COVER STORY, SEPTEMBER 2012

SALE-LEASEBACK MARKET'S BIGGEST CHALLENGE
Investor appetite is strong, but low interest rates reduce corporations' needs to sells assets.
Liz Burlingame and John Nelson

Investors continue to clamor for sale-leaseback transactions, which have shown to deliver stable and predictable returns in today’s volatile economy. But as the pool of buyers grows, the supply of attractive deals for this popular investment vehicle is dwindling.

“Because investors remain risk-averse, many are focusing on the same type of credit profiles in metro areas. A lot of investors find themselves targeting the same types of properties,” says Randy Blankstein, president of The Boulder Group, a Northbrook, Illinois-based brokerage firm that specializes in corporate sale-leaseback transactions.

Sale-leasebacks are an alternative form of financing companies can turn to when traditional financing, such as a bank loan, is expensive to secure. It’s been a viable strategy in commercial real estate for more than a quarter century, but extremely low interest rates have cooled corporate enthusiasm for the sale-leaseback model during the past few years.

“We’re in a historically low interest rate environment,” says David Sobelman, executive vice president of Calkain Cos., a national brokerage and consulting firm for private and institutional clients in net lease. The 10-year Treasury yield, a benchmark for long-term, permanent financing in commercial real estate, is currently hovering around 1.67 percent, up from approximately 1.4 percent one month ago.

“Historically, there are certain periods of time in the business cycle or capital market cycle where it might make sense for corporations to leverage their real estate as a source of capital growth,” says Dan Fasulo, managing director for Real Capital Analytics (RCA), a New York research firm that tracks sale-leaseback deals of $2.5 million and above.

Fasulo explains that the sale-leaseback option is a popular way to free up capital for business expansion. Sale-leasebacks typically comprise roughly 20 to 30 percent of the single-tenant transactions completed each year, according to Robert Micera, chief investment officer of the office and industrial division at Cole Real Estate Investments.

However, “not everyone is growing right now,” Fasulo says, adding that companies are less willing to commit to sale-leasebacks with interest rates so low. Companies with a strong credit rating have access to cheap capital.

“For some companies, traditional bank and bond financing is attractive in the current interest rate environment and they would prefer not to invest their resources into analyzing and completing a real estate transaction,” says Micera.

Blankstein says many tenants are finding that in the short term it’s less expensive to borrow money from other sources than it is to enter into a sale-leaseback transaction. In the long term, a sale-leaseback deal is often cheaper for sellers, he adds.

“Right now, a lot of companies don’t believe interest rates are moving anywhere in the next few years. Accordingly, they don’t feel an urge to lock into this long-term financing, which is essentially what sale-leasebacks are.”

Still, sale-leaseback transactions have not come to a halt in the U.S. They’re making a gradual comeback this year due to the high demand among buyers, says Fasulo. “These transactions are considered among the least risky type of deals in our industry.”

While activity is still well below the high-water mark of 2007, when sale-leasebacks among industrial, retail and office properties totaled $16.1 billion, transactions have risen in the last several quarters, according to RCA.

After falling to a low of $3.7 billion in 2009, about $5.3 billion in sale-leaseback deals closed last year. Preliminary numbers show $4.5 billion in sale-leaseback transactions year-to-date through July 31.

Blankstein says sale-leaseback transaction volume should be relatively flat during the next six months, as interest rates are expected to remain steady or decline.

“A lot of [tenants] are saying, ‘I’m going to stay on my short-term financing as long as the outlook for interest rates is stable to lower. As soon as it’s stable to higher, I’ll switch over to a sale-leaseback,’” says Blankstein.

HEALTHCARE, RETAIL ACTIVE
Office properties are among the most active sector for sale-leaseback transactions. Though sale-leasebacks for industrial facilities edge out office properties in the total number of deals nationwide, office space has historically generated a greater dollar volume, according to RCA.

