The coming months may provide additional opportunities for net lease financing, although some investors have tightened their criteria for deals and certain segments of the real estate sector may be temporarily out of favor now.
Those points may be minor, as many net lease financing firms gear up for what may be another banner year in the industry.
Gary Ralston, president of Commercial Net Lease Realty, Inc. of Orlando, an equity REIT, invests in high-quality, freestanding retail properties, is bullish on 2001. He notes that the net lease financing industry should encounter increasing business opportunities this year and for the next five years. Corporations own $1.7 trillion of an estimated $4 trillion commercial real estate in the United States, and about 60% of that — or around $1 trillion — would be suitable for net lease financing.
“We believe that corporations will be doing more net lease financing,” Ralston said. “First, technology will impact corporate margins. Although technology can result in greater margins via increasing the efficiency of their supply chain, there is another side to the story. We believe that the Internet empowers and informs the consumer. Thus corporations will be facing increased pressure on pricing, which translates into lower margins. In order to remain competitive corporations will need to invest in new technology and infrastructure improvement.”
Lower margins result in less free cash flow — so corporations will have less available internally generated cash for infrastructure investment. Access to capital via issuance of debt will be limited by the ever-conservative posture of the rating agencies. Thus, Ralston said, corporations will need to seek alternative sources of capital. One of the best alternative sources of capital for real estate assets is net lease financing.
Sidney Domb, president of United Trust Fund (UTF) in Miami, which invests in single-tenant net lease properties, agreed, noting that the credit lease finance industry is active in nearly all facets of the real estate sector — retail, industrial, manufacturing and office.
“But the trend is getting away from retail, because the industry seems to be overbuilt, Domb said. “Lenders are starting to back away because they had all these drug chains with tremendous expansion plans that have now cut back, and now the sales of some other drug and retail companies are off. Lenders are also getting frightened of a pending recession. And, of course, there are some problems with the movie theater business, because all those companies are in trouble.”
UTF is doing more deals with companies who own U. S. real estate, he adds. “We have completed two deals with companies owned by foreign companies in the past two weeks and we have several more that we're working on. A total of four in six months is a lot. The two we're working on — one from Germany and the other from Japan — signals that more foreign companies are now willing to sign leases in the U.S. for their U. S. subsidiaries, with the lease guaranteed by the parent company. Most times the parent doesn't want to get involved, but that's changing.”
Also changing, is the attitude toward net lease financing by many corporations, Domb said. Companies today are becoming more receptive to net lease financing transactions, including some who seek to conclude deals quickly. UTF recently completed a sale-leaseback in Anaheim, Calif., for Polaroid, Domb said.
“The property, a brand-new 59,000 sq. ft. distribution center was under construction and Polaroid had said they would buy it when it was completed,” he continued. “But three to four weeks prior to completion we got a call from Polaroid saying they didn't want to lay out the money to buy the property and asking us if we would we buy it and lease it back to them. We studied the deal, closed it for Polaroid and leased it back to them for 15 years. This is happening time and again.”
The reason the method is becoming more common, he said, is that companies are now more conscious of their cash flow. “Say a company has a contract for a building at $10 million, and they're getting ready to close in four to five weeks, so a vice president walks into the CFO's office and says he needs $10 million to close,” Domb said. “The last thing on the CFO's mind is buying property and writing a big check, so the CFO may say ‘get someone else to buy the building and we'll lease it.’ That's what we have been doing since 1972.”
The net lease finance industry is currently experiencing two distinct trends, explained Ronald Max, regional vice president and chief investment officer at Captec Financial. “First of all, we're seeing a tightening of credit standards among lenders,” he said. “Whereas one or two years ago, you could finance higher credit deals with very little equity — sometimes only 1 to 3%. But those times have changed. Lenders are now requiring equity contributions of 20 to 35%, depending on the creditworthiness of the client. I think that when you get down to it, investors are being more cautious. We view it as a good thing because it takes some of the marginal players out of the market and brings pricing into our favor.”
Secondly, firms such as Captec see the retail side of the equation slowing a bit, Max said. “We feel it's good and it will end up increasing the value of the assets we have in our portfolio. The type of product we deal with are the smaller net lease properties — under $3 million — and investors in general seem to be looking for smaller properties than larger ones. There has been a lot of supply of retail properties lately and we see supply diminishing which will have a positive impact on values.”
He added that while retail expansion might be slowing down with a number of retailers in bankruptcy or close to it, “there have always been retailers who were marginal and we always looked at their credit very closely and with a view toward where the company's trends are headed. We wanted to make sure their financial ratios are trending upward. For instance, we stayed clear of video chains over the past couple of years because we weren't sure what impact new technology such as the Internet would have on video chains.”
Paul McDowell, senior vice president at Capital Lease Funding, New York, offers a unique perspective on the industry because his company specializes on the debt capital market side in the credit lease business.
“My sense of the net lease market right now reflects what we're reading on the front page of the newspapers. There is a significant concern about deceleration in corporate earnings and that is having an impact on investors who buy whole loans or who are investing in bonds backed by retail credits particularly,” McDowell said. “It's having a significant impact on the credit net lease market.”
