Demand for sale-leasebacks is only expected to intensify as investors continue to search for a safe haven for investment dollars. This investment niche has earned a reputation for delivering steady returns. The long-term lease guarantees by the seller/tenant perform much like a corporate bond. “As the global economies and domestic economies continue to be volatile, I think we will see more money coming into the market for hard assets in the U.S., and that is going to improve pricing for companies doing sale-leaseback transactions,” says Jeffrey Shell, executive vice president of corporate finance at Grubb & Ellis in Grosse Pointe, Mich.
The biggest stumbling block for investors is a shortage of core sale-leaseback properties—those assets located in major metros that are occupied by investment grade tenants with 15- to 20-year lease terms. Such deals are scarce, because firms with stellar credit have access to very cheap capital.
For example, Target Corp. recently issued $1 billion in corporate bonds at incredibly low rates–$350 million at 1.13% and another $650 million at 17 basis points over the 3-month LIBOR rate, or a current cost of funds of less than 0.5%. “That speaks volumes,” says Paul Domb, an asset manager at United Trust Fund, a Miami-based investment firm. Even companies that don’t normally issue debt are doing so, because it is essentially free money. “So the top-tier companies in America are sitting on a mountain of cash, and the net result is a deterioration of credit quality of sale-leaseback candidates,” he adds.
So far, buyers remain wary of the higher risks associated with acquisitions of lower quality deals in second- and third-tier metros. Instead, investors are aggressively bidding for top—even mediocre—quality sale-leaseback properties. Buyers are willing to commit to both higher prices and more flexible lease terms in order to win deals.
Competition boosts prices
Although a variety of factors go into pricing sale-leasebacks—such as tenant credit, the real estate and length of the lease term—cap rates have compressed about 50 to 75 basis points for good quality, well-located properties over the past 12 months. For example, the cap rate on a sale-leaseback with a BB credit tenant committing to a 10-year lease has experienced a significant drop from a 9.5% or 9.75% 18 months ago to a rate of 8.25% today, notes Shell.
Cap rates for investment grade tenants, such as top-flight drugstores, with a long-term lease of 15 years or longer are approaching the same cap rates that the properties were generating at the height of the market in 2006 and 2007, which was below 7% for top credit deals. For example, during second quarter, the median asking cap rate for net leased McDonald’s properties was 5.4%, according to data from The Boulder Group, an investment and brokerage firm specializing in triple net lease properties based in Northbrook, Ill.
In addition to pricing, companies are taking advantage of market conditions to obtain greater flexibility and more beneficial terms in how their leases are structured. “The flexibility that we try to build into deals relates to enhanced subleasing and assignment rights, attractive renewal rents, and a shorter lease term, if possible,” says Brian Scott, senior managing director of the Sale/Leaseback Group at CBRE in New York.
Traditionally, sale-leasebacks are structured on long-term, triple net leases. But the 15- and 20-year lease terms that were once the norm are now shrinking in many cases to 12-, 10- and even 7-year terms due to the competitive bidding situations. For example, packaging company MeadWestvaco sold a 75,000-sq.-ft. office building in Dayton, Ohio earlier this spring for $81 per square foot or a cap rate of 8%. The deal was structured with a 9-year lease, according to The Boulder Group.
“In order to win a deal, investors are agreeing to take on more and more risk—not only with a shorter term, but also by offering greater flexibility to the lessee,” agrees Shell. For example, the owner or investor is assuming more liabilities, such as maintenance to the exterior of the building, including the roof and outer walls. Tenants also are negotiating for earlier terminations with lower penalties than what they have been able to secure in the past. “All of that benefits the lessee in today’s market, which makes the transactions more attractive,” he adds.
Creative deal-making
Despite the stiff competition, limited supply of deals and falling cap rates, the sale-leaseback market is not all doom and gloom for investors. Veteran investors such as United Trust Fund are working harder to find—and land—deals. “You have to be a little bit more creative and utilize your relationships. But if you do that, a lot of times deals will create themselves,” says Domb.
For example, in July United Trust Fund closed on a $203 million, forward funded, build-to-suit sale-leaseback. United Trust Fund is financing the construction of a 196,000-sq.-ft. orthopedic hospital in Springfield, Mo. and a 225,000-sq.-ft. medical office building in Edmond, Okla. for the Sisters of Mercy Health System. The deal provides Mercy with very low-cost construction financing and a long-term, low cost of leasing. The deal was unique because the group wanted “one-stop shopping”—a buyer who would fund construction and the sale-leaseback. Although the transaction did include a few extra steps, it did meet the main objective for UTF, which is buying an income stream, notes Domb.
Buyers such as New York-based W.P. Carey & Co. also are finding success by continuing to focus on its sweet spot–sub-investment grade companies that are rated BB+ and below. “We’re digging real hard all around the country and all around the world to find those credits and find companies who are willing to sign up for long, 15- to 20-year leases.” The investment firm expects its sale-leaseback investment activity to be on par with recent years. The company has already completed $450 million in transactions as of August, and that volume will likely grow to nearly $1 billion by year-end.
The fact that financing for sub-investment grade tenants remains challenging gives low-leverage buyers such as W.P. Carey an advantage when it comes to clinching deals. “It is really hard to go out and get 75% leverage on a sub-investment grade sale-leaseback these days,” says Gino Sabatini, managing director at W.P. Carey. Today’s buyers have to put up 40 to 50% of the purchase price in cash for the more risky sub-investment grade deals.
One of W.P. Carey’s publicly held non-traded REIT affiliates, CPA®:17 -Global, closed on the $51 million acquisition of four industrial facilities leased on a long-term basis to Flanders Corp., a top producer of air filters. The four facilities, totaling 1.4 million sq. ft., are located in Bartow, Fla.; Ardmore, Okla.; Smithfield, N.C. and Momence, Ill. Sabatini declined to disclose a cap rate on the Flanders deal. However, he did say that quality sub-investment grade deals, such as a BB credit with good real estate, are getting done in the high 7% to low 8% range.
Growing pipeline?
Favorable pricing is helping to spur activity as companies look to tap capital that is locked up in real estate. Although sale-leaseback activity is still well below the high water mark of 2007 when $16.1 billion in sale-leaseback properties traded hands, transactions have increased over the past 18 months, according to Real Capital Analytics. After hitting a low of $3.7 billion in 2009, nearly $4 billion in sales closed last year and another $2.6 billion had occurred this year as of August 15, according to Real Capital Analytics.
Unlike a traditional mortgage, which often finances 70% to 80% of the property value, a sale-leaseback allows a company to get 100% of the value from the real estate “We are seeing much more activity and interest on the part of corporations exploring sale-leasebacks and actually taking them to market than we have seen in a few years,” says Scott.
CBRE is working with an investment grade client to put together a sale-leaseback transaction for a headquarters campus that will likely fetch more than $100 million. “We are going to take full advantage of what we see as a very good market for pricing by driving down cap rates and building in as much flexibility in the lease for the corporation as we can,” adds Scott.
Many in the industry are hoping that the attractive pricing and terms will help to bring more deals to market in the coming months. “A year ago, a lot of companies were looking at sale-leasebacks as a way to fortify their access to capital,” says Shell. Now that capital is more widely available, the impetus for companies to initiate sale-leaseback s is the attractive pricing and terms generated by the crowded field of buyers.
“It is hard to imagine how any company can think that they have enough cash, given all of the dark clouds that are out there,” says Shell. “So I think that more companies will take advantage of the increasing demand.”