For instance, 32 industrial sale-leaseback transactions closed in the second quarter of 2012 nationwide, compared to 25 office deals. But in terms of dollar volume, the office transactions totaled $1.7 billion in the second quarter, while industrial deals secured only $345 million.

Fasulo says office’s larger dollar volume is mostly due to the office sales themselves, which can become very large, particularly in metro areas. “Right now, Sony is considering selling its headquarters in Midtown Manhattan that could turn into a sale-leaseback deal,” says Fasulo. “That would be a billion dollar deal.”

Besides office and industrial properties, sectors like retail are active in the sale-leaseback model. Sale-leasebacks for retail properties posted 15 deals closing for a total of $787.4 million in the second quarter. Jason Vitorino, first vice president investments at Marcus & Millichap’s Dallas office, helped Christian Brothers Automotive, a private auto store based in Houston, to free up capital and pay down debt by arranging the sale of approximately $100 million worth of properties for the firm. Also, Cole Real Estate Investments completed a sale-leaseback of 10 BJ’s Wholesale Clubs and two distribution centers.

Healthcare providers are also increasingly using sale-leasebacks, says Camille Renshaw, director and lead broker of Stan Johnson Co.’s New York office.

A medical sale-leaseback, for instance, enables physicians to free up funds to improve their practice. In many cases, their new rent payments will be less than their current mortgage payments.

“Medical office is extremely hot right now because a lot of doctors are expanding and trying to free up capital and sign long-term leases for medical office space,” offers Vitorino. “That’s been one of the most active product types in the sale-leaseback market.”

Other corporations are finding that sale-leasebacks make strategic sense for their overall business plan. These transactions enable users to get 100 percent of their capital out of the real estate compared to a traditional mortgage, which often finances 70 to 80 percent of the property value.

“What a sale-leaseback does is allow someone to capture the entire value of that property in the current market, whatever the current market may be,” explains Sobelman. “One of the downsides [of refinancing] is that clients aren’t monetizing the full value of their real estate because a lender is only going its clients a portion of that money that’s ‘trapped’ in the clients’ real estate.”

Attractive pricing has been a major tipping point for businesses such as Blue Cross and Blue Shield of Minnesota. Last February, the insurer sold eight buildings totaling 1.1 million square feet, including its suburban Minneapolis headquarters and two properties in the smaller Minnesota communities of Aurora and Virginia.

New York-based investment firm W.P. Carey purchased the portfolio for an undisclosed amount.

Blue Cross also wanted to take the equity it had tied up in these buildings and reinvest that capital in its core business. “Specifically, it had a number of health and wellness initiatives that it wanted to invest in,” says Gino Sabatini, managing director and co-head of global acquisitions for W.P. Carey.

For W.P Carey, a public company that provides financing for long-term sale-leasebacks and manages an investment portfolio of $12.5 billion, the deal offered a stable and long-term rental stream.

“Blue Cross recently put a lot of money into these buildings, so we believe Blue Cross is going to stay in the market for a long time,” says Sabatini. Blue Cross signed a 15-year lease. “We like their prospects going forward.”

In another healthcare deal last July, Miami-based United Trust Fund (UTF) closed on a $203 million build-to-suit, forward funded sale-leaseback. UTF is financing the construction of a 196,000-square-foot orthopedic hospital in Springfield, Missouri, and a 225,000-square-foot medical office building in Edmond, Oklahoma, for the Sisters of Mercy, one of the largest Catholic Health Systems in the country.

Paul Domb, vice president of asset management at UTF, says the deal provides Mercy with construction financing and long-term leasing at a very low cost. “The result of this innovative sale-leaseback is two brand new facilities where, how and when they want it,” Domb told Heartland Real Estate Business last August.

Retail properties have also been a mainstay of sale-leaseback deals because retailers have a penchant for store expansion, says Blankstein. Seeking fast growth, national chain retailers such as McDonald’s and Walgreens are snatching up properties and utilizing the sale-leaseback vehicle to recoup their expansion costs.

