case 2

9-804-012

R E V : A P R I L 2 2 , 2 0 1 3

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Professor Arthur I Segel and John H. Vogel, Jr, Adjunct Professor at the Tuck School of Business at Dartmouth College, prepared this case. For a related case, see “Shady Trail,” HBS No. 899-143. HBS cases are developed solely as the basis for class discussion. Certain details have been disguised. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2003, 2004, 2005, 2006, 2008, 2010, 2012, 2013 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means— electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

A R T H U R I S E G E L

J O H N H . V O G E L

Holt Lunsford Commercial

Holt Lunsford glanced at his remaining schedule for the day and heard his stomach growl. Sandwiched between an 11:00 a.m. conference call and an afternoon strategic planning session was a lunch meeting with his long-time client and friend, Ned Staton. Lunsford, CEO of the Dallas-based commercial real estate services firm Holt Lunsford Commercial (HLC), was looking forward to sharing some good ol’ Texas-style barbeque—and some real estate advice—with Staton. Two days earlier, Staton, who owned Staton Tees, a wholesale T-shirt distribution business, had called Lunsford seeking a solution to a classic real estate dilemma: should a company own its headquarters facility, or lease it?

Holt Lunsford Commercial provided property management, leasing, development and other real estate-related services to owners and tenants of industrial and office buildings. Lunsford founded the firm in Dallas in 1993, and soon had established a prominent regional presence, opening satellite offices in both Houston and Fort Worth, Texas. By 2012, Holt Lunsford Commercial was responsible for the management or leasing of over 44 million square feet of property, and the rapidly growing firm employed over 100 people, including an increasing number of MBAs, a group Lunsford liked to call his “young guns.”

As he prepared for the lunch meeting with Staton, it occurred to Lunsford that he’d better bring along one of those MBAs. There were numbers to crunch, sure, but this lunch with Staton, one of the firm’s smallest but most loyal customers, might provide a number of valuable lessons. In their earlier phone call, Staton had explained his predicament to Lunsford. Staton’s lease of Welch Center, the 100,000-square-foot warehouse/office property that served as headquarters for Staton Tees, was due to expire at year’s end. Staton wanted to know if he should renew the lease or perhaps pursue other options, such as buying the property outright, or even developing a build-to-suit facility. Lunsford had previously negotiated several leases on Staton’s behalf, but had yet to help Staton purchase or develop any facilities, so the lunch could ultimately expand their business relationship.

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Lunsford approached Celia Marquez, a “young gun” he hoped might one day help launch a Holt Lunsford Commercial office in Memphis, Tennessee, or perhaps Atlanta, and said, “Hey Celia, are you in the mood for some barbeque?”

The Commercial Real Estate Service Industry

As markets began to stabilize in 2009, commercial real estate in the United States had a value of approximately $11 trillion.1 Often sitting between owners and users of properties were third-party firms like Holt Lunsford Commercial offering a range of management and transaction services. Over 10,000 such firms existed and competed in a $50 billion market, offering real estate services to corporate and institutional property owners, investment advisors, and tenants like Staton Tees.2 Leading the way were global, public full-service companies CB Richard Ellis, Colliers International, and along with Jones Lang LaSalle, which continues to grow through regional acquisitions, such as the purchase of Dallas based The Staubach Co. in 2008. (See the Appendix for a summary of major industry trends.)

Commercial real estate service providers pursued a number of activities. Property management services included managing tenant relationships on behalf of owners, facilities operations and security, as well as property maintenance, landscaping, and repairs. Transaction services included leasing, tenant representation, and the brokering of acquisitions and dispositions. Additional services included project development, construction management, and financial planning. Service firms typically operated under 30-day contracts as dictated by their institutional clients, although property managers, for example, were rarely changed unless the buildings were sold.

Commercial real estate service firms typically earned revenues by generating transaction commissions or by charging service fees. Leasing commissions on industrial buildings were 4%– 6.75% of the total lease value. Holt expected to earn about 5% on average. Tenant representation yielded 3%–4.5%. For Staton, HLC typically charged 3%. For property management of industrial buildings, such as the Welch Center, HLC charged about 2%. For office buildings it would be closer to 5%. Acquisition and disposition services might earn a provider as much as 3% of a purchase or sale, but competition in the Dallas market had compressed this rate below 1%, especially for larger transactions. Finally, providers who offered development services, like construction management, earned 3%–5% of costs (averaging 4%), excluding soft costs such as marketing, legal, and architect fees. Earnings before interest, taxes, depreciation, and amortization (EBITDA) margins for firms offering property management and brokerage services often ranged between 10% and 13%.3

The real estate services business was both cyclical and seasonal. During 2012, the United States was slowly emerging from an economic slump. Space market vacancies were starting to decline, but as companies looked for ways to increase profits in a tough economy, some real estate firms moved away from third party real estate service providers and took the assignments in house. Competition remained tough as service companies pursued owners who needed to outsource both property management and leasing responsibilities.

1 Andrew Florence, Norm Miller, Jay Spivey, Ruijue Peng, “Slicing, Dicing, and Scoping the Size of the U.S. Commercial Real Estate Market.” Journal of Real Estate Portfolio Management. Vol. 16 No. 2 2010, p. 111, http://www.costar.com, accessed Jan 4, 2013.

2 Bryan A. Maher, Alex Brown, “Trammell Crow—A Leader in a Fragmented Business Services Industry,” March 30, 1999, p. 2, available from Thomson Financial, http://www.investext.com, accessed July 17, 2003.

