With many banks continuing their cautious ways -- about 40 percent of respondents to the Federal Reserve's Senior Loan Office Opinion Survey from April had tightened credit standards; none had eased them -- treasurers and other financial execs are looking at a range of financing options. One that's getting attention is sale-leaseback transactions.
As the term suggests, with a sale-leaseback, a company sells a property to an investor, which could be an investment fund, a real estate investment trust (REIT), or an individual, and gains the proceeds. The company then agrees to make ongoing lease payments and continues operating in the facility.
While the volume of commercial real estate transactions overall is down, the ratio of sale-leaseback deals has increased, reports Real Capital Analytics, a real estate research firm. Sale-leasebacks through May of this year accounted for 8.6 percent of all commercial real estate sales of $5 million and up. This compares with 7.3 percent for all of 2008 and is the highest percentage in the past 9 years, says Jessica Ruderman, senior market analyst with RCA.
Sale-leasebacks also are being used by more midmarket companies, says David Steinwedell, senior partner with AIC Ventures, a provider of alternative financing solutions, including sale leasebacks, for midmarket firms. Many businesses view the deals as a way to free up cash, says Steinwedell. "Companies can earn more dollars on their business than their real estate."
"Our philosophy is that we don't want to tie up our capital in our buildings," says Terry Braatz, treasurer with $1.6 billion Actuant Corporation, a provider of hydraulic and electrical tools and supplies, as well as motion control systems and other products. "We use sale-leasebacks as an opportunistic financing tool." In January 2008, Actuant completed a sale-leaseback, totaling about $10 million, on three manufacturing facilities in Illinois, Iowa, and Pennsylvania.
Actuant had picked up the properties via acquisitions it had completed several years earlier. When the company ends up with real estate as part of an acquisition, and if it's clear that Actuant will use the property on a long-term basis, management then decides whether it to sell it and lease it back. For industrial real estate, Braatz says, the "sweet spot" in leaseback terms is at least about 10 years. Shorter time periods scare off investors, who don't want to be continually finding new tenants. Actuant also tries to package several properties within one transaction. "You have a broader investor universe if the size is bigger," Braatz says.
Braatz noted that the environment for completing all real estate deals, including sale-leasebacks, "is a little more challenging," today. This is a result of both less investor capital and uncertain real estate values.
Talking About Sale-Leasebacks
As a result, more discussions than sale-leaseback deals actually are taking place, says Gerald Levin, senior managing director with Mesirow Financial, a Chicago-based financial services firm. Behind the disconnect, he says, is the difficulty that potential buyers have in finding lenders willing to support deals of about $50 million or more. "Big deals are very hard to do because no one source of financing is comfortable committing more than about $30 million." The sale-leasebacks that are taking place are with strong, investment-grade credits, he adds.
Moreover, some potential sellers haven't accepted the drop in commercial real estate prices, Levin notes. This has prompted some to hold on to their properties until the market bounces back.
Languishing real estate prices affect the sale-leaseback market in other ways, says Ben Harris, managing director and head of U.S. investments with W.P. Carey & Co. LLC. Until a couple of years ago, "the sale-leaseback market had been a significant recipient of 1031 exchange capital." A 1031 exchange, named for a section of the tax code, allows an investor who sells a real estate holding and reinvests the proceeds in another investment property to defer any capital gains tax hit. With real estate values falling, there's less need for sellers to defer tax hits. "It's a high-class problem that people don't have to worry about now," Harris says.
And, with less commercial mortgage financing available today, investors need to put in more equity. This also impacts the prices that sellers can get, as it decreases the amount that investors are willing to pay, Harris adds. A few years ago, an investor might borrow 80 percent or more of the purchase price. Today, loan-to-value ratios top out at about 50 to 60 percent; in some cases, no money is available. For investors to earn the same return on equity they got when financing was available, the prices need to come down.
That said, several good reasons for completing sale-leaseback transactions remain.
First, waiting until the real estate market improves doesn't make sense if the company can do better right now by using the money from its real estate holdings elsewhere. "If you have a use for the money, do the deal and redeploy it in the business," Levin says.
And, sale-leasebacks still allow companies to lock in financing for 15 to 20 years, Harris says. "It's about the longest-term capital you can get today." Of course, this means that for a sale-leaseback to make sense, management needs to have a long-term view of the company's plans for the asset.
Currently, sale-leaseback costs are similar to subordinated debt, for which interest rates run from about 8 to 12 percent, Steinwedell says. Another consideration: If a company were going to borrow against a piece of property, it probably could get about 50 to 60 percent of the value. With a sale-leaseback, the company gets it all, he adds.
What's more, investors like the long-term, contractual rent stream that they can capture with a sale-leaseback transaction, particularly on those for corporate facilities. Their decision to invest is based largely on the creditworthiness of the corporate tenant. "It's seen as an easy, passive investment," says Harris. This contrasts with multifamily housing units, which require more hands-on management, or speculative office buildings, which entail more risk.