Because retail chains typically operate out of several locations, many of them also want to avoid the large costs associated with managing national portfolios.

“Owning all of these locations is a very expensive proposition,” says Blankstein. “With most public companies, the investors would ask, ‘Why is your money tied up in real estate? I wanted to buy a company that sells product A, B or C — not a company that has a big real estate portfolio.’”

CORPORATIONS DICTATE TERMS
Historically, the credit rating of the seller has been paramount in attracting sale-leaseback investors. Many investors simply won’t enter into a deal unless the seller has an investment-grade credit rating. However, deals involving tenants who have a non-investment grade credit rating can yield higher returns to investors to compensate for the higher risk.

Domb says that rather than target certain property sectors, UTF prefers to buy an income stream from a creditworthy company. “What is in vogue this year, most likely will not be five years from now,” he says.

UTF prefers to undertake sale-leaseback deals with companies that generate a minimum of $100 million in annual revenue. Equally as important, the property must be in a favorable location.

The location of the real estate, along with the credit worthiness of the tenant and the terms of the lease that the tenant is willing to enter into, are the three pillars of underwriting a sale-leaseback transaction for Calkain Cos.’ clients, according to Sobelman.

A company with a proven track record of growing profits also is a prerequisite for UTF. “If you’re executing a 15-year lease, you want to ensure that year 15 is just as certain as year one, and that you’re going to be receiving that rental income,” Domb explains.

Domb says a challenge for investors today is that there’s more demand for high-quality sale-leaseback deals than there is supply, which has given corporate tenants an upper hand in negotiations. For one, sellers often insist on greater flexibility and shorter lease lengths.

A 15- to 20-year lease structure used to be considered the norm for sale-leaseback transactions. Due to competitive bidding, many have shrunk to 10- or 12-year lease terms.

“It’s what companies call operational flexibility,” says Domb. “They want the ability to exit a property or to renegotiate rents in the event that they have that opportunity, even though they don’t often do it.”

Because of the limited supply of deals, some investors are also agreeing to take on more credit risk in order to secure a transaction, says Blankstein. “You’re gradually starting to see [the trend] pick up pace,” he says.

The cap rate for sale-leaseback transactions today typically ranges between 6 percent and 8 percent, according to Sobelman. But the returns for investors can vary significantly depending on the credit rating of the tenant and the length of the lease term, among other factors, says Blankstein of the Boulder Group.

“For specific examples, you’re looking at a low of 4.75 percent for a McDonald’s to a high of 9 percent for a private company in a second-tier metro area,” says Blankstein.

How do sale-leaseback returns compare to other investment alternatives? Blankstein explains that it’s often situational, and depends on an investor’s risk preference. “From a historical basis, returns are below what they have been. But it’s a direct function of interest rates, meaning your alternatives are yielding less as well.”

DEMAND AHEAD
At her office in New York, Renshaw of the Stan Johnson Co. says she has been regularly fielding calls regarding sale-leaseback transactions. “I had a couple calls today for sale-leasebacks,” she recently stated, adding that she expects activity to remain steady during the next few months.

The demand for sale-leasebacks will continue to be dependent on market cycles and the availability of capital, she adds.

“Sometime in the upcoming years, I expect we’re going to go through an inflationary period, which means borrowing money is going to become more expensive,” says Renshaw. “When it’s expensive or difficult to get capital, we see more activity in sale-leasebacks.”

The demand for core properties is always going to be high. “Who wouldn’t want to buy the best properties?” questions Sobelman. For these in-demand properties, sale-leasebacks will always be an option for tenants to increase their cash flow and shore up their bottom lines.

Micera of Cole concludes that, “Real estate investors have shown a desire to invest in stable, core, income-producing assets and, in many instances, high-quality sale-leasebacks can meet these objectives.”

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