A soft economic climate normally presents a golden opportunity for the net lease industry to accommodate cash-strapped firms searching for alternative capital sources via sale/leasebacks. But these are hardly normal times as evidenced by the accounting scandals perpetrated by Enron and WorldCom and the dramatic mood swings of Wall Street.

Corporate chicanery, missed earnings and a slow, painful economic recovery have forced net lease professionals to question the creditworthiness of potential clients like never before. Net lease candidates are finding that their top-line revenues, earnings statements and overall financial health are subject to detailed scrutiny.

“Due to the surprise demise of a long list of corporations in the last year, credit scrutiny is more sophisticated than at any time in the history of the net lease industry,” says James Cate, a managing principal at Atlanta-based Newmark Capital Group (NCG). Even those companies that appear to be safe or solid credit entities are rigorously reviewed. “What we have learned in the last 18 months is that credit can be a misnomer and misunderstood,” Cate says.

Often referred to interchangeably, the terms net lease and sale-leaseback describe transactions that produce a similar result. In a sale-leaseback, a company owns real estate, sells it to another company and net leases it back. Cash replaces the asset on the company's balance sheet.

With a net lease transaction, a company looking to buy or build real estate leases the property from a net lease provider, which finances the purchase. In both cases, the company receives effective control over an asset it doesn't own under a long-term lease and makes lease payments off the balance sheet.

Given the popularity of net lease financing, more time and attention is being devoted to underwriting, and not all deals can withstand the scrutiny. The overall effect is that some deals have fallen by the wayside or become more expensive due to real or perceived risks uncovered during due diligence, say net lease experts.

Fred Berliner, senior vice president and director of acquisitions at United Trust Fund, notes that his firm has to review roughly 50% more net lease candidates to complete the same number of deals it closed before the credit scandals of the past year arose. The Miami-based firm is the owner of a $300 million portfolio of office, industrial and retail properties that are net leased.

Deals also are taking longer to complete and require more work from an underwriting perspective. “We're seeing deals take 15% to 30% longer than in the past,” Cate acknowledges. Newmark staffers spend up to twice as much time on preliminary due diligence of higher risk, sub-investment grade transactions, according to Cate.

Investor concerns about risk also affect pricing. High demand for the lower risk investment-grade deals, which involve companies with credit ratings of BBB or higher, have driven down returns by 50 to 75 basis points to about 8.5%, Cate notes. Meanwhile, investors are being rewarded for their willingness to tackle the higher risk sub-investment grade deals with returns of 12% or higher compared with the 10.5% to 11% returns that were common in the booming '90s, he adds.

The Credit Police

Net lease providers are relying less on agency credit ratings, and are doing much more independent credit analysis. That added workload is prompting firms to add layers of expertise and staffing. “We have hired a couple of people in the past year in order to free up staff who have more credit experience,” says Paul McDowell, CEO of New York-based Capital Lease Funding LLC, a direct lender of net lease properties and equity investor.

Prior to the economic slump, companies in need of capital could tap a variety of sources to create liquidity. As long as a telecom firm, for example, had access to cheap capital, it could continue to expand its infrastructure and grow a larger asset base. “As public markets have dried up for liquidity, it has exposed weaknesses in many companies' balance sheets because they don't have the revenue to support their debt,” McDowell says.

These days, underwriters are required to understand corporations, their position in the industry and their ability to be profitable over the long term. “We spend far more time reviewing financials and interviewing CFOs and treasurers to better understand financials,” explains Cate of Newmark Capital.

Research also extends beyond an individual company to include a firm's customer base and the entire business sector. “For a business that is heavily weighted with one to five clients, the demise of one of those clients could lead to the demise of the company,” Cate says.

Ratings that used to provide a good barometer of a company's health are no longer as credible due to Enron and WorldCom, both of which plummeted from investment-grade status to default extremely rapidly, McDowell notes. Still other companies have slipped from very strong investment grade to junk rating such as Qwest, or a marginal grade such as Tyco. “Those companies are exceptions rather than rule, but those credit slips have made everyone hypersensitive to movements in credit,” McDowell says.

Consequently, firms such as Capital Lease Funding first address factors such as a company's liquidity position and whether it is servicing its debt. The credit rating is still a factor, but its importance has diminished somewhat, McDowell says.

Recognizing the growing concern about corporate transparency, management and governance, the rating agencies are working to improve their own scrutiny of those issues. “We are at the forefront of trying to give as much disclosure to investors as possible, and make clear to them which companies are doing well or which companies need improvement,” says Adam Tempkin, a spokesman for New York-based Standard & Poor's.

For example, S&P has created a new U.S. Governance Services Unit that will provide investors with corporate governance scores, evaluations and customized research services, as well as help corporations benchmark and communicate their governance practices to the marketplace.

When Bad Credit Isn't So Bad

The extra scrutiny can be good news for clients with a checkered credit history. S&P downgraded the credit rating of Chandler, Ariz.-based SpeedFam-IPEC to junk status from a B+ to CCC. The credit rating of the company, which makes semi-conductor production systems, began to slip when the bottom dropped out of the semi-conductor industry.

