The Sale-Leaseback Surge
Redeployment of capital into strategic growth opportunities helps explain the recent surge in sale-leaseback scenarios. Calkain Cos., a Reston, Virginia-based commercial real estate consultancy and brokerage, estimates that 20% of commercial property sales since 2007 can be attributed to so-called triple-net sale-leasebacks, in which a company sells the building it owns and occupies to an investor, then leases it back on a long-term basis. The “triple-net” refers to the three costs that the owner-turned-tenant agrees to absorb: real estate taxes, operating costs, and insurance.
“By selling the building, a company generates capital for more-effective uses elsewhere, such as paying down debt or for expansion,” says David Sobelman, Calkain executive vice president. “Selling the building also moves its book value off of the balance sheet. Buyers of the building, meanwhile, are assured of a monthly rent check from the tenant, assuming its creditworthiness.”
There are other perks for buyers. “Generally, the yield on triple-net properties is 50 basis points or more above the equivalent unsecured debt of a company,” points out Bob White, founder and president of Real Capital Analytics, a New York–based real estate research firm. “This makes the scenario an effective form of financing. As for sellers, they can often get more proceeds via a sale-leaseback as opposed to issuing other debt.”
One such devotee of sale-leasebacks is InSite Real Estate. Over the past few years, the Oak Brook, Illinois-based real estate firm has acquired an 11-million-square-foot portfolio of primarily retail, office, and industrial buildings, most of it through sale-leaseback arrangements. “Our primary target is the middle-market tenant, although we’ve done deals with very large companies,” says Chris Hutter, InSite CFO. “These companies are more interested in using their resources to grow their businesses or acquire a competitor than in tying up their money in real estate assets. We offer them a solution where they can maintain their premises over the long term at a rent they can predict.”
KLH Capital, a Tampa-based private-equity firm, has engaged in several sale-leasebacks, buying a company and then shedding its real estate. “When we buy a business, typically we don’t want the real estate, which is not a high-return asset and is tying up capital at a low rate of return,” says Will Dowden, KLH vice president.
“With low interest rates and impending inflation, there are companies out there looking to buy fixed assets that will hopefully appreciate in value,” Dowden adds. “Some private-equity firms have even tapped the value of a target acquisition’s real estate to help them raise the capital to acquire the business. If someone can buy a company for 5 or 6 times EBITDA, then sell the real estate and lease it back for a 10th of what they just sold it for, that’s an exit at a 10-times multiple. They have now taken an asset that was purchased at 6 times and sold it at 10 times.”
All of this would sound even better if it were not for the proposed changes to lease accounting currently on the table. The Financial Accounting Standards Board and the International Accounting Standards Board have both proposed major alterations in lease accounting (see “Taking the ‘Ease’ Out of ‘Lease’?” December 2010). Under the proposals, tenants would be required to place the obligation to pay rent over the entire lease term on their balance sheets as a liability. Right now, only the current rent is booked on the financials, as an expense on the income statement. Many observers predict these changes will be adopted.
If so, those companies seeking to spruce up their balance sheets by eliminating mortgage-debt obligations through a sale-leaseback may change their minds, since a lease liability would effectively treat all leases as a capital lease, which would gum up the balance sheet. “If a company is trying to raise capital, a sale-leaseback would still be a very viable option,” says NorthMarq’s Houge. “But the proposed changes to the accounting standards will affect other agreements, such as credit agreements requiring a minimum debt coverage ratio, and that could be a problem.”
Others predict that future sale-leaseback deals will involve shorter-term leases, in the 3-to-5-year range. “If the rules change, the longer the lease, the greater the liability, so companies may want shorter leases than the typical 10-to-20-year term that makes sale-leasebacks work,” says White of Real Capital Analytics. “It comes down to a financial decision: if you can borrow unsecured debt cheaper than what a real estate investor is offering, you may pass.”
Dowden of KLH wants the lease-accounting proposals to die a quick death. “Putting all these leases, including equipment and truck leases, on the balance sheet will be extremely adverse to the leveraged-buyout industry,” he warns. “Every LBO will go into default. I’m terrified. I’ve called all of my auditors and told them that they had better be writing position papers on this and to get it turned around now.”
Russ Banham is a contributing editor of CFO.