Lowering the Bar on Sale-Leasebacks

Fuel Service Mart Inc. is by no means a big-name company. But when the St. Louis-based developer and operator of convenience stores opted for a sale-leaseback to help finance rapid expansion, the ConocoPhillips franchisee found a surprisingly receptive market. The recent sale-leaseback of the company's GasMart USA store in Algonquin, Ill., attracted a half-dozen bidders before selling for $5.2 million in December.

Such non-investment-grade deals represent the lion's share of sale-leaseback activity these days. “If you look at the composition of the market as a whole, 60% to 70% of transactions are not investment grade,” says Randy Blankstein, president of The Boulder Group, an investment real estate brokerage and financing company based in Northbrook, Ill. The Boulder Group brokered the deal for Fuel Service Mart, which agreed to a 20-year, triple-net lease on the property.

Strong competition for investment-grade corporate real estate, a limited supply of quality product, and pressures on cash-rich institutions to put billions of dollars in investment capital to work have prompted investors to consider investing in properties leased to non-investment-grade companies in order to achieve higher returns, says Darin Buchalter, managing director of real estate advisory services in the San Francisco office of Ernst & Young.

Sale-leasebacks are popular with investors because they typically involve a single tenant that is committed to a long-term, triple-net lease. These properties are known for providing steady cash flows and long-term appreciation in value. But while investors often prefer to buy properties tenanted by investment-grade companies, the options are limited. Demand for investment-grade deals, those firms ranked “BBB-” and higher, far outweighs the supply. Simply put, investors that need to place capital don't have much choice. “In order to meet certain criteria, investors need to look further down the credit scale,” Blankstein says.

The volume of investment-grade deals on the market today is about half what it was just two years ago, notes Bruce S. MacDonald, president of Boston-based Net Lease Capital Advisors. Sale-leasebacks that rely on credit-tenant financing represent roughly a $3 billion industry. In 2004, investment-grade transactions totaled $1 billion, half the $2 billion volume that was recorded in 2002, according to Net Lease Capital Advisors.

Investment-grade deals are in short supply for a myriad of reasons. Many investment-grade firms are sitting on the sidelines and taking advantage of extremely low short-term interest rates, while some “A” credits such as Home Depot have opted to own their real estate. In addition, the downturn in the economy a few years ago dropped firms such as OfficeMax and Staples into sub-investment-grade territory, sources say.

Risk vs. reward

Sale-leaseback properties across the credit spectrum are selling for record prices. An estimated $3 billion in sale-leaseback transactions occurred in 2004 with an average cap rate of 8% compared to average caps of 8.7% in 2003 and 9.9% in 2002, reports Real Capital Analytics (see table below). Intense competition for investment-grade transactions such as “A+” rated Walgreens has pushed cap rates below 6% in some cases.

Many investors are turning to sub-investment-grade companies in search of higher returns. “For investors willing to take on more risk, non-investment-grade properties are attractive because they typically generate higher yields and can be acquired for less than properties leased to investment-grade tenants,” Buchalter says. It is not uncommon for investors willing to take risks on below-investment-grade deals to generate unleveraged returns in the teens compared with investment-grade deals that offer returns of 6% to 8%, he adds.

The GasMart USA, for example, sold at an 8% cap rate in December — about 200 basis points above what an “A” credit could have fetched in the same situation, Blankstein notes. The buyers loved the deal because of strong store sales, as well as the desirable corner location that will offer great residual value 20 years from now if the tenant does not renew its lease, he adds.

Non-investment-grade deals clearly pay higher dividends, agrees Fred Berliner, a senior vice president and director of acquisitions at Miami-based United Trust Fund. UTF typically focuses on companies that are at least a strong “B” or above. Those transactions generate returns about 100 basis points higher than investment-grade deals. Although there are deals out there that offer even higher returns, such as an extra 200 basis points on the return for a “C” rated company, UTF usually steers clear of those deals because of the higher risk.

One growing concern is that investors are not achieving returns that warrant the added risk associated with buying properties leased to non-rated firms. In many cases, competition for below-investment-grade transactions is just as aggressive as investment-grade deals with upwards of a dozen bidders chasing deals. As a result, spreads have become extremely tight.

Although there will always be a difference in cap rates between sub-investment and investment-grade deals, that gap is certainly beginning to narrow. The pricing difference currently ranges between 75 and 100 basis points compared to a spread of 125 to 150 basis points two years ago, according to Blankstein. “Investors are taking on more risk, and they are not necessarily being compensated for that risk.”

Underwriting deals

No one disputes that sub-investment-grade transactions come with a higher level of risk. Because sale-leasebacks usually involve single-tenant, net-leased properties, the danger is that the company may default on the lease and leave the owner with an empty building.

