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uring the closing months of 2001, activity in the real estate sale-leaseback market surged as more and more corporations sought to raise cash in a declining economic environment.
W. P. Carey & Co., LLC, completed US$185 million worth of transactions in the fourth quarter of 2001, nearly half of the year’s total of $395 million, a company record.
“The fourth quarter of 2001 was probably one of the most active quarters for sale-leasebacks that we’ve had since before August of 1998,” says Marjorie Palace, CEO of Corporate Realty Investment Company, LLC, in Boston.
United Trust Fund of Miami, Fla., carried out seven sale-leaseback transactions in 2001, worth approximately $100 million. “That’s a normal year for us,” says James Nolan, executive vice president and chief financial officer. “But while we do about the same amount in transactions each year, this past year was more active in terms of looking at increased numbers of prospective deals.”
New sale-leaseback providers found 2001 productive in general. GE Capital Real Estate entered the business last year and logged about $120 million in sale-leaseback transactions. “We had a good year,” says Cathleen Crowley, managing director with GE Capital Real Estate. “We’re on target to meet our new business goals.”
This current level of activity comes on the heels of a sale-leaseback market that has been growing for a number of years, according to officials with W. P. Carey. “Business was increasing even while we were in a bull market,” says Gordon J. Whiting, deputy director of acquisitions for W. P. Carey.
What is fueling this increased interest in real estate sale-leasebacks? In recent years, sale-leasebacks have emerged as an important tool of corporate finance for companies in search of liquid cash resources. By monetizing real estate, corporations retain use of the property and receive cash that can fund growth, pay down debt or finance other business strategies. Exercising any of these options improves a company’s balance sheet.
Take The Cash, Use The Building
Companies that specialize in sale-leaseback transactions and financing have been promoting the idea of turning real estate into cash for many years. “We’ve been talking to corporate executives about the benefits of sale-leasebacks for 28 years, as long as we’ve been in business,” says Whiting, whose firm is a New York-based sale-leaseback provider. “A sale-leaseback takes a depreciating asset held on the balance sheet at original cost less depreciation and monetizes that asset at its full, fair-market value.”
Suppose a company purchased or built a facility for $10 million 10 years ago. That asset has been depreciating on the company’s balance sheet and today shows a value of approximately $8 million. Perhaps, the fair market value of the building has appreciated to $15 million. The balance sheet does not reflect the true value of the asset, nor is any of that value available to apply to the business.
“If you had cash representing the full market value of the building, instead of the real estate itself, you could put that cash into inventory and lower your inventory costs,” says Richard Ader, chairman of U.S. Realty Advisors, LLC, of New York, an advisory firm that works with GE Capital’s sale-leaseback group. “You would then see a return on that cash related to the returns you get on your business. In other words, it becomes a productive asset for the company, compared to real estate.”
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This example carries tax consequences. The sale-leaseback transaction would return $15 million for a balance sheet asset logged at $5 million. Hence the company’s tax return would show $10 million in income.
A sale-leaseback yields cash plus the continued use of the building for a former owner, now a tenant, under one or another form of net lease.
A net lease differs from a gross lease, a typical lease, under which the landlord retains primary control of and responsibility for the building, maintains the building, provides insurance, and pays the property taxes.
With a net lease, the tenant has primary control of the building and pays for some or all of the maintenance, insurance and taxes.
Four types of net leases define these responsibilities differently. A single net lease requires the tenant to pay the buildings taxes. A double net lease requires the tenant to pay the taxes as well as the insurance. A triple net lease adds maintenance to taxes and insurance.
The fourth type of net lease is called a bond lease. “A bond lease is a ‘hell or high water’ lease with no outs for the tenant,” says Donald Bindler Jr., a vice president with Capital Lease Funding, LLC, a New York-based lender that specializes in credit-tenant lease financing. “A triple net lease may provide the tenant with an out for a condemnation or casualty on the property. Double net leases have condemnation and casualty outs plus certain landlord obligations for maintenance and repairs, typically to the roof, structure, and parking areas. But these are limited to major capital items.”
Sale-leasebacks typically employ a triple net or bond lease.
