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Sale-Leaseback: An Appealing Strategy

The recent recession intensified corporate focus on the bottom line. In a challenging economy, belt tightening and downsizing replace growth and expansion. With real estate typically ranking as the second- or third-highest overhead cost for most corporations, a sale-leaseback transaction can present an attractive financing strategy.

By selling an asset and then leasing it back, a firm can unlock value that is tied up in real estate and deploy it as working capital. A sale-leaseback deal can improve the organization's debt-to-equity ratio and reduce depreciation and interest costs, all of which have a positive impact on a firm's balance sheet.

Recently, retailers such as Sunstate Equipment, one of the largest rental equipment companies in the United States, sold 25 properties in a sale-leaseback strategy that raised $36.4 million, and Roadhouse Grill completed the sale-leaseback of 11 restaurant properties for $21.8 million. In a single-asset transaction, a Borders Books store in Pasadena, Calif., recently commanded a sales price of $17.25 million. Borders signed a 15-year triple-net lease on the property.

Strong ROI

From an ownership standpoint, the first thing corporate executives must consider is whether they want to control property through a lease so it is treated as an expense or whether they want to own property where it is a capital investment. Factors include the use of the facility, the life span of the firm's occupation of the facility, improvements to the facility, as well as financial considerations. In general, corporations want to own strategic assets such as research and development facilities, sometimes office headquarters and manufacturing facilities. On a broader basis, leased properties tend to be distribution facilities and the bulk of office space.

By selling an asset, a company can use the proceeds to pay down debt or invest it in its core business. When owning real estate, companies accept an average rate of return of between 7 percent and 12 percent. By comparison, most corporations usually have internal hurdle return rates of 15 percent to 30 percent. Also, through leasing, firms can gain flexibility (downsizing, expanding, relocating) while still maintaining control of their facility. Long-term operating leases structured as a bondable triple-net lease let a corporation retain complete operational control of the property; it is responsible for all building repairs and maintenance, janitorial, insurance, real estate taxes, etc. Many investors are attracted to such management-free, passive investments, and these deals are oftentimes a win-win situation for both the seller and the buyer.

Excellent Fundamentals

Solid operations and excellent fundamentals continue to entice investors to buy retail properties over other property types. Single-tenant net-lease retail remains in high demand throughout the United States. With demand exceeding available supply, prices registered growth of approximately 12 percent in 2004, to around $200 per square foot. Moreover, strong appreciation will support sustained buyer demand in 2005 for most single-tenant net-lease product. While not quite at the record level posted in 2003, transaction velocity has remained strong, with sales of less than $5 million accounting for 95 percent of all single-tenant deals in 2004. Despite expected bumps in interest rates, demand for retail will remain strong in 2005, as sales encourage retailer expansion and single-tenant net-lease assets continue to outperform other property classes.

Bankruptcies, consolidations, relocations and mergers have left vacant big-box stores scattered across the country. The biggest and most criticized contributor has been Wal-Mart, which contends that the estimated 100 sites it vacates annually are simply a by-product of its explosive growth. The retail giant currently has more than 160 empty stores on its books, with more on the way in 2005. Kmart's 2003 bankruptcy resulted in the closure of 600 stores, many of which are still vacant.

The challenge with vacant spaces becomes determining the best use for the location. Retail is undoubtedly the first choice for many sites. For instance, expanding retailers such as Kohl's have opted for vacant Wal-Mart space in Southern California, where building costs are high. Many times a space can be subdivided and re-let to tenants that better support an area's demographics.

White Elephants

Large REITs such as Kimco Realty Corp. have recognized the opportunity in many of these potential white elephants and purchased portfolios of vacant boxes. Kimco's strategy has been to re-tenant spaces and then sell the newly occupied boxes individually. When retail has not been the best use, entertainment facilities, temporary tenants, office space and government facilities can find homes in dark stores.

In ongoing efforts to break into new markets, the nation's largest retailers are tweaking their conventional formats to placate opposition in some communities. Wal-Mart is opening a tri-level concept store in Hawaii, consisting of a ground-floor parking structure, a Wal-Mart on the second level and membership discounter Sam's Club on the upper level.

Family Dollar is going urban, with plans to open 300 stores in big cities in 2005. The stores will be smaller and geared toward walking urbanites in search of bargains. Whole Foods opened a 59,000-square-foot store in New York's Time Warner Center, with a strong emphasis on prepared foods. The chain has been called the first grocer to combine New York's exclusiveness with mainstream America's affinity for size.

Home Depot has also adapted, entering markets by filling existing sites or changing their inventory to meet the regulations of the community. In Hyannis, Mass., the home improvement company not only took on a space left vacant by a grocer but zoning regulations made it necessary for the store to give up its paint sales.

Leading Retail Chains Aggressively Expanding

Properties with low- or non-credit tenants remain a popular choice among buyers seeking single-tenant net-leased investments. A lack of available investment-grade assets and a significant amount of capital still chasing deals have also prompted lenders to look at properties occupied with sub-credit tenants.

Comparatively lower per square foot prices and higher cap rates, coupled with available financing, will continue to drive demand for these deals in 2005.

National director of Marcus & Millichap's National Retail Group, which focuses exclusively on the brokerage of retail investment properties

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