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Nothing but net

In July, Orlando, Fla.-based Commercial Net Lease Realty Inc. (CNLR) agreed to acquire Northbrook, Ill.-based Captec Net Lease Realty Inc. The deal set off speculation that the net-leasing industry might be moving toward a consolidation phase. There also is growing consternation that the sagging economy and lagging corporate profits will make business tougher for net-leasing specialists.

While industry analysts agree that some consolidation is taking place, they doubt a scenario typical of industry mergers, in which three or four of the largest companies devour all the smaller companies. Instead, net-leasing companies are buying and selling properties that will enable them to reposition for further growth. Others, already positioned, are using innovative strategies to tap a corporate market that increasingly views net leasing as a versatile corporate finance tool.

“The CNLR-Captec merger is really the only company merger of note so far,” said Randy Blankstein, president of The Boulder Group, Northbrook, Ill. “Consolidation is happening at the property level, when a company decides to sell its net-leased properties.”

Different strategies

The CNLR-Captec merger illustrates a repositioning trend in the net-leasing industry. Captec Net Lease Realty is a REIT that owns 136 freestanding net-leased properties in 28 states. Captec Financial Group Inc., a private company that buys and then re-sells net-leased properties, is the owner of the REIT. Upon the completion of the merger, the CNLR portfolio will contain 377 properties in 40 states with a total gross leasable area (GLA) of approximately 7 million sq. ft.

In short, CNLR buys net-leased real estate to hold, and Captec Financial buys net-leased real estate for resale. CNLR earns its profits from income generated by the properties, while Captec earns its profits on the difference between its buying and selling prices. Every company in the net-leasing industry earns profits by focusing primarily on one of these strategies. Within these broad strategic categories, other major net-leasing companies have honed additional strategic angles around the sale-leaseback concept.

Captec Financial sold its REIT — essentially a portfolio of net-leased properties — but remains in the net-leasing business, positioned as a financial resource for real-estate poor corporations that need to raise capital. “We're still an operator in the net-lease industry,” said Ronald Max, chief investment officer of Captec Financial. “But we're going to focus on a different aspect of the business. Instead of buying net-leased properties to hold, we are now going to buy portfolios and develop property with the intent of re-selling.”

Captec's plan is to re-sell 70% to 80% of its properties using the provisions of Section 1031 of the Internal Revenue Service (IRS) code, which allows property sellers to defer the payment of a capital gains tax by re-investing the sale proceeds in a “like-kind” property. Corporate financial officers don't have the time or the resources to find buyers for a portfolio of, say, 100 drug stores. They simply want to get the transaction done. Captec Financial will provide that service: It will buy the properties and lease them back to the seller. The corporate client receives the capital necessary to finance further expansion or other investments, and Captec searches the 1031 exchange market for likely buyers and disposes of the properties.

The remaining 20% to 30% of Captec's holdings will remain in the company's portfolio for a period of time collecting appreciation gains. Some properties are ideally suited to hold for a few years before selling, Max said. Captec Financial's current portfolio contains 93 retail and restaurant properties, which are net-leased and valued at $202 million.

While Max hones his company's position in the resale market for net leases, CNLR looks forward to digesting the properties it is acquiring from the Captec REIT. “This transaction reflects a continuation of our investment focus on high-quality, freestanding retail properties subject to long-term, net leases with major retail tenants,” said Gary Ralston, president and chief operating officer of CNLR.

The importance of emerging-credit companies

New York-based W. P. Carey & Co. LLC buys property from businesses, which net lease the properties back from W.P. Carey. The company holds the properties in one of four private REITs or in a public company listed on the New York Stock Exchange (NYSE). Carey's approach to the net-leasing industry begins with a complex financial engineering concept, aimed at providing what company officials call “corporate real estate financing solutions for emerging-credit companies.” What does that mean?

First, Carey raises capital by forming private REITs. “We form a REIT, or a fund with the goal of raising ‘X’ dollars in a certain time period,” said Gordon J. Whiting, deputy director of acquisitions for Carey. “Once we meet that goal, the fund closes.”