Specific Uses For Sale-Leaseback Returns
While a corporation retains use of its building with a sale-leaseback transaction, the company also receives the market value of the building in cash that can be put to some corporate use.
How do corporations use this money? The list of options includes paying down debt, funding acquisitions, financing expansions, fueling research and development.
For example, Gerber Scientific Inc. of South Windsor, Conn., executed a sale-lease back with W. P. Carey last year and used the cash to pay down corporate debt.
In this transaction, W. P. Carey acquired and leased-back three Gerber properties for $19.7 million under a 17-year bond-type net lease with two ten-year options. The three buildings include a 194,000-square-foot (18,042-sq.-m.) single story office and light manufacturing facility; a 60,000-square-foot (5,580-sq.-m.) single story office and industrial structure; and a 93,500-square-foot (8,695-sq.-m.) single story office and industrial facility.
A sale-leaseback can also help fund acquisitions. In 2000, Caxton-Iseman Capital Inc. a New York-based investment management firm specializing in buyouts, restructurings, recapitalizations and growth equity investments, took a public company private using funds in part obtained from a sale-leaseback. In this deal Buffets Inc., of Eagan, Minn., a public company that operates 400 buffet-style restaurants across the U.S., sold its stock to Caxton-Iseman.
To help finance the approximately $650 million privatization buyout, retain more equity in the deal, and lower its total acquisition cost, Caxton-Iseman included a sale-leaseback transaction in the deal’s structure.
In this part of the deal, W. P. Carey acquired Buffets’ 100,000-square-foot (9,300-sq.-m.) Class A office facility in Eagan for approximately $21 million. Under the terms of the transaction, Buffets will lease back the facility through a 20-year, bond-type net lease.
Technology companies might use a sale-leaseback to help fund research and development. In 1999, Advanced Micro Devices Inc., an international semiconductor manufacturer headquartered in Sunnyvale, Calif., set out to pay off a synthetic lease that had come to term on one of its properties. Rather than using capital to pay off the lease, the company entered into a sale-leaseback transaction with W. P. Carey, which not only covered the lease, but also raised additional capital.
In this transaction, W. P. Carey purchased AMD’s 362,000-square-foot (33,666-sq.-m.) corporate headquarters, consisting of two buildings, for $100 million. AMD leased the property under a 20-year net lease and used the $100 million in capital, obtained without adding debt to the balance sheet, to enhance its research and development capabilities.
Another use for sale-leaseback proceeds might involve boosting a company’s revenues during a lean year. “Real estate on a balance sheet typically has a greater fair market value than its book value,” says Nolan of United Trust Fund. “If a corporation has a year in which its revenues are down, that real estate can be a source of revenue and profits that can help meet projections.”
Sometimes, the sale-leaseback concept can fund the construction of a new facility. In 1998, for example, a major communications technology company devised a plan to consolidate office facilities for employees working in several locations. The company would construct a new 600,000-square-foot (55,800-sq.-m.) building complex in Denver for $120 million.
Pitney Bowes Capital Services, through its PREFCO group, acquired the site and funded the construction with a single fixed-rate credit-tenant-based accrual loan.
This sale-leaseback structure eliminated the need for interim construction funding and also protected the company against the interest-rate risk associated with a typical floating-rate construction loan.
“This is a sale-leaseback approach in which we are fairly unique,” says Naughton. “We lock up long-term debt and put the money up ahead of time. This part of the transaction is subject to the lease, which is signed at the time we acquire the site.
“We put the money in escrow and manage it like a construction manager handles a construction loan, drawing down the long-term money and our equity through the process of construction.
“At some point, when construction is complete, the tenant will begin paying rent, even though the lease is signed before the start of construction.
“Another benefit of this process is that there is a single closing instead of a double closing on the construction loan and later on the permanent loan. So there is a savings on closing costs.”
How Real Estate Financing Options Affect Corporate Proceeds
The way in which a sale-leaseback provider pays for real estate will affect the proceeds returned to the corporation as well as the rent.
“There are two categories of players in the sale-leaseback business,” says Gary Ralston, president and chief operating officer of Commercial Net Lease Realty in Orlando, Fla. “Some are equity capitalized and others are debt capitalized.”
