On a slow recovery from 2001's weak beginning, the sluggish economy has created a thriving net lease finance market. Corporations that were flush with cash during the boom of the late 1990s and early 2000 are now searching for affordable capital amid a cooler economy.

“Net leasing has always done better with a down economy,” said Ethan Nessen, an executive vice president at Boston-based Corporate Realty Investment Co.

In recent years, firms had ample financing options through both debt and equity sources. “Net leasing was not as high on the list of needs for a lot of corporate America,” Nessen said. “They had plenty of money, and didn't really need more money.”

Additionally, companies were expanding so rapidly in the surging economy that they did not have time to focus on their overall capitalization strategy. But the slowing economy and turmoil on Wall Street has prompted firms to address those strategies. Now companies are analyzing the advantages net lease finance offers as an affordable capital source, as well as the perks associated with moving real estate off their balance sheets.

In fact, the recent dip in the economy is good news for net lease brokers and investors. “2001 is looking to be a phenomenal year, and a large part of that is because of the economic downturn and equity markets turning sour,” Nessen said. “Companies genuinely need alternative methods of financing that will give them value for their assets and not go on their balance sheet.”

The current economic climate has fueled an increase in net lease transactions as firms ranging from retailers to distribution companies explore sale leasebacks. “In today's economy, companies are focusing on their liquidity. They would rather have cash on their balance sheets rather than a lot of real estate,” said Richard J. Rouse, co-CEO of Lexington Corporate Properties Trust, a New York-based REIT that invests in single-tenant net lease properties.

Tenant advantages

Tenants are pursuing sale-leasebacks and net lease finance as a means to access additional capital. “The biggest incentive is the opportunity to monetize assets; take debt off the balance sheet; and improve various financial ratios,” said Jonathan Molin, president of New York-based U.S. Realty Advisors LLC. In addition, some companies can recognize a capital gain on the sale of an existing property.

“The advantage to tenants is getting money out of real estate where returns are historically 8% to 12% and into operations where returns can be in the 25% to 30% range,” said Keith Sturm, a principal at Minneapolis-based Upland Real Estate Group Inc. Those returns from operations can be higher or lower depending on the industry, but most companies find that they do generate higher returns by reinvesting in their business rather than in real estate, Sturm notes.

Companies are using the capital to clean up their balance sheet, improve their credit rating by paying down existing debt, or put that money back into the business to boost sales performance. “The objective is to sell the asset; free up capital; and do it in terms of an operating lease so it is off the balance sheet,” said Kevin Shields, a managing principal in the Los Angeles office of Griffin Capital.

Griffin Capital recently completed a $55 million sale-leaseback with Switzerland-based Asea Brown Boveri. Griffin acquired four industrial manufacturing buildings from ABB Power T&D Company Inc. in February. Griffin leased the properties back to ABB in a 13-year triple net lease. One of the primary motivators for ABB to do the sale-leaseback was to improve the firm's balance sheet in preparation for its 2001 listing on the New York Stock Exchange, Shields notes.

Access to capital

Tenants contemplating a sale leaseback transaction need to ask themselves important questions. What will they do with the capital they are freeing up from owning real estate? And can they generate a return in excess of their rent obligation? “Once they make that decision, everything else falls in place,” Shields said.

One advantage of net lease financing compared with other traditional financing sources is that the net lease transactions provide 100% financing. For example, if a drugstore chain decided to buy a piece of land and build a new store, the total project cost might be $3.3 million. If the retailer goes direct to the bank, the lender might offer a 75% loan to value ratio or $2.5 million in financing. Essentially, the drugstore chain would have to keep 25% of their own money — $825,000 — in their real estate, notes Christian Marabella, president of Marabella Commercial Finance in Escondido, Calif.

Perhaps the drug store chain can make a 25% return or $206,000 on that $825,000 by putting it back into their own business. That is a significant amount of money for even one store, but many retailers are expanding with dozens of new stores each year. So when those figures multiply out, it amounts to a substantial amount of capital, Marabella notes.

When a tenant does a sale-leaseback — it is the investor or developer that is putting up the $825,000. The drugstore chain may be paying 8.5% of the original $3.3 million in rent or about $280,500. Even with the rent it saves them $544,500 to reinvest back into their business that would otherwise have been tied up in real estate, Marabella said. In addition, the lease deal is off-balance sheet financing. So the debt to equity ratio does not go up, and it does not negatively impact a company's credit rating, he added.