3 Andrew Jones, “Trammell Crow Company—Outsourcing America,” Morgan Stanley, October 7, 1999, p. 8, available from Thomson Financial, http://www.investext.com, accessed July 17, 2003.

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Holt Lunsford Commercial Story

Holt Lunsford began his real estate career in Dallas with Trammell Crow Company in 1986. After a successful leasing career focused on the industrial sector, he left Trammell Crow in May 1993 at the age of 29 and launched his own real estate business, Holt Lunsford Commercial. It was a daring entrepreneurial move for Lunsford, his wife, and children, but he was confident that the reputation and relationships he had built with institutional customers and tenants while at Trammell Crow would help him succeed. “I always wanted to own my own business,” said Lunsford. “I wanted to get in with a good company that would train me, then eventually strike out on my own.”4

Lunsford met Staton, the T-shirt distributor, while working for Trammell Crow. The relationship started with the two men “on opposite sides of the table” but soon developed into a close friendship enjoyed by both families. When Holt Lunsford Commercial first opened its doors, Staton gave Lunsford a $100 gift certificate for office supplies and asked Lunsford to handle tenant representation duties for his T-shirt distribution business. Although tenant representation would not be the major focus of Holt Lunsford Commercial, Lunsford happily agreed to Staton’s proposal, and Staton Tees became his first client.

Leasing and property management on behalf of large institutional property owners soon became Holt Lunsford Commercial’s core business. By 1997, the firm managed or leased over 5 million square feet of space. Two years later, Lunsford opened a new satellite office in Houston, and the firm entered a period of accelerated growth, with revenues increasing at 35% annually. In 2009, Matt Carthey, another “young gun” who embodied the culture of Holt Lunsford Commercial opened an additional office in Fort Worth. By 2012, the firm managed or leased 44 million square feet of space and was the second-largest commercial real estate manager in the Dallas metropolitan region.

Gross revenues of the service firm were $12 million, with 31% coming from the Houston and Fort Worth offices. Revenues were earned from an array of different services (see Figure A). The largest expense was employee compensation. Salaries, bonuses, commissions, and benefits totaled approximately 60% of the revenues. For most employees about half of their compensation was base pay and 50% was incentive pay. In 2012, the balance sheet was healthy and the firm remained a private entity, with Lunsford as sole owner.

Figure A Holt Lunsford Commercial Revenue Distribution in 2012

Property Management 41%

Leasing 32%

Acquisitions & Dispositions 13%

Development & Construction 7%

Tenant Representation 5%

Other 1%

Source: Company data

4 Betsey Craig, “2001 Alumni Awards: Young Alumnus of the Year,” Abilene Christian University Alumni Magazine Web Edition, Winter 2002, http://www.acu.edu/acu-today/winter2002/cover03b.html, accessed August 2, 2003.

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The Organization

Lunsford wanted Holt Lunsford Commercial to be a principled company that satisfied its customers and “glorified God” through its behavior with employees and vendors. At quarterly town hall-style meetings with staff, Lunsford often credited the firm’s success to its eight corporate tenets, which emphasized honesty and customer service. (See Exhibit 1 for tenets.) “Our value system is our corporate DNA,” said Lunsford. “If you do the right thing for people, they will entrust their assets to you and that trust develops efficient, healthy relationships.”

Lunsford built a relatively flat organization. As part of a succession plan, he had recently hired Chief Operating Officer, Sam Gillespie (See Exhibit 2 for a company organizational chart.) Gillespie had been a partner with Trammel Crow Company and shared similar styles and values as Lunsford. Most of the key employees, however, had been with Holt Commercial for a long time, including Jim Brice who headed the Dallas and Houston Industrial Division and had been Holt’s first employee.

Each office was organized into service lines, and nearly every employee’s compensation was tied in some way to individual production and performance. In the leasing group, employees were known as “marketing representatives” rather than “agents” or “brokers”5 and served as a single point of contact for property owners and tenants, handling lease transactions, rent processing, and the preparation of financial statements and reports. Lunsford encouraged the marketing representatives, many of whom were MBAs, to “get out in front of the client,” and e-mailing proposals was expressly forbidden. Celia Marquez, the recent MBA hire that Lunsford had invited to lunch, was assigned to the Staton Tees account, among others.

The firm had added professionals rapidly since its founding, and while the relocation of employees to Houston and Fort Worth had drained personnel resources in Dallas, it had also helped ensure cultural continuity across the firm. The satellite offices had significant autonomy, as Lunsford believed customers and tenants received higher quality service from individuals within their local market. Carthey described what it was like to open the office in Fort Worth: “After I learned the HLC platform and excelled in a leasing role, the opportunity to explore a new market and open a new office was an exciting challenge. Although Fort Worth had an institutional presence, we quickly determined our future client base would have more diversity with a higher mix of local owners than Dallas or Houston. The good news for our team was that we had the support from existing institutional clients that grew with us while we cultivated local relationships that are paying off today. I think opening an office in Fort Worth has shown that HLC’s platform, while well suited to support some of the largest institutional owners in the country, is flexible enough in its processes to accommodate owners on a local and regional level.”