Carey currently manages four of these REITs. Three of these funds — Corporate Property Associates (CPA) 10, CPA 12 and CPA 14 — raise money from retail investors. The fourth fund began under the name CPA 11, but Carey has reconfigured that fund into a vehicle for institutional investors, and now calls it Carey Institutional Properties (CIP).

A fifth entity, Carey Diversified LLC, raises its funds in the public markets and trades on the NYSE. With this structure, Carey Diversified has consolidated nine limited partnerships into a single limited-liability company, Whiting explained. “Moving those partnerships into a REIT would have had major tax implications, so we decided on an LLC structure,” he added.

Each of these entities invests in single-tenant, triple-net-lease properties, according to Whiting. The entities also own diversified assets including properties in the office, retail, distribution, manufacturing and hotel categories.

On the strength of the properties owned by these funds, Carey ranks as the largest net-leasing company in the country. All told, Carey undertakings own and manage more than 400 commercial and industrial properties with more than 46 million sq. ft. of space across the United States and Europe. The total value of net-leased properties held by Carey is more than $3 billion.

The bulk of Carey's growth has come since 1998, as the company's concept of corporate finance has taken root in the market. “Sale-leaseback has always been a form of alternative financing for companies,” Whiting said. “Capital sources such as debt and equity occasionally dry up. But if a company owns its own building, the company has one of two choices: It can take a mortgage, or do a sale-leaseback.”

Mortgages come with disadvantages, said Whiting. First, a lender typically will finance only 60% to 75% of a building. Second, mortgage debt appears on the balance sheet as a debt obligation. On the other hand, by selling the property and leasing it back, a company receives the full market value of the building in cash. The transaction appears only in a footnote to financial statements, not on the balance sheet.

A historical perspective

Until the mid 1990s, companies availed themselves of sale-leasebacks to raise cash during liquidity crunches and other unusual economic circumstances. In the 1980s, sale-leaseback transactions actually were more popular than today, according to Rich Ader, chairman of New York-based U.S. Realty Advisors LLC. “The reasons involved the sky-high interest rates of the early 1980s and aggressive tax laws,” he said. “Interest rates ranged from 15% to 17% and higher in the early '80s. Corporate financial managers were loath to put that kind of debt on their balance sheets. Instead, they raised capital through sale-leasebacks.”

Buyers of sale-leaseback properties earned money through real estate appreciation and an accommodating tax structure. When the tax laws changed in 1986, the benefits of sale-leaseback to real estate investors changed substantially, Ader said. As a result, the business went into decline until the early 1990s, when it began to re-emerge in the form of a smart corporate financing alternative, thanks to companies like Carey.

For years, Carey and its competitors have promoted sale-leaseback as a tool that can convert unproductive real estate assets into cash that will help generate growth. In other words, sale-leaseback can serve a company's goals in both good and bad economic times.

“About three years ago, the lights went on in the market, and our message took hold,” Whiting said. More and more corporations decided to raise money through sale-leaseback transactions. In 1997, Carey's sale-leaseback transactions totaled about $150 million. In 1998, volume tripled to $350 million. The explanation for Carey's growth involves the company's promotion of its message on the one hand and its strategic approach to the market on the other.

Courting companies on the rise

Most net-leasing firms prefer to deal with investment-grade companies because these tenants are a safe bet to perform well on demanding triple-net leases. But investment-grade companies, which can employ a variety of debt and equity strategies to raise capital, offer limited sale-leaseback potential. That's not the case with below-investment-grade companies — the market in which Carey specializes.

“Our specialty is doing sale-leasebacks with credit companies that are below investment grade,” Whiting said. “We look for companies that have had problems and are turning the corner. The returns are better on properties owned by this category of companies. We can charge more, and our shareholders get higher returns,” continued Whiting.

Carey's funds typically invest about two-thirds of their cash in below-investment-grade properties. In a few years, according to Whiting, the balance flips to two-thirds investment grade, as once-struggling companies recover.

