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Bulging Sale-Leaseback Pipeline

Taking advantage of an aggressive investment climate, corporations are pulling the trigger on sale-leasebacks with greater frequency. With many investors willing to buy at cap rates as low as 6% to 7% and lease terms less than 10 years, industry experts say the sale-leaseback environment has never been more attractive for corporations.

Historically, sale-leasebacks were 20-year, bondable leases that targeted solid companies with strong credit ratings. That is no longer the case. “There are non-institutional buyers out there that are willing to look at almost any type of deal and lease term and bid on it,” says Steve J. Tinsley, senior vice president of corporate finance at Chicago-based Equis Corp., a real estate services firm. “The bar has lowered in favor of corporations. ”

Case in point: Delphi Corp., the beleaguered auto parts supplier that has filed for bankruptcy, recently completed a sale-leaseback on four industrial buildings in Mexico. Delphi agreed to a four-year lease on two of its buildings, and a six-month lease on the other two — which were already empty. The automotive components firm was clearly planning to vacate the buildings. Yet the 648,000 sq. ft. package attracted seven bidders and sold quickly at a cap rate of 11% — not bad considering that the lease terms fell well short of the industry norm. Most sale-leasebacks inked today include commitments between seven and 15 years.

“I think that goes to show that there is still a huge pent-up demand for capital that has to be placed,” says Tinsley, who represented Delphi in the transaction. “There are so many buyers with so many different criteria, that some of the deals out there are ones that corporations just have to look at because the terms are so favorable.”

Peak year ahead

The sale-leaseback industry has enjoyed robust deal flow in recent years, thanks in large part to cash-hungry companies and strong investor appetite for real estate. Sale-leaseback properties continue to be highly desirable investments because most are structured with long-term,triple-net leases, which often makes them perform similar to a corporate bond.

Transaction volume surged in 2005 as rising interest rates convinced many firms that it was an ideal time to lock in long-term financing. An estimated $11.7 billion in sale-leaseback transactions were completed in 2005 — up 53% over the $7.6 billion in sale-leaseback properties that traded in 2004, according to New York research firm Real Capital Analytics.

Many industry experts anticipate that 2006 volume could be even larger. “Certainly, we are seeing tremendous deal flow in traditional, corporate deals that are $15 million and $20 million and up,” says Stephen Olsen, managing director at New York-based CBRE Investors Global Net Lease Partners, a net-lease fund sponsored by CB Richard Ellis Investors that purchases corporate sale-leaseback properties in both the U.S. and Europe.

Currently, CBREI Global Net Lease Partners is working on nearly 20 sale-leaseback acquisitions, all of which are quality deals, says Olsen. That volume is up more than 30% from last year. CB completed about $100 million in sale-leaseback acquisitions in 2005, and expects to more than double that volume this year with a target between $200 million and $300 million in new investments.

CBREI is not alone. Chicago-based First Industrial Realty Trust is beefing up its stake in sale-leaseback deals in a big way. In March, the firm announced a co-investment program with UBS Wealth Management-North American Property Fund. The combined equity stake is $290 million. Based on expected leverage of 60% to 70%, the fund anticipates buying about $900 million in such properties.

Turning point imminent?

The sale-leaseback industry has too much momentum and girth to change direction on a dime. Yet 2006 could be a significant transition year as rising interest rates, particularly long-term rates, impact supply, demand and pricing.

From the investor side, rising long-term interest rates mean higher borrowing costs. Consequently, owners will either pay less for properties or incorporate higher rent bumps in the lease structure to protect their yield. On the corporate real estate side of the ledger, rising rates may spur companies to act now to get the best price for their properties.

Until recently, corporations have not had a strong incentive to lock into the long-term financing of a sale-leaseback because short-term financing was so inexpensive. Investment-grade firms in particular have enjoyed access to cheap capital.

But in the last year that scenario has changed along with rising interest rates. Pricing on sale-leasebacks are tied to long-term interest rates because buyers typically use long-term debt to finance acquisitions, and those costs are passed on to tenants in the rental rate.

The 30-day LIBOR has risen nearly 200 basis points in the past year from 3.22% a year ago to 5.16% as of May 4. At the same time, the 10-year Treasury yield is up about 100 basis points from 4.14% a year ago to its current 5.15%. Long-term rates remain near historic lows, and the fact that rates have finally begun to move higher has encouraged some firms to pounce on attractive long-term financing and what could be peak pricing.

“This is a phenomenal time for corporations to lock into long-term, net- lease opportunities,” says Ethan Nessen, a principal at Boston-based CRIC Capital. Those conditions are driving more deals to market as firms take advantage of good deals before that window of opportunity closes, and real estate prices begin to fall.