In order to mitigate that risk, investors need to conduct thorough due diligence to have a solid understanding of the tenant — its business plan, industry trends, management, financial viability and overall creditworthiness.

Through this process, the investor can evaluate the risks of the transaction and assign a credit rating, if the company is not rated by one of the rating agencies. That rating also will help determine the sale price and the amount of rent that the investor will require the tenant to pay.

Today, many investors are performing the same financial analysis, regardless of whether a firm is a solid “A” credit, or non-rated company. Why? Investment-grade ratings are practically meaningless today because of the shortening of the business cycle and quick changes in the economy, says Michael John Naughton, an executive vice president at New York-based U.S. Realty Advisors. “As far as investment vs. non-investment, there has been such a collapse of investment-grade companies that people are taking a lot of the investment-grade (designation) with a grain of salt and doing their own credit analysis anyway,” Naughton says.

UTF has a long track record of buying deals with sub-investment-grade or non-rated companies, which typically represent about half of the firm's annual sale-leaseback transactions. However, the company is more selective when it comes to choosing those non-investment-grade investments. UTF utilizes credit agency ratings and assigns grades to non-rated firms based on its own internal analysis. In some cases, those firms are very good companies, but they may have a weak “B” rating simply because they are small, Berliner notes.

UTF recently acquired a 127,000 sq. ft. industrial facility in Dallas from a light manufacturer. Although the firm was not rated, UTF valued the company as a strong “B” credit. UTF met with management and concluded that it was an improving company with little competition. “We liked the trends and the industry,” Berliner says. The company agreed to a 12-year lease, and UTF expects a net annual return of 8%.

Real estate plays a more important role in underwriting non-investment-grade deals. “The biggest issue,” MacDonald explains, “is that if we get this real estate back and there is no tenant, where will we be?” Underwriting needs to take into account whether the property is situated in a market that is strong and growing. Are there opportunities to expand, or subdivide the building if the tenant should vacate?

Ideally, rents should be equal to, or lower than, current market rents, which creates more value-added opportunities if re-tenanting the property comes into play. “The whole issue is what can we do to add value, “MacDonald emphasizes. “If the tenant leaves, we want to be in as good a position if the tenant was there, or better.”

In fact, some net-lease investors pursue non-investment-grade acquisitions solely as real estate plays. These buyers are focused on value-added opportunities that might come from re-tenanting the property at a higher rent level, or perhaps expanding the property. “There is a real strategic opportunity in looking at deals if you can underwrite both the credit and the real estate,” MacDonald says.

Ebbing tide?

Avid investor interest is good news for firms that don't possess stellar credit ratings. Non-investment-grade companies are facing a market where real estate properties are selling for top dollar, while still being able to structure their lease terms in a favorable interest-rate environment. “This is a tremendous market for sub-investment-grade companies to be selling into,” MacDonald says.

But the question remains as to whether this is a narrow window of opportunity for below-investment-grade firms that will close as interest rates rise and higher-rated companies return to sale-leasebacks, or whether the huge demand for sale-leasebacks will continue to drive demand for all types of credit companies.

In theory, as the spread between short- and long-term interest rates narrows, it will encourage more companies to lock in long-term financing. A spike in the 10-year Treasury may help companies decide that the time is right to shift back to long-term financing.

The conventional wisdom is that in order for investment-grade firms to return to the sale-leaseback market, long-term interest rates need to rise and stay up for a period of time. While the 3-month London Interbank Offered Rate (LIBOR) has jumped 179 basis points in the past year to 2.91%, the 10-year Treasury yield has only recently showed signs of real movement, rising from 4.3% to 4.6% between March 4 and March 22.

Chances are that the lagging increase in long-term rates is a market anomaly that won't last long, Blankstein says. “Interest in non-investment-grade companies will be there so long as credit tenants are in short supply, which will probably be until at least the end of the year,” he adds.

In addition, the flow of dollars into the sale-leaseback market does not appear to be tapering anytime soon. Nearly $3.1 billion in sale-leaseback transactions occurred in 2004 compared to $2.4 billion in 2003 and $2.9 billion in 2002, reports Real Capital Analytics. Therefore, sub-investment-grade transactions are not only going to continue, but they are going to be essential, particularly for closed-end funds that have already raised capital and have no other investment alternatives.

“Many buyers can't wait for market dynamics to change so they can pursue only investment-grade transactions,” Buchalter says. Funds need to spend the money, and non-investment-grade companies present a viable alternative.

Some industry experts believe the surge in sub-investment-grade activity is part of a larger evolution of the industry. “A few years ago, investors wouldn't do non-investment grade deals. But the whole net-lease market has trended to be more inclusive,” Naughton says.

