Signs of Life in Sale-Leasebacks
Signs of Life in Sale-Leasebacks
A renewed interest in sale-leasebacks is starting to stir as businesses shake off survival mode and start thinking about growth. These transactions, in which an operating company sells the real estate it owns and occupies to investors and then leases the same space back on a long-term lease, are a popular way to free up capital for business expansion. And sale-leasebacks allow companies to free all the value of a building rather than the 50 to 60 percent they could get by mortgaging the property.
A volatile economy with tight credit would seem to be an ideal environment for sale-leasebacks, but these transactions, like the commercial market in general, fell on tough times during the downturn.
Sale-leasebacks allow companies to free all the value of a building. What every sale-leaseback needs:
- A long lease. Ten years is minimum; 20 is better.
- A tenant with good credit. Check the franchisee's credit, not just the franchisor's.
- A good location. Prime locations in larger cities are easier to lease.
- A rental rate at or near market. Otherwise you can’t re-lease easily.
- A triple-net lease. Paying expenses cuts into your return.
In 2007, research firm Real Capital Analytics reported 1,109 sale-leasebacks. By 2010, that number had dropped to 184. Corporations hit by the recession no longer had the top credit that investors demand, says Sidney Domb, president of United Trust Fund, a Miami-based company that works exclusively with sale-leasebacks. "We turned down a number of deals last year because of weak financial statements," he says. The good news: Domb saw a pick-up in transactions beginning in mid-2010. Despite strengthening corporate profits, companies seeking to expand don’t want to tie up capital in real estate. That creates an ideal climate for sale-leasebacks.
More Scrutiny of Retail
Retail sale-leasebacks, most of which are smaller sales of freestanding buildings occupied by drugstores, fast-food outlets, and the like, held up best until last year, when they fell by 80 percent, according to Real Capital Analytics. Lack of financing and higher loan-to-value ratios are keeping many private partnerships and 1031-exchange buyers out of the game, says Eddie Blanton, CCIM, with Tradd Commercial Real Estate in Charlotte, N.C. The retail investors that remain are looking much harder at the individual retailer’s credit, current income, same-store sales trends, and years of operation, says Tom Schmidt, CCIM, with Colliers Parrish Commercial Investment Group in Redwood City, Calif. Sales-to-rent ratios are also tightening, with investors looking for a 7 to 8 percent ratio on current market rents.
The retail sale-leasebacks that are closing mostly come from all-cash buys by larger equity funds and institutions, says Blanton. Deals work like this: Institutional buyers are willing to sign preconstruction contracts on multiple properties, which enables merchant builders to obtain financing more easily. The payoffs are cap rates in the 8.5 to 9 percent range—a point higher than even most class-A retail deals today. Builders can recoup part of this discounted price because desirable pads are selling at a 20 percent or higher discount, Blanton says.
Where the Activity Is
Sale-leasebacks in less-traditional niches are also picking up some of the slack. Private equity companies that acquired companies during the downturn often want to leverage a company’s warehouse or office building for funds to expand, which makes them good candidates for sale-leasebacks, says Geoff Faulkner, CCIM, a broker at Colliers Parrish in Redwood City, Calif. The bigger deals for corporate sale-leasebacks usually go directly to a large REIT or institutional investor. Smaller local companies and one-off single-building deals are more likely to be sold by commercial brokers, he says.
Health care providers also are increasingly using sale-leasebacks, says Mark Samples, CCIM, with Prime Healthcare Properties in Huntsville, Ala. Samples, who started his career in retail sale-leasebacks, says that these days most of his business focuses on developing or acquiring and redeveloping medical office and stand-alone ambulatory surgical and dialysis facilities. Once complete, the centers are sold to investors, which can include the doctor tenants. Sale-leasebacks also provide a good exit strategy for a physician—or any business owner—who might want to leave a partnership. To make such projects work, he says, it’s "imperative to understand the initial lease rate to determine if there is a spread appropriate to the investment’s risk between the development cap rate and the exit cap rate."
What Makes a Good Deal
There’s no question what the most important factor is in making a sale-leaseback marketable: The credit of the property’s owner and soon-to-be tenant. "It’s more important than the real estate," says Domb. In retail sale-leasebacks, investors also need to compare the sales of the location to averages for the franchise, says Schmidt. For smaller companies, personal guarantees from owners will lessen risk.
Yet, it’s often the companies facing particular business challenges that have the greatest need for the cash infusion of a sale-leaseback. In these situations, a broker has to "be able to tell a story about the overall strength and history of the company, not just about what’s going on right now," says Faulkner. "You have to help a buyer assess whether the company’s weakness is temporary." The upside: Deals with weaker tenants yield higher returns to investors to compensate for the higher risk.
Long leases are another cornerstone. Shorter leases can work, but they come with a much different goal than the steady income that attracts most investors to sale-leasebacks. "With a shorter lease, you’re really selling the underlying real estate instead of the income stream from the real estate being leased back," says Mike Senner, SIOR, senior vice president with Colliers International in Rosemont, Ill. But unlike an outright sale, using a sale-leaseback structure gives investors cash flow until they want to redevelop. Financing with a tenant in place is also much easier.
Another criteria for good sale-leaseback investment are rents in line with the market. A 2010 research paper by C.F. Sirmans and Barrett A. Slade ("Sale Leaseback Transactions: Price Premiums and Market Efficiencies," Journal of Real Estate Research, April-June 2010) speculates that somewhat higher rents might be justified for sale-leaseback properties because of the lower risk of vacancies and the higher credit profile of most sale-leaseback tenants. Yet, too great a discrepancy is "a red flag," Faulkner says. A deal based on an unrealistic rents inflates the price and can make it impossible to re-rent the property, he explains.
Buyers should also be wary of multi-year rents with no escalations and leases that are less than the standard triple-net, says Domb. Many national retailers offer investors leases where they have to pay for costs like roof replacement and parking lot repair. "Once you start fixing things, you have to look at how that affects your overall investment return," he says.
Meeting a Need
Sale-leasebacks seem poised for a comeback, helped by the fact that "there will always be companies that need to liquidate their real estate for business-related reasons," says Senner. Moreover, as the economy improves, more businesses will have the credit to qualify for sale-leasebacks and the need to convert bricks and mortar into cash.