From Site Selection magazine, May 2013
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Corporate Real Estate as a Long-Term Source of Financing
Explore an alternative to ownership that can free up capital.
s more sophisticated financing techniques and structures continue to be developed, business owners, managers and financial officers need to be aware of alternatives for managing and financing their real estate assets. An evaluation of these alternatives takes into consideration the nature of the firm's current and future real estate needs, the company's financial structure, access to capital and capital requirements, and the firm's ownership structure and external performance measurements. Even though there are some benefits to ownership, it may not make sense for a company to own its real estate. Consequently, it is useful to explore other options such as sale-leaseback which might better address the firm's operating and financial goals.
Businesses have traditionally had the option of freeing up capital tied up in property through a standard mortgage financing. Another alternative is to enter into a sale-leaseback transaction. Nevertheless, some businesses prefer to control their real estate through direct ownership. A typical mortgage gives the firm access to capital equal to 50 percent to 75 percent of the real estate value while allowing it to retain the depreciation tax deductions and the potential appreciation or depreciation in value of the underlying real estate (residual risk). However, this is an "on balance sheet" debt instrument, and interest payments combined with depreciation expense can impact a firm's earnings statement.
An alternative to direct ownership that provides companies a similar long-term control of the property is the sale- leaseback transaction, which can often qualify as an "off balance sheet" financing. The increasing awareness and popularity of this type of financing was recently highlighted at the RealShare Net Lease conference in New York where experts noted that the net lease sector had just come off a $30-billion year in transactions and stood to do $40 billion in 2013.
A sale-leaseback is typically long-term in nature with a lease term ranging from 10 to 25 years.
Additional financial benefits include:
- Unlocking cash equal to 100 percent of the value of the property. By replacing an illiquid real estate asset with cash, the company's current ratio and liquidity can be improved, making it possible to grow the firm's core business, pay down debt, improve coverage of debt, or increase borrowing capacity;
- Structuring the lease so that it qualifies as an operating lease where the obligation does not appear on a firm's balance sheet;
- Organizing lease payments so that initial rents are relatively low (often below depreciation and interest expenses), thereby improving a firm's net earnings.
For a company that currently owns its real estate, capital can be freed up for operations without either incurring additional indebtedness or diluting equity.
Depending on whether a property is existing or to be built, the lease can take one of two basic forms:
- Triple-Net Lease: This type of lease is typically "off balance sheet" and can be short or long-term in nature. The tenant is responsible for paying all the property-related expenses throughout the term of the lease such as taxes, maintenance and insurance. In addition, roof and structural expense is often the expense of the tenant. The rationale for this type of lease is that the tenant can best manage its own property costs and the lessor, with reduced operating exposure, can offer lower rents accordingly. Residual risk is borne by the lessor in this transaction.
- Build-to-Suit Lease: This type of lease can be structured as "off balance sheet" and is signed before a property is constructed. The future lessor funds the construction during the construction period, and rent is typically accrued into the overall project cost. The initial term of the lease begins at occupancy and thereafter the lease can work similarly to a triple-net operating lease with the tenant paying all property-related expenses. By providing single-source financing, the build-to-suit lease has become increasingly popular with developers constructing customized facilities for corporate user/tenants as well as for corporations developing their own facilities. By avoiding the need for traditional third-party interim/construction financing, the developer/owner saves on related fees and expenses and is able to lock in his cost of capital early on in the development process.
Any company looking to do a sale-leaseback needs to look beyond the benefits of the transaction itself to the investor on the other side of the transaction. Given the increased volume in the sector, investors include public and non-traded REITs as well as institutional real estate funds and private investors, ranging from those who have been active and successful in the space for decades to those who have shorter track records and more limited experience. Sale-leaseback investors who have proven to be a "constant source" of capital in good times and bad are those who evaluate new investments in terms of their ability to generate consistent income over the longer term. Traditionally these investors look for critical assets owned by companies that are well positioned in their industry and have a long term business and growth strategy that will enable them to "pay the rent" well into the future. The best investors in this sector are those who are credit oriented and have the ability to look at a company and its pro forma financials. Their understanding of how the transaction will improve the company's position in its sector, as well as enable it to achieve improved operational and financial performance, will allow the investor to offer a competitive value for key assets in the context of a sale-leaseback financing that supports a company's growth and ongoing operations.Companies with substantial real estate assets that are critical for their businesses may well find that sale-leaseback financing is able to meet all or a portion of their financing needs in lieu of more traditional sources.
Although the sale-leaseback may seem like a simple concept, a company that "sells" a key operating facility to an investor needs to know that the investor is capable of closing the transaction on a timely basis. In addition, the company needs to assess the investor's ability to structure a transaction within sale-leaseback contractual parameters while addressing the specific operating and financial requirements of the company. The investor must also have the financial expertise to determine independently that the company's operations will support the rental obligations to the investor owner and also generate a profit for the company.
The purchasing fund or REIT should have secure long-term capital commitments. It should also be structured so that a failure or default with respect to any individual portfolio property does not impair the overall financial strength of the investor. Consequently, the size and diversity of the investor's portfolio as well as the financial structure of individual investments held by the investor should be understood. Portfolio diversity should include diversity with respect to geography, industry and tenant. Given that the purchasing entity in a sale-leaseback transaction is in essence becoming a long-term financial partner of the company as well as its landlord, the purchaser's investment history, reputation and depth of asset management need to be understood as well.
Companies with substantial real estate assets that are critical for their businesses may well find that sale-leaseback financing is able to meet all or a portion of their financing needs in lieu of more traditional sources. In order to insure the long-term success of any sale-leaseback financing, partnering with an investor whose objectives are consistent with those of the selling company is as critical as the terms of the transaction itself.