Impact of rising rates

Players in the sale-leaseback market are still trying to determine what the impact of rising long-term rates will be on deal flow, availability of financing and pricing. “From the investor side, there is an expectation that cap rates will rise along with long-term rates, but to date that has not happened,” says Ben Harris, managing director in charge of the domestic investment department at New York-based W.P. Carey.

“From the corporate side, it makes sale-leasebacks look more attractive than other long-term capital sources,” continues Harris, “and we expect an increase in the number of companies pursuing sale-leaseback transactions.”

Some experts anticipate that higher rates will have a dampening effect on what has been a frenzied investment market. “There almost has to be a cooling off, because demand was so white hot it was almost ridiculous,” Nessen says. Yet even if market activity slows in the coming months, considering where the market had been in terms of peak deal volume and pricing, sale-leaseback activity will continue at a strong clip.

Nessen also expects higher rates to bring more prudence to the market. “There is definitely a need to be more cautious and evaluate value more closely, because the bottom line is that value becomes more important in a rising interest rate environment,” he says. Some investors and lenders may still be willing to take on risky deals, but they also may get burned if values dip. As a result, lower credit and non-credit companies may face more of a challenge in securing viable financing, he adds.

Ripple effect of rising cap rates

Cap rates on sale-leasebacks, among commercial and multifamily properties, have been steadily declining in the past five years. In 2005, average cap rates reached 7.3%, down from 7.9% the previous year. Cap rates during the first quarter of 2006 have taken another big dip to 6.4%, according to Real Capital Analytics.

Although a major pricing shift won't happen overnight, cap rates in some markets are already beginning to rise. Nessen estimates that two weeks after the 10-year Treasury yield hit 5% in early April, cap rates jumped 25 basis points.

Cap rates in some sectors are taking a significant jump, agrees Olsen. CBRE Investors closed a deal in May where the cap rate ended up being 100 basis points higher than the tenant was originally seeking. The sale-leaseback involved the upstate New York headquarters building of a BB+ rated tenant with over $1 billion in sales. The company was seeking a cap rate in the low 7s, and CBRE Investors was able to close the deal in the low 8s.

That is an indication of the rising interest rates, but also a reflection of a shift in supply and demand, Olsen notes. More deals are hitting the market, while some of the capital has been sidelined due to what has been very aggressive pricing. Olsen believes that higher cap rates are inevitable in some scenarios.

Some of the prices investors are paying for sale-leasebacks today simply won't make sense under higher long-term rates. “If the 10-year Treasury yield goes to 5.3%, 5.4% or even 5.5%, that has a radical impact on cash-on-cash returns and IRR calculations,” he says.

Searching for greener pastures

Rising cap rates can't come soon enough for some investors. For now, stiff competition is driving down returns. “We are passing on a lot more transactions because the pricing and structure and proceeds don't make sense for us,” says Harris of W.P. Carey. The private investment firm typically looks for deals that deliver returns between 7.5% and 10.5%.

In fact, W.P. Carey has cut its U.S. sale-leaseback investments in half due to the intense competition and is focusing on more lucrative sale-leaseback deals in Europe. The firm recently acquired 18 properties in Poland for $200 million. It purchased the facilities from OBI AG, the fourth largest do-it-yourself retailer in the world based on sales. Although W.P. Carey does not release cap rates on specific deals, the firm's return expectations are higher than the U.S. average, or above 10.5%.

In 2006, W.P. Carey expects a 50-50 split on sale-leaseback volume between its U.S. and European investments with total acquisitions valued at about $1 billion.

Despite aggressive pricing, $500 million in U.S. transactions isn't exactly chump change. “We're trying to focus on staying disciplined and chasing the deals that we like,” Harris says.

Smart business strategy

In spite of peak deal flow in 2006, corporations are expected to continue to initiate sale-leasebacks as an option to raise capital. An active arena for mergers, acquisitions and limited buyouts is pushing some firms into sale-leasebacks in search of less expensive capital. In May, for example, W.P. Carey acquired the global headquarters of Datastream Systems Inc. in Greenville, S.C. for $16.3 million.

Datastream is a leading provider of asset management software, and the cash infusion from the sale-leaseback helped to pave the way for the firm's acquisition by Alpharetta, Ga.-based Infor Global Solutions. W.P. Carey liked the deal because both Datastream and Infor are leaders in their respective software markets, and the firm expects the merger to strengthen its long-term growth.

Firms also are looking at sale-leasebacks as a key component of their overall business strategy. In 2001 and 2002, companies were executing sale-leasebacks because they wanted to free-up capital. “Now we're seeing companies with strong credit ratings go into sale-leasebacks because it is the right thing for their business,” says Eric Bowles, head of research at Atlanta-based CoreNet Global.