Equity players such as Commercial Net Lease and W. P. Carey tend to fund real estate acquisitions with balance sheet equity or credit lines.
In addition, equity players tend to focus more on underwriting the real estate than the company or tenant. “We’re focused on market rent compared to contract rent,” Ralston says. “We want to do transactions with tenants where their rent is equal to or less than market rent. If a tenant is paying more than market rent, then the sale-leaseback is financing not just the real estate but part of the business.”
This focus on real estate value makes it possible for less than investmentgrade corporations to take advantage of sale-leaseback techniques.
Rating agencies, of course, define the difference between investment-grade and below-investment-grade companies. Investment grade companies are rated Baa-3 or higher by Moody’s and BBB- or better by Standard and Poors and Fitch.
Less-than-investment-grade companies find it difficult to acquire longer-term credit without sufficient collateral. But owned real estate can serve as collateral.
It’s true that higher risks require higher interest rates in financial transactions. A less-than-investment-grade company should expect to pay a higher rent on a sale-leaseback transaction than an investment grade company, even if the same real estate anchors the transaction.
Given their focus on real estate underwriting and strong equity positions, companies such as Commercial Net Lease and W. P. Carey will deal with companies up and down the investment-grade scale.
Sale-leaseback providers that finance their debt tend to focus more on the investment-grade corporations. Lend-ers in this category have developed strategies and products that tie transactions to contract rents that might rise above a rent based on a fair-market-value purchase price. The benefit to the owner/tenant in this comes in the form of higher proceeds.
They provide a form of financing called credit-tenant-lease financing. “This kind of financing provides maximum dollars,” says Bindler of Capital Lease Funding. “Credit-tenant-leases lend themselves to sale-leasebacks because we rely on the credit strength of the tenant to repay our debt. It allows a real estate borrower to finance a higher percentage of the value of the property. While a traditional real estate loan typically finances 75% or less, a credit-tenant-lease transaction will finance 85% to 95%, lowering the equity requirement of the purchaser.”
Investment-grade companies that qualify for credit-tenant leases will find two key options when negotiating a sale-leaseback. “If the company’s motivation is to maximize the value of the asset, we can do that,” says Richard R. Cundiff III, managing director of the real estate finance group of McDonald Investments, a wholly owned subsidiary of Key Bank in Cleveland. “On the other hand, if the motivation is to minimize rent, we can do that.”
As an adviser that assists lenders in underwriting sale-leaseback transactions, Cundiff has helped structure deals that finance 100% of a property’s market value. Such a lease must fit with requirements outlined by the National Association of Insurance Commissioners (NAIC), says Cundiff. “If a lease fits in that box, it can be sold to insurance companies like a bond,” he continues. “We take those leases and put them into a trust and then issue debt on the trust. That debt is considered to be a capital market financial instrument as opposed to a real estate financial instrument.
“Because it is a capital market instrument, we can structure a better execution, with lower interest costs, higher proceeds or some balance of the two.”
Shareholder Demand For Sale-Leasebacks
No one and no thing gets a free ride in corporate America anymore. These days, shareholders expect money spent on people, projects and things to generate a return appropriate to the corporation’s business category. Period.
And that includes money tied up in real estate by corporations in businesses other than real estate.
When shareholders invest in a firm that specializes in manufacturing widgets, they expect to see returns appropriate to the widget business, says Bindler. “Corporate executives might believe that it sometimes makes financial sense to own real estate,” continues Bindler. “But most shareholders will argue that if they wanted to invest their equity in real estate, they would look for a company that understands real estate, not widgets.”
Considering the balance sheet problems connected to the corporate ownership of real estate, why would any company own a building?
For many companies, continuing to own real estate has more to do with emotion than finance, contend industry observers.
“In recent years, corporations have become less emotionally attached to the real estate used in their business,” says Nolan of United Trust Fund. “The emotional attachment has been replaced by financial realities. A company might produce a 15% to 20% return on equity from its business. But its real estate assets might produce returns of 8% to 10%. Shareholders demand returns far superior to the returns available from real estate.”
Which suggests that more corporations in the future develop a more emotional connection to leases as opposed to real estate.
