What it means
Many businesses own valuable property that they use in operations, such as stores, factories or hotels. Rather than keeping the property and the operations in one company, the owners can put the property into a PropCo and leave the trading business in an OpCo.
The OpCo then pays rent to the PropCo for use of the premises. There are several reasons for doing this.
The PropCo can be valued like a property investment on its rental income, which often gives a higher valuation than if the property were buried inside an operating business. The two companies can also be financed differently, with the PropCo borrowing against its stable rent and the OpCo keeping flexible financing for operations.
The split can also be a form of risk management. If the operating business fails or is sued, the property may be protected because it belongs to a separate legal entity, although courts look at the substance and a sham arrangement will not necessarily hold.
The rent must be set at a fair market level, because tax authorities watch closely for rent that is too high or too low. A common route is a sale and leaseback, in which the business sells its property to a new PropCo or to an outside investor and then rents it back on a long lease.
This raises cash for expansion or to repay debt, but it also replaces an asset with a fixed rent obligation that must be paid in good times and bad. The key measure for lenders and investors is rent cover, which shows how comfortably the OpCo's earnings can pay the rent.
If rent cover is thin, the PropCo's income is at risk, and if the OpCo fails, the PropCo may find itself holding an empty building that is hard to re-let.
In practice
Real-world examples.
Example
A restaurant group owns 12 buildings. It transfers them to a PropCo and signs 20-year leases for its OpCo, which allows it to borrow $18,000,000 against the stable rental income to open new sites.
Example
A care home operator sells its properties to a PropCo owned by an investor for $40,000,000 and leases them back. It uses the cash to repay debt, but its annual cost now includes $2,800,000 of rent.
Example
A retailer in financial difficulty finds that its landlord PropCo will not agree to cut rent. The retailer's advisers compare the rent with turnover at each store and negotiate to close the worst-performing locations.
Formula
Calculation
Two calculations matter most. Rent cover shows how safely the OpCo can pay its rent, and the capitalisation rate links rent to property value:
Rent cover = EBITDAR / Annual rent
Property value = Annual net rent / Capitalisation rate
EBITDAR means earnings before interest, tax, depreciation, amortisation and rent, which is the profit available to pay the rent.
Suppose an OpCo that runs a chain of hotels has EBITDAR of $3,000,000 and pays annual rent of $2,000,000 to the PropCo.
Rent cover = $3,000,000 / $2,000,000 = 1.5 times.
If investors value this type of property at a capitalisation rate of 8%, the PropCo's property is worth $2,000,000 / 0.08 = $25,000,000.Case study
Seen in the real world.
Eastgate Leisure is an illustrative, fictional company that owns six bowling centres and the freehold land under them. The founder wanted cash to build a seventh centre, but the bank would lend only a limited amount against the operating business.
On the advice of an accountant, he created a PropCo and transferred the six properties into it at market value. The PropCo borrowed $9,000,000 secured on the buildings and used the cash to fund the new site, while the OpCo paid rent of $1,100,000 a year.
Rent cover was a comfortable 1.8 times at first, but when a recession cut attendance, it fell to 1.1 times. The lender required the founder to freeze new projects until cover recovered. The illustrative lesson is that a PropCo and OpCo structure can release capital, but it also ties the two businesses together through rent.
Watch out
Common mistakes.
- Setting rent between the PropCo and OpCo at a convenient level instead of a fair market rent, which can attract challenge from tax authorities.
- Assuming that separating the property automatically protects it from the operating business's creditors, when the protection depends on proper structure and conduct.
- Ignoring that a sale and leaseback converts an owned asset into a long-term rent commitment that reduces flexibility.
Questions
People also ask.
What is the difference between a PropCo and an OpCo?
The PropCo owns the property and earns rent, while the OpCo runs the trading business and pays rent to use the property.
Why do investors like PropCos?
They offer predictable rental income that is easier to value and finance than the variable profits of an operating business.
What is a good rent cover?
It depends on the sector and lease terms, but lenders usually want to see comfortable headroom, with many looking for at least 1.5 to 2 times.
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