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Sale-Leasebacks: Corporations Squeeze Capital out of Real Estate

Low financing rates, and access to capital offer compelling reasons for corporate sale-leasebacks.

Beth Mattson-Teig (April 2012)
Low interest rates are creating a compelling argument for sale-leaseback financing. Sale-leasebacks are often viewed as an alternative financing source that is attractive to non-rated or below-investment-grade companies that are hungry for capital. Yet, sale-leasebacks are active across the board - from "A" rated public companies to smaller mid-size firms.

The low-interest-rate environment, coupled with strong investor demand for quality properties, is helping to fuel transactions. For example, New York-based W.P. Carey & Co. had a record year in 2011, completing $1.2 billion in sale-leaseback investments. The investor typically acquires office, industrial, and retail facilities both in the United States and around the globe. "We're seeing tons of deals this year, and we think we're going to have another big year," says Gino Sabatini, managing director and co-head of Domestic Investments at W. P. Carey.

Buyers such as W.P. Carey base the purchase price on their own cost of capital, which is at near historic lows. That, in turn, is producing favorable financing for sale-leaseback transactions. Cap rates, particularly for high-quality properties with top credit tenants, are extremely low.

Low Cap Rates
For example, United Technologies completed a sale-leaseback on an office facility in Bradenton, Fla., last December for $20 million or roughly $188 per square foot. The deal was notable in that it produced a 7.17 percent cap rate. That is a low rate considering United Technologies agreed to a 10-year lease on the property, which is about half the term that investors typically prefer.

The cap rate is the rent divided by the purchase price. So companies are able to lock-in incredibly low rents in the current market. "Cap rates in the last year have been as low as they have ever been, and they continue to be low," says Sabatini. "It's a great time to look at pulling the trigger if you know you have assets that you want to remain in for a long time."

Certainly, favorable rates are a big selling point. However, other financing sources such as traditional mortgages also are boasting exceptionally low rates. One difference for sale-leaseback financing is that companies can lock in the low rates on a very long-term basis. The typical lease structure is 15 to 20 years compared to a five- or even 10-year term on a commercial mortgage. Sale-leasebacks also allow the user to get 100 percent of their capital out of the real estate compared to a bank mortgage where 70 to 75 percent loan-to-value ratios are more the norm today.

Firms Unlock Capital
Over the last several years, companies have seen that it is not the best use of capital to keep it locked up in real estate, says Jonathan M. Wolfe, a senior vice president and director of Grubb & Ellis Sale Leasebacks/Net Leased Properties Group in Chicago. "Why not take advantage of the fact that you can get 100 percent of that capital out via sale-leaseback, and then put that capital back into the business," says Wolfe.

Corporations are finding that sale-leasebacks make good strategic sense for their overall business plan. "Oftentimes companies want to allocate capital toward the core competencies, rather than keeping money tied up in real estate," says Wolfe. Attractive pricing has been a key tipping point for firms such as Blue Cross and Blue Shield of Minnesota. The healthcare provider recently announced the sale-leaseback of six buildings totaling 1.1 million square feet, including its suburban Minneapolis headquarters, as well as two properties in the smaller Minnesota communities of Aurora and Virginia. Blue Cross closed on the transaction with W.P. Carey in January for an undisclosed price.

BlueCross also wanted to take the equity that they had tied up in these buildings and reinvest in their core business. "A long-term sale-leaseback was the logical financing option for redeploying the illiquid capital tied up in our real estate holdings to fund strategic initiatives that enable us to improve the health and wellness of our members and all Minnesotans," says Pamela Sedmak, chief financial officer for Blue Cross of Minnesota.

In another example, a large private company was 10 years into a long-term lease for an industrial property. The company opted to exercise its purchase option to buy the property. The company recognized that they could enter into a sale-leaseback transaction and resell the property for what they bought it for, plus transaction costs, and their new net rent would be 40 percent less than what they would have had to pay on the prior lease. "What that gives you is an example of a large corporate tenant and their treasury function making a decision that allowed them to lock-in a low rate going forward, because of the low financing rate," says James R. McCartney, CFA, managing director at Net Lease Capital Advisors in Nashua, N.H.

Strategies Influence Decisions
Certainly, the financial advantages are one of the main drivers for sale-leaseback financing. The argument against sale-leasebacks is that most companies still have a lot of cheap financing available to them. As a result, those companies that are moving forward with sale-leasebacks are often motivated by other strategic reasons.

Some firms consider sale-leasebacks as part of an exit strategy for corporate real estate. A company will structure a sale-leaseback with a shorter term, perhaps five to seven years, if they know they will be closing or relocating operations after that term expires. Even though investors will price the deal lower due to the shorter term, it allows the occupant to re-capture some of that value early rather than selling a vacant building for a potentially steep discount when they do vacate the property.

In another recent example, a company bought back a facility that they were leasing and then entered into a new sale-leaseback agreement in order to give themselves expansion options. "They wanted to be able to do some things on the site that they were not able to do under the prior lease," says McCartney. "So there were some business reasons as to why they wanted to do a sale-leaseback, in addition to the obvious financial reasons of locking in a lower lease rate."

Pricing Gap Remains
Although low interest rates are creating favorable pricing for many transactions, there is no "one-size-fits-all" in the sale-leaseback arena. Investor demand and pricing vary widely depending on tenant credit, location, and the quality of the real estate.

Like the broader commercial real estate investment market, the sale-leaseback niche is seeing a large gap between "A" properties and lesser-quality deals. Cap rates for sale-leasebacks for properties in core markets with credit tenants and long lease terms are at near historic lows. However, properties in "B" and "C" markets with less stellar credit have actually seen cap rates increase.

"The properties are more challenging when you start getting into the middle-market credits in secondary and tertiary markets," says Wolfe. "It is the challenge of being able to finance those deals in a market where lenders are still very cautious, and also a challenge of finding a buyer pool that is willing to take on both the credit risk and the real estate risk associated with those deals."

That said, there is still a buyer market for distressed properties and tenants. Those deals are tougher to get done - but they are nevertheless getting done. In some cases, the risk translates into a higher return or cap rate for the buyer. In other cases, both buyers and sellers are being more flexible - and creative - to structure deals that can benefit both sides.

One alternative for companies is to execute a ground-only sale-leaseback. A company can execute a sale-leaseback on the ground in order to access a low cap rate, and still be able to put some type of leasehold financing on the improvements of the facility. Another example of more creative deal structuring includes "earn-out" security deposits. For example, an investor may buy a sale-leaseback property and then take a six-month or one-year security deposit with an earn-out based on "earnings before interest, taxes, depreciation, and amortization" (EBIDA) thresholds, where risk and return is more closely tied to the more immediate performance of the tenant.

Such examples show that sale-leasebacks have adapted to the more challenging market and are not as "boilerplate" as they were several years ago. That flexibility is helping to spark added transaction volume. "Structuring sale-leasebacks today requires more creativity from CFOs, CEOs, brokers, and buyers, particularly in situations where there is more distress," concludes Wolfe.
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