The money factor
Corporate spreads have widened, he continued. “For much of 1999 and even into the first part of 2000, the market had a significant amount of liquidity and borrowers were used to getting favorable financing terms from a variety of lenders for net lease properties even those for weaker credits below investment grade,” McDowell said.
“Those days have come to end. Now borrowers have to adjust their sights as the market reacts to current market conditions, particularly as it relates to the retail sector. As many larger retailers continue to expand, investors put more and more of those types of loans on their books and now they are getting full.”
In addition, he added, credit quality is under pressure as the credit of some of the weaker retail companies is downgraded. But from McDowell's perspective, “we look at it as a mirror image. Rather than slamming on the brakes, this is the best time to be active in the pursuit of debt securities or whole loans backed by net lease properties. The focus, however, has to be on credit and that means investment grade.”
He added that there are two sets of retailers nowadays — those with strong balance sheets in good sectors and those who do not have good balance sheets and are in weak sectors.
Walgreens and CVS, for example, are in a recession-resistant industry, with demographics moving in their favor. Supermarkets are in a similar situation.
“Look at other great retailers, such as Target, Albertsons, Stop & Shop, Home Depot and Kohls,” McDowell said. “They are household names and no matter what economic cycle the country enters, companies such as these will exit less battered than the average neighborhood shopping center — which quite often will have mostly unrated tenants.”
McDowell added that he has never been more optimistic about the net lease credit industry. “We think that as we head into the next six months, with the economy teetering one way or another, the inherent credit quality and cash flow stability of net lease product as opposed to ordinary commercial mortgage loans will become even more apparent.”
Ethan Nessen, executive vice president of Corporate Realty Investment Company LLC (CRIC), noted that lessors and lessees are learning to accept a fundamental volatility that exists in today's financial markets. “What has happened is that there has been a settling out of the bond market in a way that the volatility is still there, but it is an ‘established’ volatility,” he explained. “It's almost become the norm. People have a knowledgeable understanding that the private placement marketplace operates with more of a public trading desk mentality than it has in the past.”
In the past, he added, investors would look at each transaction and company in painstaking detail. That has changed. “Today we're dealing with a situation where institutions are taking portions of transactions with companies that are typically rated and known. The advantage is velocity. The disadvantage is that there is less of a opportunity to tell specific stories about an industry or company as there had been the past.”
In other words, Nessen said there are now certain parameters that are cut and dried. “Those parameters are dynamic and can shift at a moment's notice. There is a real industry segmentation that has occurred and it impacts what we're doing,” Nessen said. “Take auto parts retailers vs. food retailers. The perception of what is happening with both of those industries drives the pricing and execution of these transactions.”
For auto parts retailers, there is a limited institutional marketplace willing to invest in the industry. A food retailer may have worse ratios and worse credit ratings, but the transaction would be done at a better rate. The reason? “Investors are more comfortable with food retailers, at least today although the industry has its own set of issues,” Nessen said. “People feel comfortable, although that could change overnight.”
What has occurred, he said, is that “there is no longer a range; you can no longer look at a lessor and its XYZ credit and that it's going to translate into XYZ costs. You have to look specifically at the industry, the average life of transactions and all the elements occurring in what is effective quasi-public/private institutional sector. You have to make determinations on the specifics. You can't generalize, because the market has become more and more specified.”
From the industry's point of view, there continues to be a tremendous need for companies to convert illiquid assets into liquid assets, he added. “There is overall value added for a corporation, the ability of having more cash available and converting illiquid assets into cash,” Nessen said. “Cash means that a company can have more flexibility to manage operations.”
At the same time, the net lease financing industry could be facing some uncertain economic times, according to Brant Bryan, president of Dallas-based Staubach Financial Services, a firm that is an active buyer of both investment-grade tenant credit leases and sub-investment grade tenant credit leases. While the country is experiencing job creations and economic growth, participants in the capital markets remain skittish because of recent trends such as downsizing and bankruptcies, he said.
“There are some people pulling out of equity and debt investments because of this uncertainty,” Bryan said. “One of the biggest concerns we hear is about the credit quality of corporations. Investors have seen some failures in the high technology and telecom sectors, where rapid growth was generated in a short period of time and a lot of space was leased and a lot of employees were hired. Then all of a sudden, those cubicles were empty and the company had left the building.”
Staubach, which represents corporations in the real estate equation, now is handling a large volume of sublease space. “We have an unprecedented amount of sublease to deal with because companies have downsized or gone out of business,” Bryan said. “A number of markets have more than 1 million square feet of sublease space because these fast-growing companies went bankrupt or stopped growing. The sublease space is sort of ‘hidden’ because it doesn't turn up in vacancy rate surveys, but it's there.”
Because of the economic slowdown and the fate of some retailers, Bryan said it is becoming more difficult to finance non-investment grade tenant transactions. “For some retailers and tech users, we're not able to get quotes under any conditions,” Bryan said. “It affects the ability of some to get space to optimize their needs and to grow.”