As an additional venture, Lunsford started Frontier Equity as a subsidiary of Holt Lunsford Commercial for the acquisition of office and industrial properties. Frontier Equity focused on small and large cap properties in the Texas market with a 3 to 10 year investment horizon. There were two areas of opportunity that weren’t in direct competition with HLC’s clients: most institutional investors were only willing to take on properties with low risk profiles and wanted a “baked cake,” meaning the property was already developed and leased. Secondly, many large investors would only purchase large properties. Frontier Equity found opportunities to buy smaller properties large investors would not pursue, due to scale, and aggregate them. Investing in value-add properties was an advantageous way to create wealth for Lunsford and his partners. The service business informed

5 In order to legally earn commissions for leasing space, these marketing representatives needed to be licensed real estate agents or brokers.

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their investment decision and created high returns on a risk adjusted basis. The program was accretive to the growth of the service business as the majority of the investments were eventually sold to their institutional clients. As Holt Lunsford Commercial grew, so did Frontier Equity. Lunsford was intent on imbuing the same ideas and values into the equity division of Holt Lunsford Commercial as he was the leasing division.

Clients

Holt Lunsford Commercial’s primary customers were a select group of nationally focused real estate advisory firms including TA Associates Realty, Invesco Realty Advisors, and the Principal Global Investors, each of which acquired properties and provided asset management services on behalf of institutional owners like pension funds and insurance companies. Over 60% of Holt Lunsford Commercial’s revenues were derived from the firm’s top four advisory firm clients. Working with these advisory firms posed several challenges for Holt Lunsford Commercial, including the threat of being replaced by another third-party service provider. “What keeps me up at night is that all of our property management and leasing contracts are 30-day contracts,” explained Lunsford. “We’re constantly on the hot seat to please and serve clients well.”

Invesco’s Michael Kirby was one of Lunsford’s clients. In 2012, Dallas-based Invesco Realty Advisors managed $12 billion in real estate assets for institutional owners, $7 billion of which was placed in 375 direct investments across 30 states. Said Kirby:

At the end of the day we have to make sure we have the best available property management and leasing talent serving an investment and helping to maximize returns. Our preference is to work with large players like our national preferred service providers Jones Lang LaSalle and CB Richard Ellis, because it creates a tremendous amount of efficiency. Holt Lunsford Commercial are a niche player with a particular strength in Dallas and Houston, and they are respected regionally, so we gave them one or two investments and have entrusted more business over time. Holt in particular is a unique person who is very ethical and hard working, and I like the fact that if there is an issue, I can speak to him personally.

In Dallas, Holt Lunsford Commercial faced competition from global real estate service firms CB Richard Ellis, Colliers, and Jones Lang LaSalle, each of which boasted over 500 offices in over 60 countries. But Lunsford was undeterred:

I know the institutional owners would often prefer to work with national service providers who are in many cities, but we’ve been so strong locally they can’t ignore us. These institutions won’t give their business to just anybody. You have to be a certain size. Sometimes you will see an advisory fund manager choose a name-brand national service provider to protect their job—they’d rather see an asset suffer and keep their job than take a chance on a regional player like us and potentially lose it. But you have to ask yourself why is it that these pension funds and advisory firms do not choose the same provider in each market. The answer, I think, is there is no dominant service provider with consistent behavior across multiple cities.

It was necessary to clearly and consistently communicate financial results for each property to the advisory firms. “Our clients have stringent reporting requirements,” said Lunsford. “Pension funds are on top of the chain, and they drive this. We’re at the low end of the food chain. You have to provide accurate and consistent reports for all properties out of every office, or you might get replaced.” (See Exhibit 3 for a diagram illustrating real estate investment process flows.)

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Proper reporting was a virtue, but successful lease-ups and avoiding vacancies were both crucial to the long-term success of a service provider like Holt Lunsford Commercial. Lunsford viewed the more than 1600 industrial and office tenants that had signed leases with Holt Lunsford Commercial as a second key group of customers. Close relationships with prospective tenants were particularly beneficial when trying to secure more leasing business from the advisory firms and when negotiating lease expansions or renewals. In addition, tenants like Staton often brought development proposals to Holt Lunsford Commercial, and increasingly Lunsford was hearing about intriguing, “off-market” real estate investment opportunities, but he wondered if raising and deploying capital would clash with his firm’s service provider model.

The Lunch Meeting

Lunsford and Staton agreed to have their lunch meeting at Dickey’s, a popular cafeteria-style barbecue restaurant in North Dallas. Lunsford and Marquez arrived first and both cracked a smile when Staton drove into the parking lot. His friend was driving what appeared to be a freight truck crossed with a sports car. After inspecting the SportChassis Freightliner, which featured studded chrome hubcaps, leather seats, and a DVD entertainment system, they entered Dickey’s, ordered lunch and began to talk business, with Marquez taking notes.

Staton started the conversation. Staton Tees’ lease of its headquarter facility, Welch Center, was due to expire in nine months, he explained. The owner of the building had indicated a desire to negotiate a lease renewal, and had also offered to sell the property to Staton. But if he was going to own his headquarters, Staton asked, perhaps he ought to simply develop a customized build-to-suit facility? Was it the right time to even consider relocating?

Lunsford chuckled. With so many options on the table, it was sure to be a long lunch.

Staton Tees

Ned Staton founded Staton Tees in 1981, in Baton Rouge, Louisiana, to service the emerging T-shirt printing industry. By 2012, Staton was the largest distributor of Hanes products and generated over $200 million in total sales. The firm warehoused sportswear in a variety of styles and colors and distributed on an “at once basis”6 to screen printers and embroiderers seeking to avoid the inconvenience of mill purchase requirements and long delivery times.

