Real estate alternatives deals often require the buyer to make an important decision: will they opt for a traditional sale and leaseback, or create an operating company/property company deal (OpCo-PropCo) in which a company is divided into at least two parts: a property company that owns all the real estate and assets associated with generating revenues, and an operating company that uses those assets to generate sales.
The latter strategy has had mixed results over the last few years with some well-known success stories, such as Blackstone’s overhaul of Center Parcs (see box), and high-profile failures, such as the 2011 collapse of Southern Cross Healthcare, where high rental levels became unsustainable and the business became insolvent five years after splitting into a PropCo and an Opco.
The rationale for OpCo-PropCo structures is that a firm could theoretically acquire a company, which had good underlying real estate assets, trade the real estate and then end up owning the business for free, says Keith Breslauer, founder of UK-based private real estate firm Patron Capital.
“So the thinking was: very stable cash flows in the underlying business, you convert them into a lease, create a PropCo as a result and then sell the real estate into a market that values the property far higher than the company,” said Breslauer.
Breslauer points to UK financier and founder of private equity firm Terra Firma, Guy Hands, who became the UK’s biggest pub landlord following a series of acquisitions in the late 1990s.
Accrediting him as setting an example, Breslauer recalls how Hands created operating entities to lease the property from property companies which could be sold for more than he paid for the whole business. Doing so, he was able to keep the operating entities from which he could make further profits.
Jos Short, founder of pan-European asset management firm Internos Global, which has a minority position in the operating business of a German student accommodation business, and former executive of Pramerica (now known as PGIM), which backed Big Yellow storage in the US and Sunrise Senior Living in the UK, highlights potential negative factors which can arise from owning and managing the OpCo.
“It is difficult being a passive investor when you are sitting on an operating company because you are typically, in racing terms, riding a stallion,” he says. “The nature of the beast means they move very quickly, are very entrepreneurial, set strategy very quickly and are on a steep growth trajectory. Much depends on whether you are a minority or a majority investor.”
“But let’s say you own a majority: you have to control the board who have got to set remuneration and you have got to have strategy and financing. You have really got to be a private equity businessperson and that does not necessarily sit with traditional real estate fund managers,” Short adds.
Some say the relative advantages and disadvantages of the OpCo-PropCo structure balance out. Benefits include efficient capital structure, greater proceeds to the owner and better valuations.
The major concern in the OpCo-PropCo strategy, according to Breslauer, is that the PropCos have to be careful of not overburdening the OpCo with too high or too restrictive a lease.
“OpCo-PropCos are a great idea when someone will pay you a lot of money for a stable cash flow and at the same time the OpCo isn’t overburdened, and further that it doesn’t need to change much for growth,” he adds.
For some, alternative assets are not as attractive without the operating company, but Breslauer says the issue is not so cut and dried. “In theory, they can still be attractive,” he says. “The rationale is that the assets in the alternatives are less attractive to the normal real estate investor. Therefore, when you buy an alternative and you free the real estate, you might find buyers who didn’t exist before who will pay you for them.”
Phillip Newborough, managing partner at London-based impact investor Bridges Ventures, asserts that the more the operational complexity within the alternatives sector, the less attractive the OpCo-PropCo structure becomes.
“With self storage or student accommodation, the operational complexities are pretty small, the value-add to the operations is pretty small and therefore they lend themselves incredibly well to these OpCo-PropCo structures,” says Newborough. “The more the operational complexity increases, then the less the smaller component of rent is of your total cost. So care homes for example are really complex to run and a lot more complex than a self-storage unit.”
Owners must also decide whether or not to split the OpCo and PropCo in the first place.
Breslauer believes the main reason for doing so is because of the assumption that you can generate a greater amount of proceeds to the business by creating the division. “You don’t do it when you over-constrain or you overburden the OpCo with this split idea. The reason why people pushed it historically is that they believed they could raise much more proceeds by having a split,” he says.
“I always believe it’s better to hold both” he adds. “Because you are able to play all your different options and potentially achieve a higher value. But ultimately, it is not clear. It really depends on the market, on the specific asset and on the underlying operations, so there’s are a lot of other issues.
Newborough says, however, one negative aspect of not splitting is the potential conflict of interest. “This is where some of these structures have come apart in the past, and led to some car crashes for example in the care home sector,” he says.
“The conflict is between wanting to maximize returns in the short term against having a structure that’s long term sustainable,” he adds.
The case for splitting the PropCo and the OpCo is further highlighted when it comes to valuing the operating element and the real asset element. “If you have a hotel business, and you have both property assets and the operating business in the same entity, then it is quite hard to value,” says Newborough.
“If you have both together, then, firstly, you are trying to blend the value of those two things and there are a relatively limited amount of people who will invest in those things and, secondly, be able to put a value on them,” he adds.
With numerous success stories like Center Parcs and Big Yellow, alternative assets becoming more mainstream plus burgeoning investor confidence in these strategies, expect to see plenty more examples of firms implementing the OpCo-PropCo in the alternative space. Whether they all get the all-important split or not decision right is another matter.
Success story: Center Parcs
In 2006, when Blackstone acquired leisure operator Center Parcs, which owned four short break destinations across the UK, it paid £1.1 billion – £205 million for the operating company and £900 million for the real estate.
One of the key moves that followed was Blackstone’s decision to combine the operating company and the property company. This was seen as somewhat unprecedented at the time as Blackstone had already been successful splitting up OpCos and PropCos.
After doing this, Blackstone invested heavily in the real estate, resulting in more than £100 million being spent on accommodation, restaurants and retail outlets, as well as the development of a fifth site in 2010. By 2009, in the midst of the financial crisis, almost 40 percent of accommodation had been refurbished.
The bullishness of Blackstone to pump significant capital into Center Parcs during Britain’s recession and the global financial crisis paid off in the long run as the firm was able to book nearly 4x its initial investment with an eventual £2.5 billion sale of the business to Brookfield in June 2015.