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The Next-Best Bet

Main story: Making the Most of it

Real estate developers and investors know it's tough to find financing today. But the real estate industry isn't suffering alone — companies operating in other industries don't have access to capital either. Banks, largely overextended and wary of taking on more risk, aren't being generous with credit lines, while the corporate bond market has seized much like the CMBS market.

Only the companies with the highest credit ratings have access to capital. But even stellar ratings aren't a guarantee. The financial markets have all but turned their backs on certain industries — including retail. Recession fears, coupled with worries about inflation and decreased consumer spending, have made retailers less than attractive to bond investors and banks.

That means most retailers can't access capital as easily or as cheaply as they have in the past. Even worse, the retailers that have debt expiring in the next six months are in a risky position. Capital markets are frozen, making refinancing difficult or impossible. As a result, some retailers are facing big payments, or, in worst-case scenarios, defaults. In fact, most of the analysts on Wall Street are zeroing in on companies that have a lot of debt on their books and are calculating the burn rate — or due date — of that debt. So far, this debt hasn't impacted any credit ratings, but some experts believe it could be a predictor of future financial difficulties and even bankruptcies.

And, since most retailers relied on the credit lines or bonds for their capital needs, many of them are in a position they've never been in before. “For a lot of retailers, their dry powder has blown away with the wind,” says Tom Lewis, CEO of Realty Income, a Santa Monica, Calif.-based REIT.

Perhaps this is why an old standby — the sale-leaseback — has become one of the hottest real estate investment deals going at a time when just about all other investment has come to a standstill. Sale-leasebacks allow retailers to sell the real estate they own and occupy to an investor and generate immediate cash from that sale. It can then be used to pay off debt or shore up the balance sheet, and at the same time, retailers can still occupy the same space they sold by renting it.

Cheaper than bonds

Philadelphia-based Pep Boys, for example, has closed sale-leasebacks on 75 stores in the past eight months totaling roughly $300 million. The proceeds of the deal were used to pay down debt, according to CFO Harry Yanowitz.

Lewis says that today's attitudes about capital and real estate are dramatically different than they were 12 months ago when cash was easy to come by, but quality real estate was in high demand. Today, cash is difficult if not impossible to find, and it's the real estate that is much easier to secure.

Cash-strapped retailers with debt-burdened balance sheets don't have a lot of options except for sale-leasebacks, says Jeffrey Fleischer, senior vice president of acquisitions for Spirit Finance Corp. That's why he and other sale-leaseback experts are seeing more interest from retailers to sell real estate. And, much of the interest is coming from retailers that have never before considered sale-leasebacks. In December 2007, Spirit Finance purchased 73 Smokey Bones units for an undisclosed amount. This was part of a transaction done with an affiliate of Sun Capital, which acquired Smokey Bones, and is now leasing the properties back.

But, there's every chance that retailers who run into problems in the capital markets won't have much luck in the sale-leaseback arena either. Retailers with investment-grade credit have a better chance of closing a sale-leaseback transaction today, while companies with marginal credit or questionable financials might find it difficult to attract investors.

Lewis expects that more retailers will be eager to complete sale-leasebacks as the year goes on and their need for capital becomes more acute. The ability to refinance debt coming due is critical. If firms can't refinance, they risk default. That's why Realty Income has slightly modified its investment strategy, moving away from targeting specific sectors within the retail industry — restaurants, convenience stores and child care — to focus on retailers that have financed past growth with a large amount of debt and are now looking for ways to reduce their debt load.

At the same time, Lewis says that Realty Income isn't rushing to get sale-leasebacks done right now, though, because cap rates are still too high. “I have a feeling that I'll be able to buy at a lower price a few months from now,” he says. Some experts expect cap rates could rise 50 to 100 basis points depending on the credit quality of the tenant and whether the assets are sold as part of a portfolio or in a one-off transaction. Previously, portfolios generated lower cap rates. But now one-off deals are traded lower, primarily because difficulties in financing large portfolios has winnowed the pool of potential buyers.

Much-needed liquidity

Retailers that pursue sale-leasebacks today won't receive the same favorable pricing and cap rates as retailers did 12 months ago. Last spring, sale-leasebacks for investment-grade credit retailers were 6 percent and below. Deals with longer-than-normal leases — more than 10 years — were trading in the 5 percent range. Sellers in general, not just retailers, got used to low cap rates and high prices, and now they're being forced to adjust their pricing. Retailers entering into sale-leasebacks must change their expectations, says Dan Weber, chief investment officer for Cole Capital.

Because of the credit crunch, the pool of buyers for retail sale-leasebacks is far smaller today than it was previously. And, investment volume is down. So far this year, $142 million in retail sale-leaseback transactions have closed, according to Real Capital Analytics. However, the total number of retail sale-leasebacks is likely higher since Real Capital doesn't track deals less than $5 million or sale-leasebacks with banks, which have been and continue to be very active sellers. Overall, while sale-leaseback volume is down from last year, the decrease will not be as dramatic for investment sales as a whole.

Most of the retail sale-leaseback activity today is being generated directly from retailers, and that's a big change from the past three years during which the retail sale-leaseback market was dominated by private equity players. Several private equity players gobbled up a number of retailers, and then turned around and sold off the real estate to finance their acquisitions. Perhaps the best example of this kind of deal was Sun Capital Partners Inc.'s acquisition of ShopKo Inc. and the subsequent $815.3 million sale-leaseback with Spirit Finance. Last year, retail sale-leaseback volume came to $1 billion, and in 2006, a whopping $3.4 billion traded hands.

The retailers that pursued sale-leasebacks over the past couple of years used the proceeds for expansion or capital expenditures. Today, few retailers are expanding or making investments in their current stores, so they don't need the funds from a sale-leaseback to build or open new stores. Instead, they need money to shore up their balance sheets in preparation for some tough economic conditions.

They're using the cash to pay down their credit lines and put themselves in a more liquid position, says Randy Blankstein, president of the Boulder Group, an Oak Brook, Ill.-based net lease brokerage firm and investor.

Jonathan Hipp, CEO of Reston, Va.-based Calkain Cos., is working with a small regional bank to do a sale-leaseback for some 25 bank branches. The bank had expanded rapidly over the past several years and is now looking to “pull some chips off the table” to increase its liquidity.

A number of institutional investors are currently active in the market. Phoenix-based Cole Capital expects to invest as much as $2 billion this year. It recently acquired 83 Circle K properties in a sale-leaseback for $133 million from Quebec-based Couche-Tard.

Beyond core sale-leasebacks with the typical 15- or 20-year lease term, there's also a lot of demand for value-added sale-leasebacks, says Guy Ponticello, a managing director with Jones Lang LaSalle who brokered the Couche-Tard deal.

That's especially good news for retailers that have done an analysis of their real estate portfolios and realized they have several sites they'd like to get rid of.

“Now might be a good time to do short-term sale-leaseback deals,” Ponticello says. “There are a lot of value-added investors in the market who are looking for assets with two-and three-year leases.”

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