Staton’s first warehouse was a 600-square-foot (20 feet by 30 feet) storeroom leased for only $100 a month. “Flexibility with our real estate was very important early on,” said Staton. “Leasing was our only option because we didn’t have many assets, so we always tried to sign one-year leases. We’ve probably moved 40 times.”

After several years of rapid growth, which included the opening and closing of several distribution centers, Staton moved the firm’s headquarters to Dallas in 1987. Growth continued, and in 1993, Staton assigned his tenant representation business to Lunsford. Holt Lunsford Commercial secured and managed leases on behalf of Staton Tees in five cities—Dallas, Memphis, Orlando, Los Angeles, and Chicago—and was responsible for a total of 506,600 square feet of warehouse space. Lunsford’s Dallas team remotely handled tenant representation work outside of Texas for Staton, traveling when necessary, and since being hired, Marquez had increasingly been responsible for the account.

6 All orders were shipped to customers within 24 hours of receipt.

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Real estate occupancy costs represented around 4% of Staton’s cost structure. “We have very specific needs,” explained Staton. “A big box, not too deep, with lots of dock doors across the front. In all of our warehouses except Dallas, we don’t need office space, just a small shipping and receiving area. Ceiling height does not matter; about 18 feet would work fine.”

By 2012, Staton was considering adding more industrial space in the Northeast, perhaps in Philadelphia, but his mind had also turned to other matters. He wanted to spend more quality time with his family, traveling, and pursuing his hobby flying airplanes. Fortunately, Staton’s home, his son’s school, and the private airport were within two miles of his Welch Center office, making the commutes convenient.

Welch Center

Built in 1989 on a 5.5 acre site,7 Welch Center was a 102,718-square-foot front-load, dock-high industrial bulk warehouse, with a 24-foot ceiling floor to joist. (See Exhibit 4 for industrial property classifications.) The building had a concrete truck court (120 feet)8 and 107 parking spaces for employees.9 Although the building was designed to hold two side-by-side tenants, Staton Tees occupied the entire facility. Inside, there were approximately 15,000 square feet of office space on the ground floor devoted to the firm’s corporate headquarters, call center, and customer pick-up area. (See Exhibit 5 for truck court and building picture and Exhibit 6 for site layout.)

The building was in good condition, except for the roof, which had an estimated remaining life of five years. Built-up roof systems used in Dallas traditionally cost $4.00 per square foot to replace. The offices had recently been renovated, and major truck-court repairs were completed in 2010.

Welch Center featured slightly above average column spacing,10 fluorescent strip lights, sprinklers, super hard floors for stacking pallets, and 30 skylights that could be opened to release smoke if a fire occurred. Staton Tees did not use sophisticated racking systems on the warehouse floor, choosing instead to stack T-shirt boxes up to eight feet high and to arrange merchandise in rows. Order fulfillment process control was vital, as any errors that occurred when items were “picked” and “packed” inevitably led to merchandise returns, each of which cost the firm around $20.

Welch Center was located in North Dallas in Metropolitan Business Park (Metropolitan), at the intersection of Interstate 635 and the Dallas North Toll Road, two main thoroughfares in North Dallas. Customers from around the Dallas/Fort Worth area could easily identify the address and conveniently pick up their orders. Due to its proximity to high-end residential, upscale retail, and office properties (see Exhibit 7 for aerial photo) and lack of available land for development in the area, the industrial sector at this location had seen some transition to alternative uses such as furniture outlets and wholesale showrooms. There was even a Starbucks coffee shop in the neighborhood, attached to a converted warehouse inhabited by The Great Indoors, a home furnishings retailer. Pressure to convert these warehouses had pushed rental rates above traditional industrial rates and solidified values for all owners of Metropolitan property. Some buildings with

7 One acre is equal to 43,560 square feet.

8 Warehouses typically have one truck bay or dock for every 10,000 square feet of floor space. Welch Center had 12 truck docks on the east-facing side of the building near the street, and seven railway loading docks on the west-facing side. The rear doors and the railway were no longer in use; therefore the building would be classified as a “front-loader.” A modern cross-docking facility would have trucks bays on both sides of a warehouse to maximize throughput.

9 Industrial buildings typically have one parking space for every 1,000 square feet of warehouse space.

10 The column spacing was 42.5 feet by 42.5 feet. Standard was 40 feet by 40 feet for comparable warehouses.

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more prominent addresses had sold for as much as $50 per square foot to furniture companies that could better take advantage of the high traffic count and visible addresses.

Dallas Industrial Property Market

The Dallas/Forth Worth industrial market consisted of approximately 714 million square feet of warehouse and manufacturing space, making it the third-largest U.S. supplier in 2012, behind only Chicago and Los Angeles. (See Exhibit 8 for the leading U.S. industrial markets and for sector performance data.) With a central location in the southwest United States and excellent thoroughfare systems, Dallas had become a major distribution hub for the flow of goods to the consumer. The city’s demographics and legal/regulatory frameworks made it an attractive market for corporations needing industrial space. Dallas ranked ninth in the nation in total population (over 1.2 million people), and during the last decade, Texas led the nation in job creation, averaging approximately 115,000 new jobs per year. Notably, Texas had no personal or corporate income tax.

