One of the ways corporations raise funds, increase earnings and enhance liquidity is by freeing capital tied up in their sometimes massive real estate holdings. When a higher rate of return can be generated from their primary businesses than from owning real estate, many of these corporations are using sale-leaseback arrangements to move real estate capital into their core businesses, whether banking, petroleum refinery, or selling books and shoes.
In the conventional sale-leaseback, a corporation sells the real estate it owns outright, then leases all or a portion of it back from the investor, thereby freeing most or all of the capital.
One of the single biggest reasons why a company undertakes a sale-leaseback is to gain off-balance-sheet financing. This is an important consideration: If there's a loan on the property, its full amount is clearly on the balance sheet as a liability. For most operating leases, or sale-leasebacks, the only thing seen on the balance sheet is that year's obligation or lease payments, which casts a more favorable look on the balance sheet for that company.
Contrasted with traditional debt financing, the sale-leaseback usually brings 100 percent of the asset's capital back to the corporation, where traditional financing offers a percentage of the asset's value. Sale-leasebacks also provide an agreed upon annual rent for the asset, rather than an amortized or single lump payment. These lease payments may be structured in more flexible ways; for example, low rent payments during the first five years make it more comfortable for corporations from a balance sheet standpoint.
Of all their real estate holdings, companies generally choose to lease their more general purpose facilities, such as office buildings, because the lease can usually be structured to cost less. The sale-leaseback of more specialized facilities, such as manufacturing plants, presents a higher risk to an investor, and is thus more costly to the lessee, because these facilities are not as easily leased if the current tenant vacates.
In addition, since leaseback financing does not impose any operating covenants, as does traditional financing, companies can gain more operating flexibility. According to John Stanfill of CB Commercial in Los Angeles, "Corporations are often saddled with onerous and restrictive debt covenants; they have to operate in a certain way or may be declared in default of the covenants. Leaseback financing eliminates these operating covenants and provides more flexibility to the lessee.
"In doing a sale-leaseback," he continues, "you hope to structure it in a manner that will provide a lower cost of raising funds than debt financing. Since sale-leaseback investors get the tax benefits of owning and depreciating the property, the seller can often be successful in obtaining a lower cost for capital than cost for debt."
One of the drawbacks to a sale-leaseback is that once a company sells the property and enters into a finite lease obligation, it no longer controls its own destiny; the company can't vacate the property as easily as when that asset is owned outright. Another disadvantage is that any residual values on the property are no longer controlled by the corporation, but by the landlord.
But the disadvantages are not stemming a modest return of corporate sale-leaseback activity.
"Sale-leasebacks are coming back into favor as a way to provide corporations with flexible real estate obligations and to finance growth," says Charlie Corson, senior vice president of the retail investment group at Staubach Co.
The Dallas-based company, best-known for its tenant representation work, is an active player in the sale-leaseback and off-balance sheet financing market. The firm has closedtotalling $200 million in the last 18 months, including sale-leasebacks with Sun Microsystems Inc., Circuit City and Dell Computer Co. Deals typically range from $10 million to $50 million and include 20- to 25-year leasebacks.
"Our company is primarily a tenant rep firm," Corson adds. "We have strong relationships with corporate customers, and the sale-leaseback is an additional service we can provide to them."
There are dozens of excellent real estatecompanies around the country that assist with sale-leaseback transactions. Following is a glimpse of just a few of these companies, accompanied by an actual case study of a sale-leaseback transaction arranged through each.
As owners of a U.S. corporate headquarters building with 1.36 million sq. ft. of net rentable space, only 25 percent of which they occupy directly, British Petroleum (BP) realized earlier this year that it was looking too much like a landlord. Though it had once occupied 100 percent of the building's space, the company had reduced its use over the years and begun leasing portions to other tenants.
Executives at the Cleveland headquarters decided BP might better deploy its assets by taking the proceeds tied up in the building, converting it to cash, and employing it in their primary business.
The company conducted an indepth internal review of its options but desired an outside perspective. CB Commercial was one of six real estate companies interviewed by BP regarding a possible sale-leaseback arrangement. Each of the six was asked to determine if and when the market might be right for BP to enter into an agreement to sell the building and lease back a portion of the space. "We were called in during what I term an `advisory phase,' with no knowledge that BP would proceed with the transaction," reports John Stanfill, president of CB Commercial's investment properties group. "We advised BP of our findings, presenting a very thorough and detailed analysis of the market.
