Unlocking trapped equity

Shane Weimer
FINANCIAL COLUMNIST

For automotive dealers in Canada, the decision to grow or exit is quickly becoming imperative. While independent dealers and small automotive groups have experienced success historically, they are under significant pressure in a world where consolidation is becoming the norm.

The challenge for smaller dealers often comes down to available cash. What they might not realize is how much equity they have locked away in their real estate and how, using a Real Estate Income Trust (REIT) structure, they can access this equity to finance other investments and acquisitions.

Many automotive dealers recognize that size makes a difference. Automotive groups and owners of multiple dealerships may obtain more attractive rebates from OEMs and use their size to negotiate better supplier contracts.

Larger dealers can also respond more readily to shifting OEM requirements. OEMs today are demanding a lot more from dealers – requiring them to build bigger locations, conduct dealership facelifts and make other operational investments.

Smaller dealers may be challenged to inject the millions needed to address such OEM demands. When cash and financing is restricted, many dealers may believe an exit is their only option.

Equity Trapped in Real Estate
Financing the real estate is the last thing that new or incoming automotive dealers want to think about. When it comes to industry consolidation, buyers generally find it less cash flow effective to finance the land and building; they simply want to acquire the dealership, which typically costs less and provides a better return on investment.

For a dealer principal considering an exit due to the inability to keep up with OEM demands or the absence of funds to grow, the lack of interest in dealership real estate can be a significant barrier. That’s because the owner might have significant equity trapped in the real estate.

This equity doesn’t need to remain locked-in. Auto dealers can use a REIT to realize their trapped equity – and, by doing so, access the cash they need to either modernize their facilities or achieve a growth agenda.

Benefits of a REIT
A REIT, whether it is publicly traded or a privately held organization, focuses on generating income from real estate assets for investors initially through periodic distributions of income and subsequently through an anticipated appreciation in value of underlying assets and accordingly the market value of REIT units.

While the first automotive dealership REIT has only recently been established in Canada, REITs have been used to generate income from real estate in other industries for over two decades.

In the case of auto dealerships, a REIT might own the land and buildings associated with one or more dealerships, while the actual dealership owner pays a lease. The unit holders of the REIT then receive distributions similar to shareholders in other publically traded companies. As land doesn’t typically depreciate in value the same way as other assets, REITs can be a viable method to generate ongoing investment income.

Dealers can transfer their real estate assets to the REIT at cost value and take back shares from the difference between their cost and the fair market value. Dealers can then hold the units deferring applicable tax until they truly want to exit by selling their REIT units.

The transfer of property into a REIT can generate cash in two ways. First, cash can be extracted on roll in of property equal to the tax cost of the property. Second, partnership units issued on roll in of property have the same distribution entitlement as publically traded REIT units, and so can generate additional cash flow from distributions.

Issues to Consider

Cost
Some estimates suggest it can cost several million to set up a REIT, depending on the complexity. Automotive dealers may want to compare the costs of establishing a REIT to those of hiring a commercial real estate agent. In some cases, the cost of establishing a REIT will be far less than hiring an agent to find a buyer, and control of the land may remain with the dealer.

Size
When it comes to utilizing a REIT structure, dealers have several options: set up an independent private or publically traded REIT, work with a group of dealers to create a REIT or sell to an existing REIT. Depending on the size, location and relationships a dealer has, different options may work best. Before making a decision, dealers should investigate and assess which option would best help them achieve their objectives.

Financial Reporting
Whether private or publically traded, a REIT is required to provide continuous disclosures and to adhere to relevant regulations related to financial reporting. In the case of private REITs, this process may be relatively straightforward. However, the public nature of reporting may cause consternation for dealers who may want to use the REIT to raise money and buy more land in the future. As a public entity, information related to the REIT’s strategy will be highly transparent.

Market Risk
Public REITs are susceptible to market volatility as we have seen during recent economic downturns. As a result, the value of publically traded units may not reflect the value of the underlying real estate assets. Instead, the value of the units may fluctuate up and down rapidly in relation to investor pressures and market conditions. Private units meanwhile face less volatility, tied only to the value of the underlying assets.

Human Capital
Most dealers do not have in-house capabilities and expertise required to manage public reporting and disclosures. In addition to appointing a CEO and CFO, dealers may need to hire staff with the expertise to assist with REIT management.

Achieving the full value of a REIT
For automotive dealers, there is a lot of value in consolidation – from improving efficiencies and margin to perhaps having a better bargaining position with OEMs and other suppliers.

To make sure you can get the most value out of setting up a REIT, start by considering the following activities:

• Identify experienced accounting and legal tax advisors to make sure you implement the most effective REIT structure for your needs.

• Determine your objectives: grow through acquisition, make an exit in the future or exit now.

• Develop a REIT plan that evaluates current abilities and identifies skills needed to develop and manage your REIT.

Shane Weimer is a CPA with BDO. For more information, contact him at 403-205-5741 or sweimer@bdo.ca