Nationally, and in Dallas, just-in-time inventory management had reduced storage requirements for many firms and relieved pressure on demand for industrial space, although new facilities with large truck courts able to accommodate increasingly larger trucks (up to 54 feet in length), and with cross-docking capabilities were highly sought after. Many manufacturers had begun outsourcing distribution activities to third-party logistics firms, which operated massive modern facilities out of regional hubs. This had changed the complexion of the tenant pool in Dallas and across the U.S., as service providers like Holt Lunsford Commercial increasingly worked with third-party logistics firms rather than with wholesale distributors like Staton Tees that targeted one specific industry.

Institutional investors seeking consistent returns in a stable industrial market had long favored Dallas, and the flight of capital from stocks and into real estate in the early twenty-first century had heightened this interest. Industrial properties were often considered defensive investments. Short construction cycles allowed industrial developers to quickly curtail efforts during recessions, limiting oversupply and vacancy problems. Conversely, these short construction cycles often meant the industrial property class was first to recover during economic rebounds. In Dallas, investors seeking stable yields had pushed pricing for core warehouse/distribution buildings to $34–$55 per square foot in 2012.11 Welch Center was considered a Class “A” building, and if fully leased at market rates, might fetch between $38–$42 per square foot on the open market.

Despite its favorable characteristics and the capital frenzy, the Dallas industrial market was not immune to the tenant-demand problems that had plagued many U.S. commercial real estate markets starting in 2008-2009. During 2009 Dallas-Fort Worth experienced negative industrial absorption of 3.3 million square feet – meaning that space vacated by tenants exceeded newly leased space, on a square foot basis – and the citywide vacancy estimate for distribution and warehouse space was 12%.12 By contrast, 2007 vacancy rates were 8.4%, and in 2012 conditions were improving and rates were at a more acceptable 9.7% by the third quarter.13

With the supply-demand imbalance, and real estate uncertainty on the horizon, many options were available to tenants. Rents remained low (see Exhibit 9 for Dallas industrial market rental and investment sales data), debt was inexpensive, and build-to-suit industrial construction had recently increased in popularity as corporations sought new, customized space. In 2012, FedEx and Subaru

11 Company document. 12 CoStar, Dallas/Ft Worth Industrial Market Report, Q3 of 2012, http://www.costar.com, accessed 7 January, 2013 13 Ibid.

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had pursued this option, and Amazon had recently completed a new one-million-square-foot built- to-suit distribution warehouse in both Dallas, Texas, and Jeffersonville, Indiana.14

Staton’s Options

During the lunch meeting, Lunsford and Staton discussed trends in the Dallas industrial market and strategies for Welch Center, while Marquez scribbled down projections for three different options: renewing the Welch Center lease, buying the building at the conclusion of the current lease, and abandoning the property to pursue a build-to-suit option. (See Exhibit 10 for Marquez’s analysis.)

The lease-renewal option Lunsford and Marquez estimated the market-lease rate for Welch Center to be $3.35NNN per square foot, upon renewal. This “triple net” rental rate was exclusive of taxes, insurance, utilities, and common area maintenance fees, which would add an additional $1.15 per square foot in year one, bringing Staton’s total expected occupancy costs in 2013 to $4.50 per square foot. For long-term leases of five years or more, annual rent bumps of 3% would typically be built into the rental agreement to adjust for inflation; however, the Dallas market usually only afforded property owners rent bumps in three- to five-year increments. Marquez assumed there would be an inflation adjustment every three years if Staton signed a new 10-year lease.

Leasing had several benefits for business owners like Staton. Many companies chose to lease space and treat the expense as an operating cost, while focusing assets on their core product or service offering.

Flexibility was important. Changes in standard fulfillment processes, along with new technologies and equipment, could cause an industrial firm’s space needs to vary. For instance, clear heights for newly constructed warehouses had risen from 28 feet to 32 feet, which allowed additional product storage and reduced required floor area, but it also necessitated the purchase of special materials- handling equipment to reach higher racking systems. A company’s space requirement could also change with the adoption of new distribution strategies, such as moving from a centralized approach with large, regional centers to a decentralized plan with many small local centers. Staton had considered these alternatives but did not anticipate any immediate changes to his logistics and distribution processes.

The buy option Staton wanted to explore the benefits of ownership

The current owner of Welch Center was a well-known institutional property owner. The owner had purchased the building as part of a larger portfolio purchase, with several similar properties, and was now looking to unload some of the properties and reallocate funds. The owner had expressed a desire to sell the property for $39.41 per square foot, or $4,048,300. Lunsford estimated the required equity to be $1,012,075, assuming 75% leverage and a loan of $3,036,225. In addition, there would be closing costs of approximately 2% of the loan amount, or $80,966, for the engineering, appraisal, legal and loan origination fee. Staton’s total out-of-pocket expense would be $1,093,044. To Staton that represented a significant but doable investment.

If Staton chose to purchase the building, Lunsford could help him obtain debt financing. Interest rates were at 55-year lows and owners were seizing the opportunity to refinance existing commercial mortgages, and to originate new ones. Lunsford estimated the cost of short-term bank debt financing

14 CBRE, US Industrial Marketview, Q3 of 2012, http://www.cbre.us/AssetLibrary/USIndustrialMarketView_Q32012.pdf, accessed January 7, 2013.

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at 4.5% for a five-year interest-only note.15 Bank debt was less expensive than permanent financing from other capital sources, but typically was full recourse, and thus would require a personal guarantee from Staton. A pre-payment penalty equal to 1% of the total loan amount would apply, if Staton paid off the loan during the first four years.