"Our recommendation indicated that it was a favorable time to sell the building," says Stanfill. "We found that the rising market would translate into more favorable pricing and a higher value for the property, and deliver a lower occupancy cost. This recommendation was in sync with BP's internal analysis, and we were awarded the business."
BP's U.S. headquarters building went on the market in early June 1996 for the asking price of $145 million. CB Commercial's target is to close the deal within six months.
Stanfill reports that, as is typical in a transaction of this type, the buyer is likely to be a fairly sophisticated but "passive" investor that won't be exposed to a construction and leasing risk, since the facility is already about 75 percent occupied. "Reduced risk is one of the advantages of investing in a sale-leaseback," states Stanfill. He adds that this particular building will have little lease rollover during the next 12 years.
"One of the benefits of this deal to CB Commercial, besides being paid for the transaction," states Stanfill, "is the opportunity to be of service on still another level to British Petroleum, with whom we have a long-term relationship."
COMMERCIAL NET LEASE REALTY
One of the ways of handling a sale-leaseback is through split funding. That's how Commercial Net Lease Realty (CNLR), a real estate investment trust based in Orlando, Fla., helped Barnes & Noble of New York expand into Daytona Beach, Fla.
According to Gary Ralston, president of CNLR, Barnes & Noble had identified a 2.1-acre site on which to build a super-store in Daytona Beach, and approached CNLR about the opportunity. As part of the two companies' program relationship, CNLR crafted a tandem process whereby CNLR did due diligence and review of the real estate while Barnes & Noble did due diligence and review of the retail business and construction of the store.
The designated site was owned by Best Buy, which constructed a store on part of the land and contracted with Barnes & Noble to sell the 2.1-acre outparcel. Barnes & Noble assigned the contract to CNLR, which closed on the land in September 1995. Using a standard lease document package used between CNLR and Barnes & Noble on 12 other occasions, Barnes & Noble was given up to one year to construct the building, with the agreement that CNLR would reimburse them for the cost of construction. The building was erected in January 1996 and opened for business on February 1.
This mutually beneficial, split-funding system provided Barnes & Noble with lower rent rates, among other benefits, and CNLR with a good return on invested dollars. "The advantage of this transaction over other sale-leaseback or build-to-suit arrangements, which may have three closings," says Ralston, "is that there's only one closing and one set of documents, so more of the money goes into sticks and bricks. In a typical sale-leaseback or build-to-suit, a retailer might steer a developer to the land, who then has land and construction loan closings, and a third closing when the store is sold to the retailer. Each closing can inflate the property cost by 3 percent to 5 percent without adding any value.
"Our split-funding structure brings a strategic alliance approach to the business by attempting to provide more value to the parties involved directly, with fewer third-party transactional costs that don't add any value," Ralston continues. "I like surveyors and attorneys, but how many reissuances of title insurance do you need?"
Dealing with the legal transaction just one time also may result in a lower tax assessment on the property because the assessor picks up just the land sale and cost of improvement as opposed to an inflated investor purchase price, Ralston says. "In addition, with this type of structure, the retailer is never in the chain of title and so is not exposed to any environmental risks."
An increasing number of CNLR's sale-leaseback transactions are being handled through split funding. The company has narrowed its focus over the years to specialize in free-standing retail stores. The company works with about 30 major retailers around the country, serving as landlord to most of the category killers. According to Ralston, of the $100 million of business CNLR conducted during the first half of this year, as much as 80 percent was designed as a sale-leaseback. Much of CNLR's business, about 75 percent, is repetitive, relationship transactions which utilize a specific set of sale-leaseback documents again and again to reduce cost and speed the exchange.
Today the 28,000-square-foot Barnes & Noble superstore in Daytona Beach offers 150,000 book titles ... and coffee, too.
EDWARD S. GORDON
Like British Petroleum, New York Life had once occupied 100 percent of its 800,000-square-foot office building at 63 Madison Avenue in New York City. But with a change in the company's various business lines, a significant block of space -- roughly 40 percent -- had become redundant.
New York Life looked at two alternatives: 1) staying in the landlord business [they remain as one of the biggest landlords in New York], or 2) selling the building and leasing back a major portion of it, which ultimately achieved the highest and best use for that particular asset.
