Government Operations Committee on May 1st, 2007

[The Chair, Liberal, Diane Marleau]

I call the meeting to order.

We have with us today James McKellar, who is the associate dean, external relations, for the school of business at York University. We've invited him here to talk to us about the sale of federal buildings. Hopefully he can enlighten us somewhat.

Mr. McKellar, normally we allow our invited guests to speak for 10 minutes. If you require less time, that's fine too, and then we open it up for questions and go from there.

Thank you for coming, and welcome. Hopefully, we won't give you too hard a time.

[Prof. James McKellar, Professor of Real Property, Academic Director, Real Property Program, Schulich School of Business, York University]

Thank you for the opportunity.

I would suspect that your questions are more important than my brief, so I'll keep it fairly brief.

I should say that throughout my career, for some reason, I gravitated toward the study of the management of public assets, and last year I published a book--it was published out of Washington--with a colleague of mine. We looked at the management of public assets in various countries, really, in order to assist some of the more emerging economies in how they handle that. As you know, many countries that were communist or socialist or that had controlled economies own a lot of property. So their problems are certainly larger than ours.

I am also an advisor to a group we set up about 10 years ago called the National Executive Forum on Public Property. We now have 30 members--10 from each level of government--and we try to share insights.

The bottom line, I will say right at the outset, is that every government does a terrible job of managing its assets, so that's a given. We are no better than most former communist countries in that regard, and there are lots of reasons why. I think that now many of the assets have been so badly managed over the period of time that we have to do something about it. I think the problems we face in Canada are no different from those faced by Australia or the U.K. or France or Switzerland, etc., and now we see the problems in emerging economies.

To talk directly about sale/leaseback, it's essentially a financing mechanism. It's really a form of releasing capital and redeploying it in the private sector, as I've outlined. It's well used in the private sector, and more so now because a lot of industries really don't want to be managing real estate or owning real estate when in fact they're making gadgets and so forth. So over the past 10 to 15 years, most organizations, including our major banks, have basically gotten out of real estate. Part of that is also driven by the fact that there's so much money that wants to buy real estate today.

When you look at sale/leaseback, you're really looking at three things: What are you going to do with the money? What's the price? And what are the terms and the lease rate? The difficulty in this whole topic is that, given my first comment about the state of these, it's kind of like taking a car that is not running very well, you don't have any money to fix it, and asking someone to buy your car, fix it up, and lease it back to you. That's a simplification, but it raises the issues of what the car is worth, how long it is going to run, and how much money you are going to put into fixing it up. It all comes down to the details, so a lot of this is all about the detail.

The fact is, in commercial real estate you don't sell buildings. In fact, I always said bricks and mortar are a liability. You're selling leases, and those leases today are packaged. They're sold in the secondary market as mortgage-back securities or what we call commercial debt obligations. Wall Street is great at taking these and slicing and dicing them.

The last thing the people who buy real estate today care about is buildings. In fact, I don't know if they could identify a good building from a bad one, because millions and billions of dollars now go around the world chasing real estate, and it's all predicated on leases.

Is this a sound approach for government? Well, the answer is both yes and no. You have to know what the details are. It could be a good deal. It could be a bad one. I don't know what the details are. I could say, however, that what distinguishes between this whole business in the public sector and that in the private sector are the two variables that the private sector doesn't deal with. One of those is public perception.

It's very interesting. As we looked around the world at various countries for our book, we found that there are countries in which you just don't sell the public asset--for instance, Switzerland. And they don't care what condition it's in. They expect government to keep it. The argument that we don't need it, or it's in bad shape, or we can't afford to fix it, they don't care about.

There is a public perception. I remember years ago when the government was going to sell off small harbours in little towns and there was a public perception that the government was going to do something bad, etc. So there is this element. And this isn't a real estate issue; it's an issue for you as politicians.

You have to realize that there are Canadians, as well as people in other countries, who really view our public assets as sacrosanct. No matter what you do, they're going to feel that you're selling our legacy. I don't have an answer to that.

The second one is just the politics itself. One of the comments in our book that we like to recite is that removing politics from a process is like taking sand from the beach, one grain at a time. No matter what you do, it's going to be open to politics. I'm not saying that in a negative way, because these are political decisions. I'm just saying that those are two variables that you have to deal with when you take this concept. It's a sound approach; it can be well used in the public sector. I would suspect that both public perception and politics are going to limit its applicability.

I had experience with two of these. I was a vice-chair and then chair of Ontario Realty Corporation, and I took it through a restructuring. We tried two sale/leasebacks. One was in Kingston, I believe. It was difficult. I remember years ago when the federal government, I believe, was trying this idea or something similar to the sale of a building on Adelaide Street West, and they pulled it back at the last moment, again because of public perception. So they can be very good business deals, but they do run into these difficulties.