A key for many firms is flexibility. For example, Michelin North America Inc. entered into a sale-leaseback in February with First Industrial for its 663,000 sq. ft. distribution center in Houston. When the lease expires in 10 years, the company has the freedom to walk away from what may be an obsolete building, or perhaps relocate to a more central location due to changes in its distribution system.

Companies are certainly not ignoring the cash incentives of a sale-leaseback, but they are adding a strategic component to their thinking and evaluating sale-leasebacks in relation to long-term plans for their real estate. “Even if companies are flush with cash,” Tinsley says, “that doesn't mean it is cash they can or want to spend on real estate.”

Beth Mattson-Teig is based in Minneapolis.

A 1031 exchange isn't ideal for every seller

Investors are considering a radical option — opening their wallets to pay capital gains taxes. Real estate owners cashing in on rising property values often roll sale proceeds into 1031 tax-deferred exchanges of “like-kind” properties in order to avoid paying what can be a hefty capital gains tax bill.

But considering capital gains taxes are near historic lows — not to mention the difficulty in finding desirable replacement properties — some sellers are opting to pay taxes now rather than later.

The steady rise in 1031 activity in recent years mirrors the boom in real estate transactions in general. According to data from the Internal Revenue Service, 171,600 tax-deferred exchanges were completed in 1999. By 2003, the volume of transactions had risen to 220,000, according to industry estimates, a 28% increase over four years.

Yet 1031 exchanges may not be the best option for every investor. “Some of our clients are certainly saying they would rather pay the tax now rather than risk a higher rate in the future,” says Marty Verdick, a managing director at RSM McGladrey, an accounting firm based in Bloomington, Minn. Still other taxpayers are opting to pay the tax now because they are not finding suitable replacement properties in a highly competitive real estate investment market, he adds.

Favorable tax climate

The maximum capital gains tax rate assessed by the federal government is 15%. From a historical perspective, that's relatively low. In 1995, for example, the maximum rate of tax on capital gains for individuals was 28%. Those figures make it easy to see why a seller might consider paying taxes now rather than later when rates might not be as favorable.

The federal government does assess a higher rate — 25% — on depreciation deductions already taken on a property. For example, if a taxpayer bought a building for $1 million, took depreciation on the building to the amount of $200,000 and later sells the building for $1.5 million, the total gain is $700,000 — $500,000 of which would be taxed at 15% and $200,000 of which would be taxed at the higher 25%.

Ultimately, the decision whether or not to pay that tax bill could depend on where an investor lives. In states such as Nevada and Texas, where there is no state income tax, an investor that is selling a piece of land with no depreciation may face a rate of 15%. But commercial real estate owners in California or New York who have taken depreciation on their properties would pay double in taxes: a 25% federal tax, plus nearly 5% in state taxes depending on the individual's tax bracket.

More pros and cons

A 1031 exchange may also not be an ideal option in instances where a taxpayer can take advantage of a capital loss carryover to reduce the amount of the taxable gain. For example, if a taxpayer records a $50,000 gain from the sale of real estate, but also posts a $45,000 stock loss, the taxpayer can use the stock loss to offset the gain and only be taxed on the net difference of $5,000.

Many publicly traded corporations and REITs are compelled to initiate 1031s. Why? If they were to sell their properties and not place the proceeds in a tax-deferred exchange, REITs would have to distribute the money to stockholders and pay taxes, which would in effect shrink the company's asset base, notes Lou Weller, national director of real estate transaction planning at Deloitte Tax LLP in San Francisco. Private investors certainly have more freedom in their decision-making, and can weigh the pros and cons of a 1031 exchange more thoroughly.

Still, the percentage of taxpayers that do opt to pay taxes now continues to be quite small. The vast majority of investors would rather defer those taxes. “The mantra of a successful real estate investor is ‘pay later,’” Weller says. “Investors have bought these properties with other people's money and deferred taxes. That combination is what makes real estate wealth.”
Beth Mattson-Teig

Penciling out the deal

Trying to decide whether to pay the capital gains tax now or later may be a simple matter of dollars and cents. Below is a comparison of tax bills on two hypothetical property sales.

Owner A, living in the state of California, realizes a capital gain of $1 million on the sale of a small apartment complex. (The California income tax varies depending on income levels with the highest rate assessed at about 9%.)

Capital gain: $1 million

Amount of depreciation: $250,000

The depreciable gain is taxed at a federal rate of 25%, or $62,500.

The gain without depreciation, $750,000, is taxed at a rate of 15%, or $112,500.

Federal subtotal: $175,000

California state income tax of 9% on $1 million: $90,000

Federal tax: $175,000

California state tax: $90,000

Total tax on sale: $265,000

Owner B, living in the state of Texas, sells a parcel of land for a $1 million gain.

Capital gain: $1 million

Federal tax rate: 15%

Total capital gains tax: $150,000

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