Lunsford asked Marquez to prepare a 10-year pro forma analyzing a purchase of Welch Center by Staton. It was debatable what the highest and best use of Welch Center would be after 10 years; however, to determine expected residual value, Lunsford and Marquez estimated a year-10 inflation- adjusted rent of $4.37NNN per square foot16 and assumed a 7.5% exit cap rate, along with 2% closing costs. Staton wanted to know if he could lower his annual total occupancy costs by buying Welch Center instead of renting. He expected a 20% pretax return on his investment. To make it an apples- to-apples comparison, Staton indicated that if he invested the equity to purchase real estate in his business, for proforma purposes, he assumed he could refinance at the same 4.5% interest rate. But there was a risk. Public companies facing this dilemma—and pressure from shareholders—had increasingly moved away from ownership and toward leasing, often utilizing sale-leaseback mechanisms to redeploy capital and use it more productively.17 Lunsford was unsure whether this same argument should be applied to Staton’s privately held firm.

The build-to-suit option The third option Staton was considering was to leave Welch Center in favor of a new facility that Holt Lunsford Commercial would develop to suit the needs of Staton Tees. The building could be financed and owned by an institutional investor client of Lunsford’s and then leased to Staton, or Staton Tees could itself own the building. “The building would have all-new, customized systems and since it would be Staton’s headquarters, they could use this as an opportunity to recharge the corporate image,” said Lunsford.

Staton told Lunsford that while he generally liked Welch Center, he did have some customization ideas for a new facility if they were to pursue the build-to-suit strategy. First, Staton wanted to increase his corporate office space to 20,000 square feet, but build the office space two stories high within the warehouse to maximize floor space dedicated to fulfillment activities. A specialized truck bay and a pleasing outdoors environment for employees, like the one found at Welch Center, were also on his wish list.

Lunsford had identified a 315,000-square-foot parcel of land in the Colony Crossing area, 20 miles north of Dallas, on which Holt Lunsford Commercial could develop a 110,000-square-foot facility. The land would cost $2.50 per square foot, making the effective land cost $7.16 per square foot of building, given the 35% coverage ratio.18 Lunsford estimated he could build a 28-foot-clear warehouse that met Staton’s specifications in six months using tilt-up construction techniques. The facility would have 90,000 square feet of warehouse space along with a 10,000-square-foot office footprint built two stories high. Total construction costs (not including land) would be $33.43 per

15 Staton would have to pay off the principal or secure new financing after five years.

16 Lunsford assumed 3% annual inflation with rent bumps at the end of years three, six, and nine.

17Dirk Brounen and Piet Eichholtz, “Corporate Real Estate Ownership Implications,” 2003, p. 5, www.landecon.cam.ac. uk/property/Braunnen_Eichholtz.pdf, accessed August 23, 2003.

18 As a rule of thumb, industrial buildings covered one-third of the total land plot, with an additional one-third allocated to parking and the truck court and the final one-third devoted to green space. In practice, and especially in Texas, the amount of green space was often significantly less.

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square foot, which includes $4 per square foot in soft costs,19 and a 4% developer fee on construction costs. Ongoing operating costs would be similar to those of the Welch Center facility.

Lunsford believed he could help secure a similar financing arrangement to the one he suggested for Staton’s possible purchase of Welch Center. Assuming 75% leverage, Marquez’ calculation showed the required debt to be $3,348,600. With a strong tenant like Staton, Lunsford said he could easily recruit one of his institutional investor clients to cover the required $1,116,200 in equity. Lunsford told Staton he would likely need to commit to a ten-year lease with an inflation bump at a $3.45 NNN/sf rent in return for the new customized building. Alternatively, Staton or his firm could provide the equity and own the new building outright.

Conclusion

After finishing their barbecue lunch, they each grabbed a cup of Dickey’s complimentary soft- serve vanilla ice cream and walked outside. The scorching Texas summer sun welcomed the trio, and began melting their desserts, forcing a quick goodbye. Lunsford and Marquez were needed back at the office for Holt Lunsford Commercial’s afternoon strategic planning session. With a final handshake, Marquez promised Staton she would run some additional calculations, while Lunsford agreed to mull over all of Staton’s potential options, and to have a final recommendation to him by the end of the week.

19 Soft costs included interest, taxes, and marketing expenditures, as well as architectural, engineering and legal fees. Hard costs included site development, shell construction, and finishing costs.

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Exhibit 1 Holt Lunsford Commercial’s Eight Tenets

HOLT LUNSFORD COMMERCIAL

VALUES

“To be the preferred professional real estate service provider in the industry. This culture will perpetually diversify and expand our customer base, thereby insuring the security and financial growth for each team member.”

Truth: Always tell the truth. Relationships with family, co- workers and customers will be guided by a relentless commitment to honesty.

Customer Service: Servanthood must dominate our thinking and actions. The customer always comes first. Internal and external customers are the reason we exist.

Expertise: A commitment to professional expertise will set us apart from our competition. We must be our best individually to be the best corporately.

Growth: Our culture will promote and reward spiritual, personal and vocational growth.

Learn: Mistakes are tolerated when performed towards customer service. Ask questions – life is too short to always learn by mistakes.

Performance: Financial rewards tie to performance.

Fun: Have fun – enjoy yourself, co-workers and job. ”A happy heart makes the face cheerful.”