The point here, though, is that it's really a practical solution to a political dilemma, and that is, there is virtually no evidence that governments in Canada and other countries will accept the fact that maintaining a building is a cost of doing business. I think you can find taxpayers' money to build new hospitals, new schools, but it's very difficult to take taxpayers' money and put it into changing light bulbs and changing the carpets and so forth. Again, this is a systemic problem. I think it's fair to say that most governments today are acknowledging that, number one, there isn't the political will to maintain old buildings, and, number two, they're lousy managers; they're just not good at it compared to the private sector.

So we are looking at office buildings, in this case I believe eight of them. In fact, it's interesting. Commercial property is a good substitute for federally owned buildings. I think around 43% of office space is in fact leased from the private sector. So maybe the issue of public perception isn't that difficult to deal with in this case.

Why sell? I think the reason you sell is that you admit that you're lousy managers of your property. It's that simple. I'm not pinpointing any particular government. I'm just saying governments in general. There's ample evidence, certainly in our research all over the world, that governments acknowledge that they are not good managers of their property, and they're likely not going to be good managers in the future. Many of the assets are coming to a point of severe deterioration and something has to be done.

It's also clear I think that governments, like industry, are saying perhaps we have to refocus ourselves and not worry about being good building managers, but being good at the delivery of services.

Is it a good time to sell? It's a great time to sell. I don't think we've ever seen real estate prices almost at a ridiculously high mark. It's a very legitimate asset class today. It's a strong generator of cashflow, and certainly it's a very appealing asset in the marketplace. I'm not saying that's a reason to sell; I'm just saying that certainly it's a very healthy market today.

What is government selling? In this case, I think it's not the bricks and mortar, but it's the leases. Unless you know what's in those leases, it's hard to know just what is going on. How much are you willing to pay over 25 years? What is it you're buying on a lease basis? What's the quality of the space that you're going to get? Do you have rights to reduce the amount of space? There's a tremendous amount of detail in this.

Will it lead to higher accommodation costs in the future? My answer is yes. You cannot transfer risk over to someone without paying for it. And what you're doing is you're transferring the risk of the asset, of managing these, to someone else. You're also having to pay to have them upgraded. So yes, it is a higher cost, but again, it's one thing to dwell on the costs and it's another to dwell on what you're going to get.

In industry, for example, we know that about 3% to 5% of the total costs of a business will be real estate, and yet the most important asset a service organization has is its people. It's rather interesting that we continue to say we're in a knowledge-based environment and we have to recruit people, but then we turn around and say, “You know, we should stick them in smaller offices.” We have to be conscious of the role this real estate plays, going forward, in the quality of the work environment we produce.

So there may be added costs. The government is saying they don't want to bear those costs at the moment. Again, the sale/leaseback has some advantages. There are savings and there could be efficiencies, energy efficiencies and so on, depending on the retrofit.

In terms of lease structures, normally in industry they run between 15 and 20 years. I always say that 25 years...I don't know. I won't be around that long, and today there's so much going on in terms of the impact of technology and the way people work, etc. All I can say is that normally in industry it's 15 to 20, with a five-year option.

What are the risks of this arrangement? First and foremost, it's just the political risk. It's really an imperfect asset, imperfect in the sense that no one really knows what something is worth.

Take the famous case from years ago, after the Vancouver Expo, when the government sold a piece of land by tender. It was purchased by a Hong Kong investor who I think took one piece of it and sold it within months at the value of the whole asset. There was no fraud involved. Put simply, it's an imperfect market, and you're always subject to that.

Second, there's the market risk. I for one do not believe rents always go up. I believe they go just down just as fast as they go up. Going back to 1993, I signed a lease for 18,000 square feet in the TD Centre. It was 98¢ a foot for 10 years. It's gone up today, but in 1989 that rent was forecast to be $65 a foot. Again, there is that market risk. You may find at some point in time that you're paying a higher rent and you may find at some point in time that you're paying a lower rent.

Third, though, is what perhaps is much more important in any lease term, and that's the opportunity cost of making the deal. As long as you know you're going to have your business there--that business, for 25 years, in that location--then you can lock in. But again, you have to be careful that in fact the lease is consistent with the objectives of your business.

There is an opportunity cost when you lock in for that long; you are committed. However, again in the lease arrangement, you can have ways by which you can relinquish some of that. Again, it goes back to the details.

What I really come down to in all of this is that a sale/leaseback is nothing more than an assignment of risk and the mitigation of that risk. We have to know what those are. In the private sector, it's a little easier. In the public sector, we have political risk and we have something that drives that, called public perception.

What does it receive? There are some very good benefits from sale/leaseback. If it works, you get better working conditions for your employees. You get a long-term cost base. You know what your costs are going forward. In some ways, you avoid the political risk of having to deal with this problem year after year. You avoid some of the risks of just managing the property itself. It also gives you an exit out of years of neglect, of not being able to address the problem. So it's not a bad exit strategy.

