Sale Leaseback Insights with Katie Elliott
We recently sat down with Katie Elliott, an Associate Director in Stan Johnson Company's Atlanta office to gain insights into the current state of the sale leaseback market. Elliott is a commercial real estate broker working in our Corporate Finance Group, who specializes in sale leasebacks and net lease assets. Her clients include corporations and private equity firms that work with industrial, office, and retail assets.
What is a sale leaseback?
A sale leaseback is a transaction in which the owner of the real estate can sell their asset and then lease back that same asset from the purchaser while remaining an occupant in the building. A lease is negotiated prior to the closing of the transaction in which details of the deal, such as the lease payments and lease term, are determined.
Why would someone consider a sale leaseback?
There are many reasons why companies consider a sale leaseback option. I would say one of the most popular reasons is to raise funds in order to pay down debt. However, other reasons include raising funds to reinvest back into the core business or buy add-on company acquisitions. Returns on the growth of a company would be greater than how real estate typically appreciates. Capital could be used to expand real estate facilities. We see this a lot with manufacturing companies, for example. They are growing at such a pace they need to double the size of their existing footprint. Companies may want to divorce the risk of business with the risk of owning real estate. Do you really want all your eggs in one basket and have your life’s investment wiped out if your business hits the rocks and you also own the real estate your business occupies? We also see groups wanting to mitigate future risk of functional obsolescence of their real estate. Think about the past year during the pandemic and how much our lives have changed and how we utilize or don’t utilize the built world. Another example of this could be with heavy technology real estate. Data centers, for example, are constantly shifting and are incredibly expensive to build. With the speed in which technology changes it may be better for companies to not own these.
Are there benefits to using sale leasebacks as opposed to other fundraising methods?
One of the main advantages of a sale leaseback from a fundraising perspective is that the company would receive 100% of the financing. With a typical mortgage, you would get anywhere from 60-75% of the value. Therefore, if you had a building that was worth $10 million, you could potentially only get $6 million leaving $4 million on the table. For this reason, we encourage CFO’s to think about cap rates the way they think about their WACC or their weighted average cost of capital. If you were going the traditional financing route to raise $10 million you would have $6 million in debt but would need an additional $4 million of equity. While their interest rates will likely be low, the cost of their equity is probably expensive, likely in the double digit percentages. As a result, if you were to blend the two together, the comparison of the WACC to the cap rate makes more sense than simply just comparing interest rates.
Who can benefit from a sale leaseback?
Owner/Users are the obvious answer to your question. And these can be anyone from large corporations to smaller, single unit owners. Albertsons, for example, did large sale leasebacks on some of their distribution facilities back in 2019. Big Lots did a massive $725 million sale leaseback last year and saw their stock price rise 30% as a result of it. Our team has helped Delta Airlines monetize a number of their owned facilities. However, we have also worked with owners of childcare facilities who own their business and their real estate. It goes back to what I mentioned earlier about not having all their eggs in one basket. One other group we have seen in recent years is the rise of private equity firms in the sale leaseback market.
That’s interesting. Why are they getting into the space and what are some scenarios where a private equity firm might leverage a sale leaseback?
Some of the reasons private equity firms consider a sale leaseback are the same scenarios a corporate user may consider – they have expensive debt they would like to pay down. They bought a manufacturing company that is growing and they want to expand the facility. They may want to fortress their balance sheet, raise capital and increase liquidity. One of the main reasons has to do with the value creation because there is often an underlying arbitrage to be captured between the business EBITDA multiple and the effective real estate multiple. Generally today’s cap rates imply multiples between 11x – 16x. If a sponsor is buying a company for 8x EBITDA multiple and can sell the real estate for a 15x, that’s a big difference that could potentially result in millions of dollars, not to mention a decrease in equity required for the purchase of the business. This leads me to another reason sponsor-led sale leasebacks are increasing and this has to do with acquisition financing. This can be done post close on the business or even at the same time. There are sale leaseback buyers out there capable of doing what we call a simultaneous sale leaseback transaction. That means the real estate investor is able to come alongside the sponsor as they close on the business they are buying. The real estate investor funds the real estate which in turn funds the acquisition of the company. Given where cap rates are, this can be an attractive source of financing. It could also differentiate them from other bidders who may not be considering the real estate as part of the transaction.
Are sale leasebacks all-or-nothing or is it possible to take a tiered approach?
There is definitely a tiered approach. For example, there is a partial sale leaseback. This means that a portion of the building is leased back while a portion remains vacant, giving some upside to a potential investor. For example, there may be a 100,000-square-foot office building and during the pandemic they realized they now only need 60,000 square feet. They can lease back that portion while the investor would put together a strategy to lease up the remaining 40,000 square feet. There is also a short-term sale leaseback. A company may know in the next 2-3 years they plan on vacating a building. If the building is sold with some sort of income on it, it gives a future investor some cash flow while the building is repositioned or leased. As a result, an owner would get more value than if they just sold it completely vacant.
With interest rates likely on the rise, how do you see demand for sale leasebacks shifting?
We are predicting an increase in interest rates over the next 12-18 months because the odds are high that the 10-year treasury will hit 2% in 2021. In March, we were at 1.7%. At the end of February we were at 1.3% and this indicates a steep, rapid increase. The Central Bank declined to extend a rule expiring at the end of March that relaxed the supplementary leverage ratio for banks during the pandemic. This decision could potentially have some adverse effects if, in response, banks sell some of their treasury holdings. This could send yields even higher at a time when a rapid rise in rates is already making investors nervous. But, what does this have to do with sale leasebacks and how we see demand shifting? A couple comments: 1. Back in Oct 2018, the 10-year treasury hit the highest point during the past 5 years at 3.2%. In the net lease market, this was one of our strongest years with $70 billion in sales volume and historically low cap rates. On average, cap rates hovered around 6.19% across the industry. 2. Where were average cap rates in 2020 with the 10-year treasury close to zero? 6.19% across the industry. Why would this be? Last year in the net lease sector we saw the rise of Essential Real Estate. This is real estate that is vital to not only the daily lives of Americans, but also mission-critical to the operations of a company. Think drug stores, grocery stores, data centers with our insatiable need to stream entertainment or Zoom calls so that we can work or kids go to school. 3. Therefore, if a company owns essential, mission-critical real estate, we believe it will continue to be a seller’s market over the next 12-18 months and a prime candidate for a sale leaseback transaction. 4. Where we are really seeing this play out is in the industrial sector. What the pandemic taught us is, at the end of the day, you can’t manufacture from home and these facilities proved invaluable. Industrial has been a growing category for a while, but now we are seeing funds and groups that traditionally pursued other categories specifically raising money for industrial sale leasebacks. With this dislocation of supply and demand and money pouring into the category, we believe cap rates will remain stable if not lower for the category assuming that the 10-year treasury increases at a measured, moderated speed rather than super aggressively.
Is there anything you would like to end with?
I would say that right now the market is ripe for sale leasebacks. Generally speaking, investors are moving into essential, mission-critical assets as a result of the pandemic. There is a flight to safety. We saw this during the financial crisis back in 2009 and 2010 in which investors sought security and stability with long-term leases and credit and we are seeing it today. It’s the place to allocate capital, making it a seller’s market, especially for industrial users, so it's a great time to consider it.