Although companies across a broad spectrum of industries use net lease financing, the format is ideal for retailers that are inherently real estate driven. Same-store sales growth is typically minimal. “Where a retail entity starts to add to the bottom line is by adding new locations,” Shields said. But that real estate growth can produce significant constraints on capital. “So retailers are better off doing sale-leasebacks or straight lease deals,” he said.

Another advantage for tenants is that they can design their leases ahead of time. This is particularly advantageous for retailers with hundreds of stores. “So as much as they can do a cookie-cutter type lease, the easier it is for everyone involved,” Marabella notes.

Growing niche

The net lease finance market is a growing niche for both brokers and investors. “There are more players in this market, and consequently there is more competition,” Molin said. U.S. Realty Advisors coordinates $1 billion to $2 billion net lease transactions each year. The firm serves as an advisor to institutional clients such as GE Capital, as well as working with private investors on 1031 tax deferred exchanges.

“As the net lease market has grown in popularity, there are definitely more firms that are specializing in it,” said Randy Blankstein, president of The Boulder Group in Northbrook, Ill. The Boulder Group is a real estate brokerage company that focuses on single-tenant net leased properties.

Newcomers to the net lease market include Stamford, Conn.-based GE Capital Real Estate. GE Capital started a new net lease investment program in January 2001, and the firm expects to place $500 million in net lease properties this year. GE Capital is targeting tenants with BB or higher credit ratings, and deals include office, industrial and retail properties $15 million or larger.

GE Capital has been a significant real estate investor for the past 30 years with investments in excess of $8 billion each year. But tackling the net lease market is a new endeavor for the institution. “As we look at the net lease market, we see a good real estate market and good credit companies,” said Cathleen Crowley, managing director of GE Capital Real Estate. “Those two factors, for us, have made for a great investment.”

GE Capital recognized an opportunity to help corporations move sizable chunks of assets off their books. “As the credit view of a company shifts, this type of vehicle becomes very appealing, because they would rather put their capital to work in their main business rather than in real estate,” Crowley said.

Investor interest

Investor appetite for net lease transactions is on the rise. “I think it has grown more competitive, but the supply of properties has easily kept pace with the growth in competition,” Rouse said. “So we're seeing more deals than we were seven years ago.” In 2000, Lexington closed on eight transactions totaling about $275 million. “We're hoping to at least match last year's acquisition pace,” Rouse said of 2001.

Lexington faces fewer direct competitors primarily because the REIT pursues large transactions, which eliminates most 1031 buyers. Last year, Lexington acquired properties ranging from $8 million to $82 million. One major sale-leaseback Lexington closed on last December involved the $82 million acquisition of an Aventis-owned office building in Parsippany, N.J. Aventis continues to occupy the building under a long term net lease.

The intensity of the competition depends in large part on the size and type of deal. Fewer investors vie for large transactions in excess of $10 million. Investors at that level also focus on various specialties such as property type or investment grade, which narrows the field even further. Competition tends to intensify on deals in the $5 million to $10 million, with the most competition below $5 million due to the volume of individual 1031 buyers, Shields notes.

Griffin Capital is one net lease investor that has been on an aggressive growth track. The firm has increased its portfolio by 55% over the past five months. Founded in 1995, Griffin acquires net lease properties and currently has a portfolio of 6 million sq. ft. Griffin focuses primarily on industrial warehouse, distribution and manufacturing facilities.

One function that has helped Griffin add to its portfolio is its ability to develop build-to-suit properties for net lease tenants. The company recently constructed a 700,200 sq. ft. distribution warehouse in suburban Chicago that is net leased to World Kitchen.

Griffin also is anticipating increased activity in 2001 when it introduces its first fund for outside investors. The fund, which is scheduled to launch this summer, targets high net worth individuals and families as well as entrepreneurial-minded institutions.

1031 Investors

REITs and other institutions are the biggest group of net lease investors based on dollar volume of transactions. However, 1031 investors represent a key part of the net lease market. 1031 buyers seeking like kind properties for tax deferred exchanges are able to make acquisitions at a lower cap rate because they are trying to avoid tax liability. “An exchange buyer could have a big tax liability — $500,000 to $1 million in liability, so they are willing to accept a lower cap rate,” Marabella notes.