As I indicated before, I see it as a practical solution to a political dilemma. It's one solution. It can be a very effective approach. Really, the success of this first round will depend upon the details of the arrangement itself.

And I don't know those details; I have no idea. I'm relying simply on what I read in the newspapers and what I can get on the website. And it will be the details that will ultimately dictate whether the taxpayer got value for money.

[The Chair, Liberal, Diane Marleau]

The only other thing I want to add to that is there are slum landlords as well, and there's no guarantee that the person you're leasing the building from, depending, as you say, on what's in the contract, will keep it up. There are leased properties right here in downtown Ottawa that are in terrible shape and people are housed in them. So I get a little leery sometimes. I thought I'd throw that in.

[Prof. James McKellar]

There is a partial solution to that. So often what happens is we measure input costs, but really you can structure the lease on what I would call output performance. That is that landlords must deliver the following things, and if they don't, there are adjustments made.

To give you an example, that was the approach that was used in the famous...it's called the PRIME, the big English deal where government services sold all of their buildings to a consortium called Trillium for £250 million up front. They signed a lease, for which the net present value was about £2 billion, and it was performance based. Each time these objectives weren't reached.... Now, the problem is, in order to do that you have to keep information, you have to keep data, and you have to be on top of it.

[The Chair, Liberal, Diane Marleau]

Thank you.

Monsieur Simard, for seven minutes.

[Raymond Simard, Liberal, Saint Boniface, MB]

Thank you very much, Madam Chair, and thank you for being here, Mr. McKellar.

I guess the chair's comment was my first question. I'm from Winnipeg, and I can tell you that in the private sector...I'm just trying to think. If I look at the government buildings in Winnipeg, and I take the private sector buildings and I take an average.... My feeling is that I'm not sure the government is that bad a manager overall.

You've obviously done the stats and the work on this. Are you telling me that if we take 10 average buildings, compared to the government ones we're looking to divest ourselves of right now, the government ones would be in a lot worse shape than the private sector ones?

[Prof. James McKellar]

That is certainly my experience. I can tell you that when I was involved at Ontario Realty Corp., whenever we went to place a ministry, it was clear they didn't want to go into a public building, because a building that was managed by Oxford or Cadillac Fairview or someone....

To give you an example, a general rule of thumb is that a government should budget annually somewhere between 2% to 3% of the capital costs of an asset for annual reinvestment. As you well know, it can only be done in government by annual appropriation. Not to be critical, but when it comes to funding health care, defence, and other things, it's hard to come up with that. The City of Montreal has in fact now instituted that rule, but there are very few governments that do that.

I come back to your question. My own impression and first-hand experience is that our buildings...and it was quite severe. We had one situation where there was severe mould. We had a lot of buildings with severe mould, which is simply caused by water coming in. I could also indicate that this is true of schools. It's not only federal buildings; it's schools, it's local government buildings.

[Raymond Simard, Liberal, Saint Boniface, MB]

In the federal government, my experience has been that when you have lousy.... One of your comments was that we have lousy managers or we're lousy managers of our buildings. Normally, what we try to do here in Parliament is improve things. I'm wondering if you've ever analyzed the possibility of having a government agency that would do nothing but manage buildings. Public Works is obviously a huge box. Have you seen that as a possibility?

[Prof. James McKellar]

I have to tell you, when I took over Ontario Realty Corp., I downsized it from 2,500 to 300, because I felt they should be managers. We outsourced all of that.

Here's the problem you get into--a very simple one. I tell my students, graduate MBAs, to go and work for government. It's like a six-month process. By the time they go through all the...you can't get those people. Industry comes along and interviews them and two days later they've hired them. So even getting good people is difficult, and really the question is, if the private sector can manage these properties, why not?

There are alternatives. You could outsource, which the federal government has done in a number of situations.

[Raymond Simard, Liberal, Saint Boniface, MB]

They have. For instance, some of the ministers who were here told us that they did outsource and hired professional managers.

Can you tell us if there was a notable change when they hired professional managers? There are people like Century 21 who do just that, property management. Is that an option that you've considered, and is that a viable option, as far as you're concerned?

[Prof. James McKellar]

It's a viable option to manage the property. The problem is, where are you going to get the money to fix them up? That's your dilemma.

I think the portfolio of federal buildings that Public Works owns, the last time I looked, had an average life of 39 years. That's a long time. Many of these buildings are going to require major overhauls to meet green standards of efficiency and air quality. They're going to require major retrofitting.

That's already happening in the private sector. We have a situation in Toronto today where we're going to build three million square feet of office space and there's absolutely no demand for it. What they're going to do is to move people out of what were.... So the demand in the marketplace today is for really good quality workspace.