While retail and technology have borne the brunt of the downturn, Bryan said, “we're seeing the same issues in other areas, especially in non-retail credit. It's extremely difficult to find financing for non-investment grade companies.”
Bryan added that 2001 could be a difficult credit environment, but that could benefit the net lease finance industry. “Under the current economy, the benefits of net lease financing continue to be attractive, because net lease financing has inherent advantages over traditional real estate financing,” he explained. “If a company is a single tenant in a building, it makes sense for them to explore net lease structure. We're bullish on the industry because the market is growing and corporations are converting from real estate financing to net lease financing.”
While the industry has been preoccupied with the retail sector over the past several years, he said there is room for it to grow in non-retail arenas. “The retail part is still good, but we see office and industrial users as a significant growth area,” Bryan said. “And we also see a lot of innovation on the debt side, more exotic and alternate forms of debt vs. traditional life deals or conduit deals.”
Bryan stressed that net lease financing is readily available for investment-grade companies “and it's very competitive at this time. That part of our business is growing rapidly at this time.”
Bruce MacDonald, president of Net Lease Capital Advisors, a Boston area-based investment and advisory firm that focuses on credit tenant property and financing using variety of sophisticated investment strategies said that in today's market, it is difficult to secure credit leasing finance for non-investment grade transactions said
“There has been a flight to quality,” MacDonald said, “and it has become increasingly frowned on — and difficult to do — hospitality and retail transactions that are sub-investment grade. Two days ago we had conversation about doing a BB+ credit package and we talked to the lender community. They said it wasn't going to get done. Unless you have the highest credit, the deal is very unlikely to happen.”
He added that his firm recently closed a $68 million transaction involving a New York office building that had greatly appreciated, and individual partners were facing large capital gains tax. The replacement property would not be financed today, he said, citing the changing standards of the industry.
“One-third of it was financed in December 1998, with the second financed portion in June 1999 and the third in June 2000,” MacDonald said. “The piece financed in December 1998 was investment-grade credit non-retail and would have been financed today. That's understandable. But the other two pieces wouldn't be financed today because they are borderline investment grade credit hugging to non-investment grade credit. It just shows lender preference. Lenders have become more stringent.”
Net Lease Capital Advisors has been approached by a number of build-to-suit developers over the past year, he added, with developers asking how they can maximize their value. Net Lease Capital Advisors is working with one set of developers to help them restructure a deal.
“They expected to sell their properties for $47 million and we've been working with them to restructure the transaction,” he continued. “With a long term bond lease, they could expect to receive $47 million in loan proceeds with a sale price in the $51 million range. They could pick up an extra $2 to $4 million in value — 5 to 10% — by using credit tenant finance. My feeling is that we're going to see more people using credit tenant finance for build-to-suits because interest rates are low and cap rates are trending higher.”
Still, those in the industry predict a busy time ahead for business. Dick Rouse, co-chief executive officer of Lexington Corporate Properties Trust, a New York-based REIT, noted that his firm focuses exclusively on purchasing single tenant properties, typically with lease terms of 10 years or longer “and right now we've never been busier. We're seeing a lot of business. I would anticipate we will conservatively complete $300 million in acquisitions this year, compared to a record $275 million last year.”
Rouse said there are several reasons for this surge in business. “Our supply of funds is good right now. We have a major joint venture with an institutional partner — a state pension fund. In addition, we're an advisor to a Saudi Arabian private investor that has funds to make acquisitions. So we're seeing plenty of deals and, unlike prior years, this year there are bigger deals — between $20 and $100 million.”
In addition, companies are continuing to focus on their balance sheets, with an emphasis on improving their return on assets, Rouse said. “One way to improve the return on assets is by reducing the denominator — selling assets. I also think companies are focusing on maintaining high liquidity as we are approaching this potential downturn in the economy,” Rouse said.
He stated that he attended a pension fund conference in Phoenix, and judging from the speakers, “it appears that pension funds will increase their allocation for real estate, so we expect pension funds will be a bigger factor this year than last. Still, there continues to be a lack of serious foreign competition, which I think relates primarily to where the Euro is relative to the dollar. We also believe the Japanese economy continues to keep Japanese investors out of the market.”
What about the future of the industry? Ralston of CNLR said another trend will be the movement toward securitization of net lease. “Historically net lease financing has been along the lines of credit tenant lease — the real estate debt for net lease has often been directly placed with lenders and institutions based on the credit of the tenant,” he said. “In the future we believe there will be more securitized pools of net lease (credit tenant lease) loans — this will result in less pressure on the bonds of an individual credit.
Even so, Max of Captec Financial said he sees continued growth for the net lease finance industry, “although we have a temporary slowdown now, the future looks bright. As credit tightens, more and more corporations will be examining their the real estate assets, looking to take their real estate assets off books — and sale-leaseback as a viable alternative for that.”
Mike Sheridan is a Houston-based writer.