Carey's sale-leaseback margin premiums flow from those recovering companies. “If you have a less-than-investment grade tenant, you can charge that tenant the equivalent of a high cap rate for rent,” Whiting said. “Suppose we charge rent at an 11% cap rate to start. Over the term of the lease, the rent will increase along with the Consumer Price Index.

“As the company's credit improves, the rent continues to rise, according to the terms of the lease,” Whiting continued. “In time, many of these kinds of tenants become investment grade, as they work out their business issue. With that approach, we end up with many investment-grade tenants paying more than they might have.”

If the tenants were investment grade at the time of the sale-leaseback transactions, Carey might have charged the equivalent of a 9% cap rate with increases scheduled every five to seven years, Whiting noted.

Blending financial tools

New York-based iSTAR Financial is a REIT that behaves like a finance company, with a focus on net leasing, structured and corporate finance, portfolio finance, and loan acquisition. Founded in 1993 as an opportunity fund that capitalized on structural inefficiencies, the company owns a diverse portfolio totaling $4.5 billion. The portfolio includes 161 net-lease properties valued at about $1.7 billion.

“We have expertise in the capital markets, in credit underwriting and in real estate,” said Barclay Jones, executive vice president for iStar. “In the net-leasing market, we look for chances to apply each of these skills.”

For example, IBM recently spun off a printer manufacturing division into a public company called Lexmark, which owned a distribution center in Seymour, Ind. Officials at iStar believed that Lexmark corporate bonds, which were trading at 7%, looked like a good investment. Could a net-lease deal on the distribution center beat that return? After purchasing the property, iSTAR found out.

“Lexmark is an ‘A’ credit corporation,” said Jones. “We bought the distribution center using debt financing and then leased it back on a long-term lease. The transaction created a stream of cash flows with a substantially greater return — north of 300 basis points over 7%.”

Engineering a transaction that produced a 10% return required expertise in each of iStar's three disciplines: real estate, credit and equity. iStar's skills also allow it to play the net-lease market without owning. A recent transaction involving Kansas City, Mo.-based Entertainment Properties Trust (EPT), a REIT that specializes in sale-leasebacks in the movie theater industry, serves as an example.

“Banks are getting clobbered today by credit lines extended to movie theaters,” Jones said. “EPT's banks were encouraging the REIT to move on to other capital sources when its credit lines were due to roll over. But EPT was buying theaters and net leasing them with those credit lines. We participated in a conduit mortgage facility that took the banks out.”

In this undertaking, iStar helped structure a CMBS issue for a group of EPT theaters. There were no buyers for the B-rated tranche on that issue — no one except iStar, which worked with the rating agencies in defining the tranches and then bought the B piece.

A common tool

As some net-leasing companies hone their strategies in what they believe to be today's opportunity-rich markets, others are exploring the markets as first-time net lessors.

At the beginning of the year, Stamford, Conn.-based GE Capital Real Estate formed an alliance with New York-based U.S. Realty Advisors LLC to enter the net-leasing market. “We're interested in pursuing the net-leasing market with good credit tenants,” said Cathleen Crowley, managing director for GE Capital Real Estate.

GE's goal for its first year is to build a $500 million net-lease portfolio. Targets include properties in the office, retail and industrial categories. While Crowley declines to discuss specific deals, she said several are under way and that GE will likely reach its goal by year's end.

Indeed, GE's strength lies in its access to capital. “The GE structure is one of putting in 20% to 30% in equity, which gives corporate clients confidence the deal will close,” said Ader of U.S. Realty.

A $500 million net-leasing portfolio does not represent an end goal for GE. Crowley sees net leasing as one finance tool among many that GE can offer.

In the end, net leasing still does what it always has done for corporations: provide a way to monetize real estate. But net leasing no longer is the last resort of cash-poor companies. It is a resource that every corporation can use.

Mike Fickes is a Baltimore-based writer.

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