A case in point is Kansas City--based YRC Worldwide Inc., a $9 billion transportation services provider. As of early June, the company had completed sale-leaseback transactions for more than 40 of its terminals and one office building; by the end of the year, YRC will have completed sale-leasebacks, as well as a few property sales, of about $350 million, says chief financial officer Tim Wicks.
Two goals are behind the deals, Wicks says: "We want to lighten our balance sheet and to put our real estate in the hands of professional real estate investors." In this way, YRC's obligation is reduced primarily to writing a check once a month. Perhaps even more important, the company wants its management team to focus on its area of expertise: transportation and logistics. "The sale-leasebacks are part of the organizational design to have a strong, deep focus," he adds.
Because YRC is focusing on facilities it expects to use for 20 to 30 years, potential investors know what tenant will be in the building and will invest (or not) based on their evaluation of YRC's creditworthiness. "It's a very different equation versus the normal commercial real estate deal, like a strip mall, where you need occupancy," Wicks says. As a result, YRC has been able to get rates that are "in line with senior secured debt across the corporate spectrum," he adds. The company also gets the right of first refusal if the new owner decides to sell the property, as well as the ability to reconfigure the buildings.
When Sale-Leasebacks Don't Make Sense
To be sure, not every property is a good candidate for sale-leaseback deal. If a company has an extremely high need to secure its facility, management may not want to sell and lease it back, since the new owner likely will have the right to enter the building at least once a year. And, if management doesn't plan to be in the building for more than a few years, a sale-leaseback probably won't make financial sense, as the lease rates would head up.
In addition, the deals can mean less flexibility. In late 2007, Luby's, the Houston, Texas-based chain of about 120 restaurants across the Southwest, faced an activist shareholder, Ramius Capital Group. Ramius wanted management to sell and lease back the 90 company-owned restaurants, says Rick Black, investor relations director.
Luby's management team and board of directors disagreed. First, the shareholder's calculations assumed that all 90 properties would fetch a good price, even in the declining real estate market. The leases would have restricted each restaurant's flexibility to move or make other changes if the market demanded. And, the lease payments would have left the company with little cash to get through downturns or to use in updating the restaurants, Black says. Finally, working with multiple landlords, as it was unlikely that one investor would have bought all 90 properties, would have consumed a great deal of management time and attention. "It would have strapped the company with a lot of debt, and we wouldn't have the flexibility to do much else," Black says.
Ramius argued that the sale-leasebacks would boost liquidity and that the rent expense would reduce taxes. In the end, shareholders voted down Ramius's proposal.
Accounting for Sale-Leaseback Transactions
Currently, most sale-leaseback transactions are structured as operating leases, Steinwedell says. Companies can deduct the rental expense, and the lease obligation is not included on the balance sheet.
If the U.S. moves to International Financial Reporting Standards, the features of operating leases pretty much would be eliminated, Levin notes. However, he questions how much this might change companies' interest in sale-leasebacks. For starters, even with operating leases, they still have to disclose information on the lease. "Whether it's in the financial statements or the footnotes, it's considered in evaluating the credit of the company," Levin says.
What's more, eliminating the idea of operating leases actually could simplify the decision to do a sale-leaseback, Levin adds. This is because evaluations of potential leaseback deals would then be made based just on their costs and the company's ability to profitably redeploy the money. As it is now, the potential tax ramifications can muddy the evaluation.
If the U.S. moved to IFRS, Actuant would still consider sale-leaseback transactions. "It's a matter of having the cash tied up in the business or not," Braatz says. "We see more value in growing the business versus keeping cash tied up long-term in real estate."
IT Sale-Leasebacks
Real estate isn't the only asset for which sale-leasebacks are done. Companies also can sell and lease back their IT equipment. Hewlett-Packard, for instance, has done transactions ranging from $250,000 to $30 million, says Thomas G. Adams, vice president and managing director with Hewlett-Packard Financial Services.
The deals usually take on a slightly different flavor than their real estate counterparts, Adams notes. This is because most sellers are looking for assistance in managing their IT assets, along with the proceeds from the sale. "We provide liquidity, asset tracking, and discipline in helping customers to better manage and refresh their assets," he says. In addition, a sale-leaseback provides companies with a predictable IT maintenance expense.
As with many corporate sale-leasebacks, the buyer's decision to enter into an IT sale-leaseback is based less on the value of the assets and more on the seller's credit profile, Adams says.
The transaction starts with the buyer reviewing the seller's fixed asset register and electronically pinging the assets in order to identify them. From this, the buyer can determine the assets' serial numbers and the dates when they were put into service.
The buyer typically pays the depreciated value of the machines. The seller's lease expense, however, is usually less than the previous depreciation expense. As with leasing a car, the customer is paying only for the use of the assets during the lease term.
Capital leases can be found when the equipment is older and highly depreciated, says Michael Cuno, spokesperson with Hewlett-Packard. Operating leases are more common with newer equipment.
The seller usually retains ownership of the software. When the buyer takes possession of a piece of equipment at the end of its life, it usually wipes clean the hard drive, eliminating any software and other files. Many donate or dispose of the hardware in an environmentally friendly way.