The volume of 1031 investors continues to grow as individuals discover the perks net lease properties offer. “As the general public becomes more aware of the 1031 tax deferred exchange rule, they are trying to take advantage of that,” Sturm said. “I have seen a definite increase over the last five years in people doing 1031s.”

Founded in 1998, Upland Real Estate Group is a real estate brokerage firm that specializes in selling single-tenant net lease properties nationally. Upland works with both institutions and 1031 investors to sell about 30 net lease properties each year. Over the last 18 months, about 90% of the transactions at Upland have involved 1031s. “In general, REITs have had less money available, and are less aggressive in pursuing properties,” Sturm said.

The acceptance of net lease deals structured as “tenant in common” transactions is expected to further expand 1031 activity. “Land costs have increased over the last five years to a point where it is difficult for an investor with less than $250,00 to buy any single-tenant net lease property,” Sturm said. “So tenant in common will open up opportunities for those investors.”

The majority of net lease transactions fall in the $4 million to $4.5 million range. So unless an individual has $1 million to $1.5 million in equity, they cannot exchange into those properties, Blankstein said. Tenant in common deals are structured to allow investors to use what equity they have from a sale to buy a percentage ownership stake in a property that can be used for a 1031 tax deferred exchange.

Small investors typically have $100,000 to $1 million in equity to invest. However, an A-rated net lease transaction for a Walgreen's or an AT&T office building may run $4 million to $20 million. Those deals are typically picked up by institutions and REITs. “This is a way for 1031 investors to participate with less of an equity component,” Blankstein said.

For example, the tenant in common structure would allow an investor with $500,000 to buy a 10% interest in a $5 million property such as a small office building or shopping center. “The investor is getting a piece of a larger property that is professionally managed and with a higher credit-worthy tenant than in that smaller building,” said Edward Hannon, president of Tax Deferred Services LLC (TDS), a division of Chicago-based Urban Investment Trust Inc. Another advantage for tenant in common deals is that the financing is already in place, so an investor does not have to go out and find additional debt.

Tenant in common

The tenant in common structure originated as part of a private transaction in the mid-1990s, and it has continued to evolve ever since.

“More people heard about the structure, and it blossomed into something that could be used for property in a like kind exchange,” Hannon said.

TDS was one of the first firms to obtain a tax opinion from a national law firm that the structure worked within the 1031 context. Now TDS sets up tenant in common deals with the help of its parent company, Urban Investment Trust, which purchases investment properties. “What we are looking for is a quality property with a high credit-worthy tenant with the property subject to a long-term lease,” Hannon said.

The issue from the taxpayers' perspective is how the IRS is going to view this tenant in common structure for tax purposes. It can be respected as undivided fractional interest in a property — tenant in common interest. Another option is that the IRS can ignore the form, and essentially view it as a partnership interest, which would not be eligible for a like kind exchange, Hannon notes.

Because tax in common deals are still not clearly defined by tax code, it is important to provide investors with a level of comfort that tenant in common will be respected by the IRS. That is one reason why TDS spent money to secure a tax opinion verifying that position. “Anyone doing a tenant in common deal should strive for that same level of structure,” Hannon said.

In the past, tenant in common deals were viewed as somewhat of a gray area. However, the IRS' position is becoming clearer due to recent and anticipated rulings. “This has been around for a few years, but it is just starting to get favorable ruling from the IRS legitimizing it,” Blankstein said. “That's why it is gaining in popularity.”

The IRS is expected to make a ruling this year that will offer more guidance on tenant in common structure. “Our impression is that they are going to provide a safe harbor method of the tenant in common structure,” Hannon said.

Tenant in common deals currently represent about 1% of net lease transactions. “Once the IRS gives its final ruling, I expect it to be a major share of the marketplace — up to 15 to 20%,” Blankstein said. Greater opportunities for 1031 buyers may increase competition for net lease investments of all sizes. But there will be plenty of deals to go around in 2001 and beyond as corporations continue to recognize the advantages of liquidating their real estate holdings. “A tenant has to accept the position that having real estate on their balance sheet is a fairly anemic asset to have on the books,” Shields said.

Beth Mattson-Teig is a Delano, Minn.-based writer.