Golden Rule: Do unto others as you would have them do unto you. All human beings are worthy of respect and our actions must reflect a spirit of empathy.

Holt Lunsford President

Source: Company document

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Exhibit 3 Direct Institutional Investment in Real Estate

Institutional Owners

(Pension Funds, Insurance Companies, Endowments)

Investment Advisory Firms

Service Providers

(Leasing, Property Management)

Property Users

(Tenants, Third-Party Logistics Firms)

Cash Flow From

Operations (CFO)

Direct Investment

&

Pay for Performance

Source: Casewriter

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Exhibit 4 Classification of Industrial Properties

Primary/Secondary Categories % of Total a Size (sf) Ceiling Height % Office Truck Docks (/sf)

1) Warehouse Distribution 55%

Regional Warehouse Up to 100,000 16’–24’ Up to 25% 1: 5,000–15,000

Bulk Warehouse Over 100,000 20’+ Up to 10% 1: 5,000–10,000

Heavy Distribution Over 100,000 24’ Below 5% Below 1: 5,000

Refrigerated Distribution Any 20’–30’ Up to 15% 1: 7,000–10,000

Rack-Supported Warehouse Any 60’+ Below 5% 1:5,000

2) Manufacturing 30%

Light Manufacturing Up to 300,000 14’–24’ Up to 20% 1: 10,000–15,000

Heavy Manufacturing Can exceed 1 million 16’–60’ 10% Varies

Airport Hangar Any Up to 100’ 5% Minimal

3) Flex 9%

R&D Flex Up to 100,000 10’–18’ 25%–75% 1: 20,000

Office Showroom Up to 150,000 16’–28’ 30%–40% 1: 10,000

4) Multitenant <5% Up to 120,000 16’–24’ Up to 50% Various

5) Freight Forwarding <5%

Truck Terminal Up to 100,000 12’–16’ 5% 1: 500

Air Cargo Up to 100,000 Up to 30’ 10% 1: 5,000

6) Data Switch Center <5% Any 14’+ 1% Usually 0

aThe United States had an estimated 20 billion square feet of industrial property in 2012.

Creation Storage

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Warehouse

Air Cargo

Office

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Light

Manufacturing

R&D Flex

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Heavy

Manufacturing

THE SUPPLY CHAIN

Source: Guide to Classifying Industrial Property, 2nd ed. (Urban Land Institute, 2003).

a “Total Industrial Market Statistics”, 3rd Quarter, 2012, www.costar.com

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Exhibit 8a Leading U.S. Industrial Markets

Market

Inventory

September 30,

2012 (SF)

New Construction

3rd Quarter 2012

(SF)

Under

Construction

(SF)

Absorption

3rd Quarter

2012 (SF)

Vacancy Rate

(%) Sept 30,

2012

Average

Warehouse

Rents (US$PSF)

Chicago, IL 1,309,885,647 966,624 4,502,026 524,550 10.0% $3.62

Los Angeles, CA 881,945,200 388,200 1,676,761 1,621,100 4.4% 6.11

Dallas-Ft.Worth, TX 714,134,535 - 3,785,480 3,097,455 9.7% 3.05

Atlanta, GA 607,222,547 1,275,640 3,961,417 2,506,050 12.7% 3.19

Detroit, MI 554,390,591 - 623,428 781,685 11.9% 3.86

Houston, TX 478,248,624 940,310 2,227,159 930,803 5.2% 5.24

Cleveland, OH 477,951,401 - 174,258 (1,439,030) 9.4% 3.29

Philadelphia, PA 408,069,656 1,481,473 3,309,530 797,162 10.2% 4.11

North, NJ 373,897,568 180,000 - (703,593) 8.3% 6.16

Central NJ 353,683,438 - 358,590 1,639,890 9.4% 4.42

Indianapolis, IN 281,555,710 852,913 3,525,273 876,724 5.2% 3.63

Cincinnati, OH 274,600,585 - 1,166,338 (117,902) 9.5% 3.22

Phoenix, AZ 270,299,123 80,000 3,636,000 698,718 13.3% 5.07

Seattle, WA 264,723,872 - 375,000 860,484 6.4% 6.02

St. Louis, MO 263,840,720 - - 221,591 8.7% 3.82

San Jose, CA 252,752,739 - 111,100 289,165 10.7% 6.24

Milwaukee, WI 245,127,494 468,000 222,000 1,334,942 6.5% 4.13

Baltimore, MD 224,535,228 74,562 1,053,235 (269,651) 10.8% 4.72

Denver, CO 215,649,622 320,072 945,271 817,071 7.8% 4.63

Orange County, CA 200,097,900 - 596,500 345,500 4.6% 6.96

U.S. Total 8,652,612,200 7,027,794 32,249,366 14,812,714 8.87% 4.57

Source: “North American Industrial Real Estate Highlights,” Colliers International, 2012.

Exhibit 8b U.S. Industrial Market Statistics

Source: Company Document

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Exhibit 9a Dallas Bulk Distribution Sales and Rental Rates (Third Quarter, 2012)

Type Year Built Clear Height Sales Price Per

Square Foot Lease Rates

Class A 1990–2013 24’–32’ $34–$55 $3.00–$3.50 NNN

Class B 1975–1989 20’–24’ $28–$37 $2.75–$3.00 NNN

Class C 1960–1974 16’–20’ $23–$28 $2.25–$2.75 NNN

Source: Company document.