Edward S. Gordon, headquartered in New York City and a major real estate player in that market, was appointed as the exclusive sales agent for the property, which is adjacent to New York Life's world headquarters. "We took a two-pronged approach," explains Robert Alexander, executive managing director of Edward S. Gordon. "We first pursued an owner/occupier, but where there were many lease inquiries, there was no real interest in buying the building and occupying part of it.
"In the second phase we approached the investment development community. Before initiating any discussions, we first culled out qualified prospects that we felt had the money but could also work well with New York Life's culture, and understand the wants and needs of the company," Alexander says.
The New York Life property went on the market early in 1995 for the asking price of $68 million. Less than a year later, it was sold for $65 million to George Comfort & Sons and Loeb partners through a joint venture.
This sale-leaseback transaction allowed New York Life to turn an asset that had been on the books since 1960 into an infusion of capital. The property sale also presented New York Life with prime office space on a long-term basis at market rents in that area. The purchaser has an excellent opportunity to lease choice space in a building that is anchored by New York Life.
"It's a rare opportunity to find a sale-leaseback of this magnitude in our area. To the best of my knowledge, New York City hasn't seen one of this size during this decade," notes Alexander. "I believe that the real estate market here is strengthening and that there are many capital sources ready to make a deal."
MARCUS & MILLICHAP
The sale-leaseback being arranged by Marcus & Millichap, a real estate investment company based in Palo Alto, Calif., for Payless Shoe Stores of Topeka, Kan., will allow Payless to take advantage of "the lowest sale and leaseback rates achievable in today's market," according to John Glass, sales associate for Marcus & Millichap. "Using a proprietary formula, we are able to obtain rates that are at least 10 percent to 15 percent below what comparable Wall Street institutions can offer."
Glass states that Payless' strategy is to focus all its capital on expanding operations, without tying its money in real estate. This has become increasingly important now that Payless has been spun off into an individual publicly owned company.
Each year Payless puts a package of 15-40 stores out for bid, with 60 bidders nationwide vying for the business. Marcus & Millichap was awarded the 1996 bid last January. The agreement has been executed, and Glass hopes to close the projected 25 stores in this year's deal by fall 1996. "The timing is really dictated by how long it takes us to get the lowest possible sale-leaseback rate for Payless," he says, adding that the total dollar volume of this year's deal will near $20 million.
The Hanover Property Company, a division of Marcus & Millichap, is the actual entity purchasing the stores, which average 2,800 to 3,500 sq. ft. each and range from $350,000 to $1.1 million.
Glass reports that the previous companies winning the annual Payless bids were not allowing the most favorable terms in the marketplace. He says his company approached Payless with a better mousetrap -- the formula that allows "the lowest possible sale-leaseback rates on the market and reduces the sale-leaseback cost by at least 20 percent." Over the course of Payless' lease per store, the formula will save the shoe retailer several hundred thousand dollars. This is achieved by eliminating the middleman and tapping into low-cost sale and leaseback funds provided for by 1031 exchange buyers, he says.
"Our company closed $2.1 billion in sales last year, and almost half of those transactions involved 1031 exchanges," explains Glass. A 1031 exchange buyer is someone who sells a building and, at closing, trades the equity for a like-kind building, thereby preserving his or her capital gains. This protection "motivates 90 percent of the exchange buyers in sale-leaseback situations such as Payless Shoes'," reports Glass. He adds that the properties involved are typically on pads in front of Wal-Mart supercenters, providing tremendous customer draw for each store. Glass emphasizes that Marcus & Millichap is the conduit whereby Payless Shoes can tap into the low-cost funds provided by 1031 exchange buyers.
Since the sale-leaseback is ultimately set around the final sale price of the property at prevailing market rates, Marcus & Millichap reduces costs by eliminating the middleman; it deals directly with the passive investor market, which traditionally has money that's far less costly than what pension fund advisers or Wall Street institutions can offer, according to Glass. Some of Payless' previous package bids were awarded and resold to third-party investors, at a substantial profit to the middleman. "Throughout our formula, we allow Payless to take advantage of lower sale-leaseback rates by providing direct access to these individual investors," Glass says.
The Payless sale-leaseback also is atypical because Payless is offering 15-year absolute bond triple net leases that are guaranteed by the Payless Shoe Corporation, though this isn't a Marcus & Millichap requirement. Tenants don't normally offer a bond-type feature to their leases because in the event of a casualty, they don't want to be on the continuing obligation. Under a bondable lease, the tenant is responsible to continue to perform under the lease obligation, no matter what. Glass reports that Payless adds this feature to its leases to obtain a slightly lower sale-leaseback rate; because there will be less of a risk in the income stream, a slightly less return can be dictated to the investor.