[Raymond Simard, Liberal, Saint Boniface, MB]

If you were to divest these buildings, what process would you use? What the government is doing now is they've hired two banks to look after divesting the properties. It seems to me that would limit you very much. In Winnipeg, for instance, there may be real estate firms that are very strong there, but not necessarily in Vancouver.

Wouldn't you be better off getting local people who know the marketplace, as opposed to having just two banks doing it right across the board, across the country?

[Prof. James McKellar]

Again, I hate to speculate without knowing very many of the details. I only read what I can in the papers, and I don't believe a lot of what I read sometimes. I'm sure there are others in this room who can appreciate that.

[Some hon. members]

Oh, oh!

[Prof. James McKellar]

But I think it's a good point. It is a local business and sometimes it's best to rely on local people.

[Raymond Simard, Liberal, Saint Boniface, MB]

Who know the market.

I know for a fact that Toronto people sometimes have no idea what's going on in the Winnipeg market. We see it all the time.

[Harold Albrecht, Conservative, Kitchener—Conestoga, ON]

Where's Winnipeg?

[Raymond Simard, Liberal, Saint Boniface, MB]

Exactly. That's the point.

So from that perspective, it would seem to me that if you're going to be divesting properties and selling buildings in certain regions of the country, it may be wise to use local people who know the markets.

[Prof. James McKellar]

I would suspect, though, that this is going to go out as a package and will be picked up by one of the large institutions. The last one I saw was when Oxford Properties set out half of their portfolio. I forget how many buildings were in it, but it sold for just over $1 billion. They had three bids: two were from offshore and one was Canadian. It was purchased by the CPP.

Don't forget these are leases. I think there's such an appetite, you're probably going to see bidding by these major institutional investors, as opposed to seeing people buying each one of these buildings.

[Raymond Simard, Liberal, Saint Boniface, MB]

That was my next question, actually. I was going to ask if you thought the sales would be partitioned to individual buyers or if there would be one big institutional buyer, like a Cadillac Fairview, for instance.

I guess the other thing is foreign ownership. Already, with the income trusts, we've just lost 16 companies to foreign ownership. The last thing we'd want to do is lose another $1.5 billion to foreign ownership. Do you see that as a real possibility in this case?

[Prof. James McKellar]

Well, it comes back to the lease. The world of real estate today is an international business. For example, Bentall Capital is over in China buying buildings. So it's hard for me to say there's some benefit to being owned by Canadians, because I do think, the way real estate is being transacted today, it is an international market. And that's the way you'll get your pricing.

To come back to your first point on whether we should sell them as a portfolio or sell them individually, that's a political decision, in the sense that there may be advantages seen. For example, I'm sure that local brokers must be yelling and screaming and saying, why are our banks getting the plum jobs when the Barnickes and the CBREs, and all of these people, are selling every day? I'm sure these people are complaining that somehow they didn't get in on the big deals.

Again, I can't answer that. I would suspect they went to the banks because they want to sell it as a portfolio.

Thank you.

[The Chair, Liberal, Diane Marleau]

Thank you very much.

Madame Bourgeois.

[Diane Bourgeois, Bloc, Terrebonne—Blainville, QC]

Thank you, Madam Chair.

Good day, Mr. McKellar.

Earlier, you stated that all governments are poor managers of their real estate assets. And yet, unless I'm mistaken, according to my large binder, the Canada Lands Company Limited, which reports to Public Works and Government Services Canada, in theory is supposed to manage, develop and sell government properties.

Does this mean that the Canada Lands Company Limited hasn't done a good job so far developing or verifying the status of federal properties? In your opinion, if the Canada Lands Company Limited can sell federal properties, how do you explain the fact that two major banks were called upon for their services? Why is that, when we already have all the services we need to help us care for our built heritage?

[Prof. James McKellar]

There are two agencies within the federal government dealing with real estate on a large scale, and those are Public Works and the Canada Lands Company—and I believe you're referring to Canada Lands in your comment.

The Canada Lands Company was created to dispose of what are called strategic assets, and in fact they've done a very good job, ranging from Garrison Woods in Calgary to.... But they are selling what we call surplus property. Canada Lands was created to sell property deemed to be surplus. This property here is not surplus.

Now, as for Public Works, if the question is, have they done a bad job, I would turn it around and say they've never had the money to do a good job. In other words, I remember not that long ago where—

[Diane Bourgeois, Bloc, Terrebonne—Blainville, QC]

I'm sorry, Ms. McKellar, but I was talking about the Canada Lands Company.

Ms. Mary Chaput from the Government Operations Section of the Treasury Board Secretariat testified before the committee that the Canada Lands Company was responsible for the orderly disposal of strategic surplus property, in accordance with business practices. Therefore, the Canada Lands Company—