One reason for that shift is simple diversification. Those who provide debt financing on these transactions — conduit lenders and insurance companies — have taken the position that diversification is desirable. Rather than doing a $100 million deal on an “A” credit, many firms would rather spread that capital around in multiple “BBB+” or even “BB” rated deals, Naughton notes. “They don't want all of their eggs in one investment-grade basket.”

Beth Mattson-Teig is a freelance writer based in Minneapolis.


Corporate America has become much more savvy in recent years about monetizing its assets. Sale-leasebacks are one way to generate cash, particularly as prices for real estate are near peak levels.

2001 2002 2003 2004
Total Sales Volume $1.29 billion $2.85 billion $2.36 billion $3.07 billion
Average Price Per Sq. Ft. $107 $95 $110 $148
Average Cap Rate 10.4% 9.9% 8.7% 8.0%
*Based on sales transactions $5 million and higher of industrial, office and retail properties.
Source: Real Capital Analytics

Non-Investment-Grade Corporations Abound

Standard & Poor's credit ratings gauge the ability of a company to fulfill its financial obligations. Companies with a credit rating of BBB- or higher are widely considered to be investment-grade companies. The number of non-investment-grade companies is quite large and cuts across all industries. Here is a sampling.

Company Name Credit Rating
• Ahold Koninklijke N.V. BB/Positive
• Ann Taylor Inc. BB-/Positive
• Georgia-Pacific Corp. BB+/Stable
• Global Imaging Systems Inc. BB-/Positive
• Goodyear Tire & Rubber Co. B+/Stable
• Lucent Technologies B/Positive
• OfficeMax BB/Watch
• Rite Aid Corp. B+/Stable
• 24 Hour Fitness Worldwide B/Positive
• Saks Inc. BB/Watch
*Credit ratings as of March 21
“Positive” means that a rating may be raised, and “negative” means that it may be lowered. “Stable” means that a rating is not likely to change.
Source: Standard & Poor's

W.P. Carey woos international deals as part of a diversification strategy

As competition for sale-leasebacks heats up in the U.S., New York-based W.P. Carey & Co. is busy uncovering new opportunities in international markets. Since making its first foreign sale-leaseback purchase in 1998, W.P. Carey has amassed a $1 billion portfolio of international properties — primarily in Europe.

“We have been growing that business for many years, and it is not an easy business to grow,” says Edward LaPuma, chief investment officer of W.P. Carey's international division. Although the $1 billion in international office, industrial and retail properties represents a fraction of the firm's $7 billion portfolio, it does amount to a sizable and growing business for the global investment firm.

Founded in 1973, W.P. Carey is widely recognized as a pioneer in sale-leasebacks and net-lease financing. The firm is forging a similar trail in the international arena, but so far it is a very tough road. One of the biggest challenges of working internationally is that every country has its own laws, customs and culture. “Every deal is like starting from the beginning,” emphasizes LaPuma.

European countries, in particular, take huge pride in owning real estate. Many of those countries have a history based on land ownership and nobility. “You can't just take a concept and say that we have the greatest thing since sliced bread that allows you to unlock cash from your real estate and redeploy it into your business,” LaPuma says. “The CEO or CFO looks at you as if you just asked them to sell the family silver.”

However, sale-leasebacks are beginning to gain a foothold, particularly among the Scandinavian countries. “They are beginning to be more receptive. Large multinationals are doing it because they are sourcing capital across the world,” LaPuma says. For example, W.P. Carey recently entered into a $110 million sale-leaseback with Pohjola Non-Life Insurance Company Ltd., one of the largest Scandinavian insurance companies. W.P. Carey purchased Pohjola's 979,516 sq. ft. corporate headquarters in Helsinki, Finland.

While W.P. Carey is certainly one of the leaders in international sale-leasebacks, it's not alone. The practice is becoming more and more acceptable, notes Bruce S. MacDonald, president of Boston-based Net Lease Capital Advisors. “We have some pension fund clients that we advise that are looking at international sale-leasebacks for the first time. So, it is something that is becoming more widely accepted,” he says.

Part of the interest in international investment is that buyers are searching for opportunities outside of the highly competitive U.S. market. The feeling is that there is more risk internationally, but there also is a likelihood of achieving a greater return. And those companies that do have larger portfolios are able to offset the risk, MacDonald adds. Domestically, sale-leasebacks generate returns upwards of 6%, depending on the credit quality of the tenant and terms of the lease.

W.P. Carey is pursuing international investments in large part as a diversification strategy. Another influence has been the increasingly global marketplace. “The reality is that American companies are becoming dominant in Europe in certain sectors, and European and Asian companies are becoming dominant in the U.S. in certain areas,” LaPuma says. “So, to be true long-term partners with companies, we need to be with them whether they want to open an office here, there or anywhere.”
Beth Mattson-Teig

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