Jay Koster, Managing Principal, Staubach Capital Markets, Inc. (Aug/Sep 07)
While discussions continue to this day in regulatory and accounting circles about sale and leasebacks, today's hyper-aggressive real estate capital markets and the private equity corporate buyout activity have, at least for the time being, put sale and leasebacks into the appropriate corporate light.
History of Sale and Leasebacks
The modern sale-and-leaseback era dates back to the early to mid-1980s, when pre-tax reform syndicated partnership transactions, many of which are at or nearing expiration today. At that time, with interest rates approaching the mid-teens levels, the tax benefits generated through sale leasebacks helped provide significant cost of capital benefits to the corporate real estate user, when compared to the traditional means of financing corporate real estate. In the challenging economic conditions of the time, corporate users were eager to access effectively priced off-balance-sheet capital.
With subsequent tax reform, the ensuing real estate market downturn and interest rate declines through the early 1990s, sale leaseback transaction activity waned as many corporate users adopted an "owning is cheaper than leasing" mentality. With the economic growth of the 1990s, corporate balance sheets swelled with real estate. Sale and leaseback activity was once again energized in the mid- to late 1990s, as the real estate markets commanded appropriately priced capital. The growth of the real estate debt securitization markets, real estate investment trusts, and the private-placement debt markets contributed greatly.
The emergence of the credit tenant lease structure in the mid-1990s was the impetus behind billions of dollars of sale and leaseback activity in the retail sector. The structure provided a unique financing tool, whereby retailers under long-term bond net lease structures could achieve a cost of capital equal to or better than their corporate cost of debt for financing retail assets. The cost of capital for these transactions continued to improve as interest rate declines fueled significant increases in general property values. With property owners looking to cash out of capital gains in traditional real estate assets, these long-term bond net leased assets served as perfect 1031-exchange properties. Property owners essentially exchanged assets bearing significant real estate risks for assets with limited real estate risk and investment-grade credit characteristics. The application of the credit tenant lease structure outside the retail sector continued to expand as the cost of capital of the transactions continued to decline.
Sale and leaseback activity gathered strong momentum in the late 1990s and early 2000s. During that time, the credit tenant lease structure remained on the primary sale-and-leaseback tools. With the collapse of Enron in the fall of 2001 and the subsequent scrutiny of off-balance-sheet obligations, sale and leaseback activity moderated as corporate users and the capital markets awaited clarity on potential modifications to the appropriate lease accounting guidelines. The sale and leaseback transaction, having been viewed by some as a tool for manipulating corporate balance sheets, was awaiting a new source of inspiration.
Viewed historically, sale and leasebacks tended to be evaluated purely on the basis of relative cost of capital and GAAP earnings impact, with a strong corporate bias tending toward ownership of corporate real estate assets. Now, with private equity firms on the hunt for acquisition targets and virtually every corporate CEO and CFO keenly aware that no target is too big in today's buyout market, corporate management is focused on addressing all areas of potential corporate value enhancement. Reviews of corporate balance sheets - where assets are reflected at historical cost less depreciation - against general real estate benchmarks, indicate billions of dollars of unrecognized value exists within many Fortune 100 enterprises.
Advantages of Sale and Leasebacks
With the significant corporate scrutiny on value enhancement opportunities, and with a growing realization that corporate organizations have traditionally managed their use of facilities rather than their use of and value of their facilities, forward-looking business enterprises are adopting a portfolio value management philosophy with respect to their real estate holdings. Realizing that many large corporate real estate portfolios possess values in excess of the largest institutional real estate investors or real estate investment trusts, CFOs have begun to think about their owned and leased real estate base differently than they would have in the past. Some have called it the Sam Zell test.
Would Sam Zell, of Equity Properties lore, have owned billions of dollars of real estate with little or no knowledge of underlying market fundamentals, value potential, or the interplay of business use and commitment to continued business with value? With the historical corporate viewpoint on real estate focused predominantly on the use requirements of the underlying business, owned corporate real estate assets tended to be retained until a business use no longer existed for the property - at which time the assets were typically disposed of at a significant value "discount" as excess, vacant assets. Now, discussions of corporate real estate assets increasingly address asset life cycle, business use duration, and real estate market cycles, seeking to better define how corporate real estate values can be maximized while effectively serving the business function required of the asset.
The emerging corporate real estate portfolio management view holds that most corporate organizations should seek a balanced portfolio of owned and leased assets, with the balance dictated by the relative availability of capital and its associated cost and the business uses required of the assets. Ownership would tend to be more appropriate for highly specialized assets or those assets for which location or other qualities will limit the availability of market capital for the asset, and leasing would tend to be more appropriate for traditional office, retail, and warehouse assets for which longer-term flexibility is desired and market capital is widely available at aggressive prices. The business use duration for the asset - the timeframe in which the operating business requirement will likely require use of the facility - should be assessed frequently, as owned assets sold with even a short-term lease garner significantly more value than assets sold as vacant in today's market. With a clear understanding of own versus lease preferences for a given asset and the asset's life cycle and business use duration, corporate executives can then evaluate the asset value in the context of then-current market conditions.
Best Uses for Sale and Leasebacks
Corporate real estate portfolio management is thus developing an active versus static view of real estate value, and sale and leasebacks remain one of the primary tools for realizing value in the portfolio management process. In today's market, the sale and leaseback is being used to:
• Improve the cost of capital for real estate asset financing: In most instances in today's market for highly desirable assets, the cost of capital for the sale and leaseback is lower than the corporate cost of capital, even for the strongest corporate credits. For less desirable assets or sub-investment grade credits, sale and leasebacks frequently result in an overall cost of capital reduction, as the aggressive real estate markets have driven all yield parameters to more aggressive levels.
• Realize unrecognized asset value: Sale and leasebacks require the amortization of gain over the life of the lease term, reducing the ongoing GAAP cost associated with the capital from the sale and leaseback, and on the balance sheet, the sale and leaseback replaces the undervalued real estate with cash equal to the full market value of the asset.
• Utilize capital loss carryforwards: For those corporate enterprises with capital loss carryforwards, sale and leasebacks serve as an effective tool for monetizing both the asset and the carryforward.
As corporate real estate users more frequently evaluate their real estate portfolios, the sale and leaseback is being utilized consistently to adjust the balance of owned and leased assets, and to maximize value of assets by selling and leasing back at the appropriate point in the asset's life cycle, based on the defined business use duration and with a clear view of current and expected market conditions. Most shareholders would be surprised at the amount of real estate market risk they actually bear in holding shares of traditional Fortune 100 enterprises - and would probably prefer to have that capital redeployed into risk areas consistent with general corporate purpose.
Regardless of where the winds blow with respect to lease accounting guidelines, or what the credit rating agencies do relative to treatment of lease obligations in leverage ratios, the sale and leaseback transaction will remain a critical tool for corporate real estate portfolio management. The motives driving current sale and leaseback activity relate much less to balance sheet presentation than they do to maximization of enterprise value and management of real estate exposure.
Jay Koster is managing principal with Staubach Capital Markets, Inc., a division of The Staubach Company that specializes in real estate lease finance for high-credit clients. Mr. Koster can be reached at the company's New York City office at (212) 418-2685.