Exhibit 9b Dallas Bulk Distribution Leasing and Absorption (Third Quarter, 2012)

Year Total Leasing Net Absorption

2012 38,824,259 SF 4,775,207 SF

2011 43,656,580 SF 9,491,777 SF

2010 52,177,944 SF 1,873,907 SF

Source: “Final Figures at a Glance”, The Dallas/Ft Worth Industrial Market, 3rd Quarter, 2012, www.costar.com

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Appendix

Trends in the Commercial Real Estate Service Industry (2012)

Institutionalization In 2012 there was continued pressure from large institutions such as pension funds, banks, insurance companies, private equity, and real estate investment trusts (REITs) to seek modest returns from real estate amidst a still recovering U.S. economy.20 Particularly, turmoil in the global economy is increasing the flow of investments to U.S. Dollars among larger investment institutions. Likewise, some firms are investing at sub-5 % cap rates with the intent to get the properties under stellar management to throw off a high net operating income (NOI). 21

Consolidation A wave of mergers and acquisitions occurred among commercial real estate service firms during the 1990s and into the twenty-first century. In many instances, large national or global firms snapped up small local players to penetrate new markets and attempted to keep the original owners invested in the ongoing business. In 2012, such acquisitions typically occurred at 4–6 times trailing 12-month EBITDA and were accretive to earnings.

Mergers between large firms were also common. In November 2006 CB Richard Ellis (CBRE) announced it was acquiring Trammell Crow Company (TCC) to create the largest global real estate service firm. The $2.2 billion purchase increased the firms’ combined market share to 10.5%, compared to the next closest competitor at 3.4%. The combined company comprised over 21,000 employees with expected revenue of $4.4 Billion.22

Service expansion Full-service firms were better able to quickly seize a diverse range of opportunities, as they occurred. In addition, cross selling was vital to the success of many real estate service firms. For example, CBRE offers the full range of real estate services and often times, brokers a deal, develops a property, manages the lease, and services the facilities.23 It was also common for firms to take advantage of property management business to acquire the more lucrative leasing account of a property. A total of nine firms ranked among both the top 25 brokerages and top 25 property managers, nationally, in 2012. (See Exhibit A-1 for rankings.)

External competition Commercial real estate service firms faced heavy competition from one another and from external threats. Many advisory firms, like San Francisco-based RREEF, had pursued a vertical integration strategy, taking leasing and property management services in-house and threatening existing third-party service providers. Advisory firms typically earned 0.75%–1.50% of assets annually in management and performance fees, and vertical integration represented a way to capture additional value.

In addition, regional owners of office and industrial properties with geographical critical mass were leasing and conducting property management services to control quality and generate a new source of revenue.

20 “Emerging Trends in Real Estate 2013,” PricewaterhouseCoopers and Urban Land Institute, October 2012, p. 1-4.

21 Ibid, p. 5.

22 CB Richard Ellis Worldwide Web site, http://www.cbre.com/AssetLibrary/ClosingPressRelease.pdf, accessed January 10, 2013.

23 CB Richard Ellis Worldwide Web Site, http://www.cbre.com/EN/services/Pages/Overview.aspx, accessed January 10, 2013.

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Exhibit A-1 Top Commercial Real Estate Service Providers

Top 25 Brokerages (2012 performance)

Investment Sales and Leasing Transactionsa

Top 25 Property Managers (as of December 31, 2012)

Square Feet Under Management

CB Richard Ellis $159,000,000,000 CB Richard Ellis 3,200,000,000

Jones Lang LaSalle 98,630,000,000 UGL Services / DTZ 3,180,000,000

Cushman & Wakefield 88,600,000,000 Jones Lang LaSalle 2,100,000,000

Colliers 68,210,000,000 Colliers 2,000,000,000

NGKF 64,350,000,000 Cushman & Wakefield 806,000,000

NAI Global 55,000,000,000 NGKF 624,800,000

Studley 48,910,000,000 ProLogis 572,000,000

Eastdil Secured 46,100,000,000 Cassidy Turley 455,000,000

TCN Worldwide 27,060,000,000 NAI Global 315,000,000

Cassidy Turley 26,600,000,000 Lincoln Property 297,170,000

CORE Network 20,360,000,000 Simon Property Group 251,140,000

Marcus & Millichap 17,000,000,000 Transwestern 193,000,000

HFF 12,890,000,000 PM Realty Group 185,000,000

Transwestern 6,500,000,000 Duke Realty 143,100,000

ARA 6,030,000,000 General Growth Properties 136,000,000

RE/MAX Commercial 6,000,000,000 Hines 135,280,000

CORFAC International 5,700,000,000 The Inland Real Estate Group 130,000,000

Sperry Van Ness Intl. 5,340,000,000 DDR Corp. 122,000,000

Lee & Associates 4,920,000,000 Westfield LLC 114,980,000

Coldwell Banker Comm. 4,860,000,000 Kimco Realty 114,010,000

Hodges Ward Elliott 3,400,000,000 USAA Real Estate 97,000,000

Avison Young 2,800,000,000 Brixmor 95,800,000

The Carlton Group 2,490,000,000 Brookfield Office Properties 82,000,000

PM Realty Group 2,100,000,000 CBL & Associates Properties 80,190,000

Kidder Mathews 1,870,000,000 Liberty Property Trust 79,370,000

Source: National Real Estate Investor, 2013.

aRepresents total value of transactions. Actual firm revenues would be much smaller: as little as 1%3% of transaction volume.

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