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Sale-Leaseback Quandary

Struggling to find capital as the credit markets tighten and the U.S. economy slows, corporations are increasingly exploring sale-leaseback deals to finance growth, repay debt and fund operations. But falling commercial real estate prices and growing worries about the creditworthiness of many corporations have curbed deal volume.

Against that backdrop, sale-leaseback buyers are redoubling their efforts to capture the highest-quality deals. That means investors are pushing for property prices and rental rates low enough to compete in the event a tenant goes under, particularly when betting on stronger operators in relatively weak industries.

Case in point: National and regional banks are unloading their real estate with more frequency to help address deteriorating fundamentals in their loan portfolios and a host of other balance sheet issues.

The Federal Deposit Insurance Corp.'s latest report says that the non-performing loan rate among institutions it regulates more than doubled to 2.04% in the second quarter this year over the same quarter last year.

In July, Inland Real Estate Group in Oak Brook, Ill. and an affiliate acquired four Bank of America office buildings totaling 840,000 sq. ft. for $152.6 million. Inland also snatched up 433 SunTrust Bank branches for $736 million in December 2007 and April 2008.

“When you're doing sale-leasebacks with banks, you've got to be darn sure you're dealing with financial institutions that are going to be around for a long time and that haven't had to drastically write down their books,” says Joseph Cosenza, vice chairman of Inland Real Estate Group. “That's something we watch very closely.”

Yet on the flip side, the credit crisis is forcing some corporations that generally would have avoided sale-leasebacks in the past to consider them, he adds. A broader acceptance of the strategy by companies coupled with the demise of synthetic leases also is driving transactions.

“Two years ago I certainly wouldn't have gotten $153 million worth of Bank of America properties,” says Cosenza. “These are telling times.”

Market in flux

In a sale-leaseback deal, corporations sell real estate they own and then rent the properties back from the buyers under a long-term net lease — roughly 15 or 20 years — with extension options. But it's not uncommon for leases to be signed for as little as 10 years.

Under the arrangement, tenants are responsible for the property's operating and capital expenses such as taxes, insurance and maintenance. For investors, sale-leasebacks typically generate returns of 300 to 500 basis points over the 10-year Treasury yield.

Among other benefits, sellers move the assets off their balance sheets for tax purposes and receive predictable long-term lease rates. Most critical, companies pocket cash they can plow back into their business to fund growth or pay off debt.

Like the broader commercial real estate investment sales environment, sale-leaseback transactions have declined over the last several months. Boulder Net Lease Funds in Northbrook, Ill., a private equity firm that tracks net-lease sales activity, reports 15,500 net-lease properties changed hands in the first half of 2008, down nearly 14% over the same period last year. Sale-leaseback transactions are considered a subset of net-lease deals.

But Jeff Rothbart, a principal and research director at Boulder Net Lease, suggests that the number of reported net-lease transactions this year is likely skewed to the high side. Some corporations are simply putting their assets on the market to test pricing and are artificially inflating supply, he says. The companies are then balking at offers and taking the assets off the market, leaving the impression that the properties have sold.

What's more, the seized-up mortgage markets and a higher cost of capital have benched many sale-leaseback buyers who at one time tapped cheap debt to finance 80% or more of their acquisitions, experts say. Some investors claim sellers need to capitulate on price to spark more deals.

New York-based CapLease, a real estate investment trust that purchases single-tenant net-lease assets, hasn't completed a sale-leaseback since April 2007.

Instead, CapLease has focused on strengthening its balance sheet while waiting for the credit markets to stabilize, says William Pollert, president of CapLease. The company owns a portfolio of some $2.1 billion in real estate and mortgages.

“Before the meltdown in the capital markets, everyone in real estate was on the crack cocaine of cheap money,” he adds. “Now the market is grappling with how to price risk in an economic downturn.”

Price hang-ups

Capitalization rates have risen between 50 and 200 basis points over the past year and range from 7% to 9%-plus, depending on the tenant's credit quality, the asset and location. An uptick in cap rates indicates downward pressure on prices.

New York-based W.P. Carey & Co., a sale-leaseback and build-to-suit investor with $10 billion in assets under management, is hunting for cap rates approaching 9% and higher, says Benjamin Harris, managing director and head of domestic investments for the company. He suggests that cap rates need to increase about 100 basis points in order for sales to boom.