Payless Shoe Stores is the largest footwear retailer in the world. The company sells one in every five pairs of shoes sold in the United States, and has annual sales of $2.3 billion.
TRINET CORPORATE REALTY TRUST INC.
Managing a company in an industry as dynamic as healthcare requires flexibility and liquidity. Earlier this year, Blue Cross and Blue Shield United of Wisconsin determined that it was time to divest of its headquarters facility that was built in 1977 and increase the liquidity of its balance sheet. In June, the Milwaukee-based insurer sold its 236,218-sq.-ft. building to TriNet Corporate Realty Trust Inc. a San Francisco-based real estate investment trust, and then leased it back.
"We're focusing on our core businesses of managed care service and insurance services," says Tom Luljack, director of corporate communications for Blue Cross and Blue Shield United of Wisconsin. "As we looked at how to maintain that focus, getting out of the real estate business was a good option because it allowed us to use the equity we had in the building as well as redirect the energy that goes into maintaining the asset."
Additionally, the insurer does not have to maintain the capital reserves for real estate holdings that regulators require.
TriNet, which owns 12.6 million sq. ft. of office and industrial space, purchased the 10-story building for $16 million and negotiated a triple-net, 10-year lease with Blue Cross and Blue Shield. TriNet's initial yield was just under 10 percent.
"We underwrite the quality of the asset, the credit of the tenant and, most importantly, the ability to re-lease the space," says Gary Lyon, executive vice president and chief acquisitions officer of TriNet, which also taps an unsecured line of credit that allows it to carry no debt on its real estate holdings. "This approach allows us to offer substantially shorter term leases."
Blue Cross and Blue Shield originally thought the building was more salable with a 15-year leaseback but TriNet was able to structure an acceptable 10-year deal that provided Blue Cross with more operating flexibility. The shorter-term lease, which includes extension options through 2021, was priced competitively with a 15-year term.
"The occupancy costs are low compared to the alternatives in the marketplace," says Luljack.
The Class-A building is located in a healthy western submarket of downtown Milwaukee. Lyon says market rents should rise at a greater rate than the 3 percent escalations written into the deal.
"Our purchase price was substantially below replacement costs," Lyon says, "and the rents are below market, both of which reduce our credit and real estate exposure. This arrangement increases the likelihood that the tenant will exercise its renewal options and provides substantial upside to TriNet in the event Blue Cross vacates."
The building, which received several major capital improvements over the years, can accommodate single-or multi-tenant occupancy.
"Sale-leasebacks are becoming more attractive because of the flexibility they offer," Lyon says. "Blue Cross wanted to augment their capital strength by taking proceeds out of the building and putting in more liquid assets."
UNITED TRUST FUND
First Union Bank of Charlotte, N.C., was able to reduce its overall borrowing costs and improve cash reserves while maintaining control of two branch properties purchased by and leased to the bank by United Trust Fund (UTF) of Miami. "This sale-leaseback provided First Union with a low cost of funds, a small gain on the book value as a result of depreciation, and increased market share without coming out-of-pocket with any dollars," states Paul Domb, president of asset management for UTF. "The deal released capital that was tied up in real estate while providing First Union Bank with the flexibility to sublease the buildings and retain any of the profits if the branches don't work."
Domb reports that UTF handles more sale-leaseback transactions for financial institutions than any other sale-leaseback company in the United States. UTF's deals typically involve branch office properties, such as the two purchased last year in Boca Raton and Ft. Lauderdale, Fla., for First Union Bank.
In search of low-cost capital, First Union Bank approached UTF in October 1995 with the desire to unlock equity tied up in real estate to use in its primary business. First Union Bank's internal real estate department designated the two branch office properties of a smaller institution it wished to acquire. "Since the bank did not want to come out-of-pocket to buy the branches, the best alternative for the acquisition was a sale-leaseback," says Domb.
He explains that UTF purchased the land and buildings for about $7 million in a deal which closed in December 1995. First Union Bank signed a 15-year absolute bond-type lease providing complete control of the properties for up to 35 years, through options. The bank's Moody-A credit rating helped impact the low cost of funds provided in the transaction.
"This is a textbook example of a typical sale-leaseback," states Domb. "It's one of the best vehicles for the many financial institutions expanding into other states."