But SpeedFam was pleasantly surprised to receive a dozen credible bids on its proposal for the sale-leaseback of its 247,000 sq. ft. R&D facility. “The people that we were shopping the deal to not only were buying the real estate, but were also looking through to the tenant,” says Mike Dodson, CFO of SpeedFam.

SpeedFam closed on the $25 million sale in June. “That is incredible for a company like SpeedFam,” says Cate, who represented SpeedFam on the deal. “When you looked at the whole story, SpeedFam became a better credit risk than what its rating reflected.” SpeedFam had already initiated a business turnaround with cutbacks in staffing, and it was positioned to benefit from a rebound in the semiconductor industry, he says. SpeedFam has since been acquired by San Jose, Calif.-based Novellus Systems Inc., a $3 billion corporation.

Quality of Real Estate Matters

Current market conditions have magnified the importance of the real estate, even for investment-grade transactions. If a net lease applicant has a sub-investment grade credit rating, the underlying real estate becomes critical to the deal. That's because the higher the quality of real estate, the easier it is to fill a space that goes dark.

“In the past we did transactions where if credit was strong enough, we wouldn't even go see the property,” acknowledges Bruce MacDonald, president of Net Lease Capital Advisors Inc. in Nashua, N.H. These days, Net Lease Capital has taken a strong underwriting position in the real estate. “Regardless of the credit, you have to be sure of the real estate you're buying,” MacDonald says. Net Lease Capital serves as an advisor and boutique investment banker for investment-grade, net lease properties.

Focusing on real estate presents its own challenges, considering the depressed real estate sector. “Net lease historically does well in downturns in the real estate market because it is a more efficient way to raise capital,” says Ethan Nessen, a principal at Boston-based CRIC Capital LLC.

CRIC acquires single-tenant, net lease assets. Net lease transactions allow companies to leverage their credit to pull more capital out of real estate. Then again, when the real estate market softens, it makes credit scrutiny even more important because people become less confident of the collateral they have behind the investment, Nessen adds.

Consistent Strategies

Selecting quality real estate has always been a part of the core strategy for long-term investors such as Orlando-based Commercial Net Lease Realty, and that strategy has not changed despite current market conditions. “As a REIT, we never forget the ‘RE’ stands for real estate,” says Gary Ralston, president & COO of Commercial Net Lease Realty, an equity REIT with a $1 billion portfolio of freestanding, net lease retail properties in 14 states.

Commercial Net Lease Realty focuses on three key components in a potential acquisition — the underlying value of the property, the credit of the tenant and financial prospects for the tenant in the future, Ralston emphasizes. “The credit ratings of companies don't stay constant. When we look at a deal, about 75% of our analysis is on the real estate side and 25% is on the credit,” says Ralston.

Diversification among property types is a critical part of Commercial Net Lease Realty's long-range vision, which means that going forward the company will seek to add industrial and office properties to its portfolio, adds Ralston.

Net Lease, A Survivor

Annual transaction volume in the net lease industry ranges between $6 billion and $8 billion, estimates Ralston, who believes the industry is poised for significant growth as net lease providers plot to capture business from the troubled synthetic lease sector.

In a synthetic lease, the owner takes out a lease from its own special purpose entity. That special purpose entity allows the firm to remove the debt involved in the acquisition of the property from its balance sheet while deducting lease payments for tax purposes. In light of the Enron crisis, the Financial Accounting Standards Board is expected to introduce tighter regulations regarding the use of those special purpose entities.

“I think the regulatory changes will result in some shifts of product to the net lease business that in the past had been purely synthetic business,” Nessen says. “The real question is how much?”

Existing synthetic lease structures throughout the commercial real estate industry are valued between $100 billion and $120 billion, according to Ralston. “I'm not saying that we're going to see $100 billion worth of new net lease transactions suddenly,” he says. “I think we could see $5 or $6 billion fairly quickly, which could effectively double the annual volume of net lease.”

Cathleen Crowley, managing director of GE Real Estate, believes the long-term prospects for the net lease industry remain positive despite the volatility in the credit markets this year. Therefore, she doesn't anticipate that the company's strategy, which is to acquire both investment- and sub-investment grade net lease properties, will change.

“This is just another example of a cycle,” she says. “The only challenge is that there is more limited deal flow. For us, the strategy is to stick to the basics.”

Despite uncertainty about when the U.S. economy will once again hit its stride, what's clear is that the net lease model has endured. Forty years ago, the pages of NREI included news items on sale-leaseback deals. Industry professionals say such longevity can be attributed to the simple and straightforward terms of net lease financing.

“The overall feeling is that the net lease world basically percolates along regardless of the economic times,” MacDonald says. “Even though credit is suspect, there is still plenty of equity money chasing net lease deals.”

Beth Mattson-Teig is a Minneapolis-based writer.