Guest Column: A conversation with Robert Corry, vice president of acquisitions with Cole Real Estate Investments, and Ed Wlodarczyk, senior vice president of DTZ.
A renewed interest in sale-leasebacks is beginning to stir as businesses shift from survival mode and start thinking about growth. These transactions, in which an operating company sells its owned and occupied real estate to investors and then leases the space back on a long-term basis, are a popular way to free up capital for business expansion. Sale-leasebacks allow companies to achieve full value of a building rather than the typical 50 to 60 percent gained through 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. 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. Despite strengthening corporate profits, companies seeking to expand do not want to tie up capital in real estate. That creates an ideal climate for sale-leasebacks, as indicated by a pick-up in transaction activity.
Critical drivers that every successful sale-leaseback requires are: • A long lease, 15 to 20 years in duration. • A tenant with good credit. • A major metro or secondary market is preferred. • A rental rate at or below market. • A triple-net lease with annual escalations.
Q: What are a few of the key trends you see in today’s sale-leaseback market, specifically regarding deal flow, cap rates and availability of financing? Robert Corry: Deal flow is increasing, but it’s still a seller’s market and there are the “haves” and “have nots.” The “haves” can offer a purchaser a primary, or at least, a growing secondary market; 10- to 20-year leases (with escalations and extension options); good credit (a reasonable leverage multiple and upper quartile industry profitability margins); good products or services with a viable future; a good management team; and a defensible niche. On a nominal basis, Cap Rates for the “haves” are trading between 6.5 and 8 percent. For the “have nots,” little to nothing is trading because leverage for these deals is relatively non-existent.
Cole closes all-cash and then places conservative leverage after the purchase. Those elements are rare in the sale-leaseback and single-tenant market.
Ed Wlodarczyk: Capital markets are still having great difficulty providing financial requirements needed by corporations in the form of working capital or debt. Many private and public REITs, as well as institutional and foreign investors, have started actively participating in the sale-leaseback market. There is a great demand for firms with solid balance sheets, good credit and good real estate.
Q: How large is the sale-leaseback market? Has it grown in recent years and why? Corry: The sale-leaseback market is growing. According to Real Capital Analytics there were $1.3 billion of sale-leaseback transactions in our core property types in 2010. Year-to-date 2011 that number has already reached $3.6 billion. Although interest rates are low, credit is harder to come by. So for many middle market operating companies in need of capital, monetizing the real estate equity on their balance sheets is a viable option. In the private equity sector, sale-leasebacks can help fill financing needs within the “acquisition capital stack.”
Wlodarczyk: I’d have to agree with Bob. The size of today’s sale-leaseback market is growing given the choppy credit markets. Sale-leasebacks are projected to remain active for the foreseeable future.
Q: How has the most recent financial crisis impacted sale-leasebacks? Corry: The recent financial crisis made sale-leasebacks a more viable, and often attractive, option. Sale-leasebacks provide long-term capitalization for firms so they can weather a downturn that comes in any form. CFOs are tapping sale-leasebacks to balance their company’s exposure to the short-term credit markets and protect their firms from swings in the markets they do business within.
Wlodarczyk: Many firms have been negatively impacted by the economic conditions during the last three years and need capital for many reasons, some of which include debt reduction, inventory purchases, staff increases and growth of their business.
Q: What are the key advantages of doing a sale-leaseback? Corry: Executing a sale-leaseback can provide a company with fixed-rate, long-term permanent capital, control of the asset for 30+ years (with extension options), 100 percent financing, an increased rate of return on real estate equity that is monetized by putting it to work in the business and the ability to pay down existing bank debt.
Wlodarczyk: Sale-leasebacks provide both parties of the transaction surety of the future. In many situations, great partnerships are formed with the right capital source becoming the owner of the asset while assisting the corporate client by providing stability and help with the financial needs of the business. Conversely, the owner of the asset is able to meet the objectives of investors and properly forecast future returns.
Q: What are some potential pitfalls to avoid? Corry: Sale-leaseback candidates need to compare the capitalization rate of a sale-leaseback against their weighted average cost of capital and with the costs of other long-term financing opportunities; not with the cost of short-term debt. The seller/tenant must understand that there will be a long-term commitment to that particular location, so that needs to be taken into consideration in their business plan. As a tenant, the former owner of the property will have some diminished control over the property.
Wlodarczyk: We ensure the parties of a sale-leaseback have an open and candid conversation as to the corporation’s needs and objectives before entering into a transaction. Leases need to be structured with clear definitions as to all terms and conditions. Rental rates need to be in line with existing market conditions. “Red flags” are thrown up on deals where unrealistic rents inflate the valuation of the asset. Also, today’s investors are skeptical when lease terms are short and do not have annual escalations in rent or are not triple net in nature.
Q: What types of companies should consider a sale-leaseback? Corry: Any company that has equity tied up in real estate and is not in the real estate investment business should analyze that investment decision.
Wlodarczyk: Sale-leasebacks are used by all corporations, small, medium and large. A candid conversation with the C-Suite of the corporation will determine if this structure will resolve the firm’s overall goals. Additionally, many firms through prior mergers and acquisitions have become owners of real estate and are not properly positioned to be owners.
Q: How do you view the future of sale-leaseback transactions? Corry: Despite the proposed changes to the current accounting treatment for sale-leasebacks, the sale-leaseback industry will continue to grow. The need for sale-leasebacks is naturally growing as the need for capital grows. Companies are rebalancing their capital stack from short-term durations to longer-term durations for protection. Sale-leasebacks will provide a major source of capital going forward to sustain and grow American companies into the foreseeable future.
Wlodarczyk: With well over $1.7 trillion of CRE debt maturing over the next three years, the capital markets are poised to remain inefficient. This will provide for a “perfect storm” for the sale-leaseback structure.
Robert Corry is vice president of acquisitions at Cole Real Estate Investments. In this role, he is responsible for identifying and evaluating single-tenant Office and Industrial acquisition opportunities, including sale-leasebacks. His territory is the East Coast.
Ed Wlodarczyk is senior vice president of corporate real estate and capital market services at DTZ.