the right way to structure it for the benefit of the entrepreneur.

But if that type of transaction were to be completed in an arms-length manner with separate entities under landlord and separate entities under tenant, the type of transaction that we typically see in that instance would never be approved by professional managers.

And even though, for the entrepreneur, it's the right kind of structure. Well, what happens 10 years later, that entrepreneur goes to sell the business and because of the very simple due diligence that most deal advisors go through from a real estate perspective, going back to what I said, real estate tends to be a second thought at best, the due diligence is not there, and those risks and the opportunities don't get identified and the risks, again, tend to hang around and the opportunities go away.

It's more than, from a risk perspective, it's much more, Travis, than is the least structured at the right rental rate. There are commercial leases of the type that I just described when an entrepreneur signs with himself or with herself that we see them as being frequently very, very simple documents, 10, 20 page leases. Well, commercial lease for a corporate facility, whether it's office or industrial or distribution, can be 75 to 150 pages because as an awful lot of stuff in there that's necessary when you're in an arm's length transaction to protect the parties.

Well, that entrepreneur doesn't worry about suing himself. So he goes into very, very simple documentation. So a deep dive into the documents to look for risk profiles like casualty clauses and insurance clauses and estoppel clauses and renewal options with specificity to protect the interest of the new occupant, the new tenant that acquires at least is very, very important.

But then digging deeper beyond the transaction is understanding the facility itself. Will the facility support the intended acquisition going forward, or is it something that the buyers should have removed from the transaction because it won't support the intended acquisition going forward?

And what's going on in the marketplace with that facility? Is there a brand new high-rise being developed next door that will actually be accretive to the value of the real estate that'll be acquired as part of the transaction? Or is there a toxic waste dump being built next door that'll have a detrimental effect?

Those kind of risks and opportunities should all be identified by the buyer prior to closing because if there needs to be an adjustment in the transaction or an adjustment in the valuation, then that needs to be identified and addressed and determined if it's significant enough in advance of closing.
TE:Andy, thank you for those comments regarding risks and opportunities. Just wanted to highlight, you and I have had a number of conversations where it's important to recognize there's a buyer and a seller, and the lessor of a property might be somebody different than the selling business, and that might create opportunities for the buyer just knowing who the seller is and in case, for example, are in some sort of financial difficulty.

So the next question I have for you, Andy, is we alluded to earlier about the whole changing workforce. So what steps can companies take to balance changes in employee work styles and preferences with the need to drive down inefficient facility costs and reduce facility footprints?
AZ:That's a great question, Travis and an awful lot of smart people have been spending an awful lot of time trying to figure this out. And with what's happening today in the economy with the expectation of recession and the inflation that we're been dealing with and all the other things that are going on that are taking up a lot of leadership's time these days, a number of companies are beginning to experience layoffs. So the expectation in those companies is that they're a lot of their surplus office space will grow by virtue of those layoffs. Other companies are struggling to figure out creative ways to bring employees back to the office and have sent them to come back. But the reality is this, the change has occurred. The expectation or the hope that office occupying companies will have an opportunity to revert back to the kind of full occupancy that they had prior to pandemic.

I don't believe that to be a practical approach. Others may differ. This is really my professional opinion. I don't believe that we're going back to that anytime soon. That said, most companies that occupy office space, whether it's a lot of office space or little, and whether it's in one location or multiple locations, the effective utilization of office, whether your employees are coming in once a week, twice a week, three times a week, varying types of schedules and different departments occupying office space differently. The overall effective utilization of office space these days is anywhere from about 20 to 40%. So let's pick a number in between just for this conversation. Let's say 30%. That means on an employee basis, companies are paying more than three times the contract rental rate that they anticipated on a per-employee basis. That's a huge amount of money. And how long does that go on before leadership finally puts a stake in the ground and says, "We've got to make a change?"

There's an awful lot of surplus office space being carried by companies these days. Now, from a cost perspective, one could say, Well, they still have the same number of employees if they're not engaged in significant layoffs, and they contracted for that office space years ago based on that number of employees, so they're no worse off than they were.