“We've seen a definite pick up in sale-leaseback inquiries, but companies are reluctant to execute transactions for fear that the credit markets will get better three months from now,” he says. “But we don't see any reason why there would be near-term improvement. Companies will have to get used to where pricing is today.”

That's true to the extent that companies are desperate for financing. Since late last year, Philadelphia-based Pep Boys has completed $411 million in sale-leasebacks of its stores to reduce or retire debt, although it still owns 235 of 562 locations. The company won't be pursuing more deals soon because cap rates have increased from more than 7% to nearly 8%, says Ray Arthur, CFO of Pep Boys.

Motivated middle market

Unlike Pep Boys, stand-alone retailers, restaurants, and other corporations have made sale-leasebacks central to their business strategy. Crème de la Crème, a preschool owner and operator, has been using the structure since 2003 to accelerate growth, says Bruce Karpas, CEO of the Greenwood, Colo. company.

Crème de la Crème has executed 14 sale-leaseback transactions on 20 of its 21,000 sq. ft. preschools. It plans to add up to eight more schools by the end of 2009.

“Sale-leaseback transactions have always been a viable financing option for Corporate America,” says Jeff Hughes, a senior director with the Stan Johnson Co., a Tulsa, Okla., brokerage that specializes in net-lease transactions. “If you're building and selling widgets, you really shouldn't be in the real estate business.”

The credit crunch has nailed that point home for many corporations. In fact, small and middle-market companies with non-investment grade credit ratings — ratings below “BBB” — are pursuing sale-leasebacks and accepting today's lower sale prices compared with 18 months ago, say experts. While some property sellers are forced to enter into deal to generate cash, most view the structure as cost-effective.

But financially struggling corporations raise red flags, they warn. That's particularly true for businesses operating in the battered automotive, airline and housing industries, according to Fred Berliner, senior vice president and director of acquisitions at United Trust Fund (UTF) in Miami.

Opportunities still exist in those industries, he adds. Last year, UTF executed a $10 million sale-leaseback with Toronto auto parts distributor Uni-Select Corp. UTF bought two assets totaling roughly 200,000 sq. ft. in Memphis, Tenn. and Mason City, Iowa.

“You have to take a hard look before you would do deals with companies in industries that are negatively viewed,” he says. Most recently, UTF acquired a 100,000 sq. ft. office building in Ft. Lauderdale from Coventry Health Care for about $26 million.

Hunting for deals

Active investors are hardly shying away from non-investment grade companies. Buyers generally pay cash for assets and then finance 55% or 60% of the property value in the following weeks or months.

“The question is, does it make sense to take somebody within an industry that's struggling?” asks David Steinwedell, a managing partner with Austin, Texas-based AIC Ventures. Since 1990, the investment manager has completed $770 million in sale-leaseback deals with middle-market companies — typically medium-sized private companies that are often struggling to grow. “We're building a portfolio across a number of industries, and there will be players in those industries that will survive and thrive even in bad times,” explains Steinwedell.

Meanwhile, AG Net Lease, a division of New York-based Angelo Gordon & Co., taps relationships with a broad array of private equity funds to source sale-leaseback deals with over-leveraged companies, says Gordon Whiting, founder and chief portfolio manager of AG Net Lease. Angelo Gordon, which manages assets of some $20 billion, pursues a handful of other alternative investment strategies beyond real estate.

In early August, AG Net Lease paid $30.4 million for six manufacturing and distribution facilities in the U.S. and Canada from KIK Custom Products, a third-party maker of national and retailer brand consumer products. KIK, a portfolio company of private equity investor CI Capital Partners in New York, is using the cash to reduce debt and fund growth.

“More companies are looking to do sale-leasebacks because they unlock hidden dollars on the balance sheet,” Whiting says. “And access to other forms of debt capital has been greatly reduced.”

Inland's Cosenza and other sale-leaseback investors see more deals in the near term. Over the last five years, Cosenza says his company has poured $3.8 billion into sale-leaseback deals. “I was shocked,” he says. “But I still want more.”

Joe Gose is a Kansas City-based writer.

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