Okay, that could be true on one level, but the reality is they no longer need that space and they likely will no longer need that space. So it's time to fish and cut bait, if you will, and it's time to find a way to get out from under the surplus office space, whether the local sublease market is robust, which is a real challenge in many markets or whether it's negotiating to terminate and cut a check with the landlord and move on or finding some alternative use for the office space.

Interestingly, we're seeing some landlords in metropolitan markets converting office buildings that, of course, are physically convertible to alternative uses like residential apartments, condominiums, co-ops, hotels. We're seeing office buildings being raised and converted to industrial distribution manufacturing facilities, condos and co-ops. Of course, in some cases retail space.

We're also seeing large suburban buildings that have high ceiling heights and broad column spacings and large floors being converted for alternate use such as distribution and light manufacture. So there's more than one way to skin a cat. And from a leadership perspective, given all that's happened and what's coming for many companies, it's time to put a stake in the ground and move on from the hope that the office space will be repopulated again the way it once was, and to drive greater efficiencies and mitigate that cost as quickly as possible.
TE:Andy, you've run us through a lot of risks and opportunity related to real estate, and for a lot of companies it definitely appears that it's more than just a side job for an individual at a company. Have companies historically utilized real estate experts in the appropriate manner? Has the timing been right? Or are companies leaving some money on the table by not addressing the real estate portfolio that they have?
AZ:What Travis, another great question. When it comes to M&A, as I said before, real estate facilities tends to be a second thought at best. And in many cases, it's really left to be one of the last items on a list, and it's frequently treated like desks and computers and paperclips. Just another thing on a long list of things to be addressed in an M&A transaction.

So the short answer is, it's our opinion, and the opinion of many folks that we've spoken to in the M&A world at CFOs and even corporate development executives, that real estate tends to be missed as an opportunity to drive better deals, both on an acquisition and disposition divestiture perspective.

So in both buy-side and sell-side, and there are a lot of bright people on the deal side and most have a working knowledge of real estate, but it's been our experience that attorneys don't do a deep dive into real estate either on a buy-side or the sell-side.
It's our experience that a lot of deal advisors also don't do a deep dive, the kind of deep dive that we talked about here today. And as a result, their clients tend to miss out on identifying and mitigating sometimes very significant risks and identifying and capturing sometimes significant opportunities.

Now to be clear, every M&A deal will not be significantly impacted by real estate. In some cases, real estate truly is insignificant. If you're buying a multimillion-dollar business or a multi-billion-dollar business that was created in a garage by two geniuses, the likelihood is there's very little real estate, if any. But when you're talking about manufacturing and distribution, there very often is real estate and it can be significant. So the correlating risks and opportunities could also be significant. And isn't it the smart approach to buy-side and sell-side to ensure that either the buyer or the seller in this case, depending upon who you're representing, has done their due diligence and has either identified those risks and opportunities or confirmed that either they don't exist or they're insignificant and wouldn't be impactful on the transaction.

That's the whole thrust of real Estate Strategies Corporation to identify if those risks and opportunities exist. Evaluate them in the context of the deal itself and our client's objectives. And then to advise our client whether we think they're significant enough to address and then advise our client as to how to address them, and then collaborate and cooperate with our client and their deal advisors to make sure that if, in fact, the risks of the opportunities are significant, the risks are mitigated and closed down and the opportunities are captured before the transaction gets completed.
TE:Andy, as we are about to wrap up, are there any additional closing comments you would like to make?
AZ:Well, I think EisnerAmper is in the forefront of this concept. Like a lot of other concepts I've seen really good intel coming out of EisnerAmper repeatedly year after year. And the fact that you're reporting on this issue for manufacturing distribution companies just tells me that EisnerAmper is still out there doing a good job thinking in advance and providing great insight to its clients.

I greatly appreciate the opportunity to share my thoughts with you today. I thank you very much for inviting me and look forward to feedback from your audience.
TE:Andy, I also want to thank you for your time today and thank you all for listening to this episode of Manufacts and Perspectives in EisnerAmper's podcast series. Visit EisnerAmper.com for more information on this and a host of other topics. And join us for our next EisnerAmper podcast.

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