Investors chasing net-lease properties are upping the ante. Instead of paying $10 million for a single property, they are forking over $100 million for an entire portfolio. Buyers are increasingly drawn to the portfolio deals because they provide a vehicle to place a large volume of money relatively quickly in an intensely competitive investment arena.
Corporate portfolio sale-leasebacks have hit record levels in the past year with major deals from retailers such as CVS and ShopKo posting staggering numbers. In December, CVS Corp. announced that it had initiated a sale-leaseback of 340 owned or ground leased pharmacy properties in 29 states for $1.3 billion. ShopKo clinched a deal to sell and lease back 112 ShopKo properties and 66 Pamida properties for $815 million. Corporations are using the capital to finance everything from aggressive expansion campaigns to leveraged buyouts.
These two deals represent the extreme high end of the spectrum, but investors are showing appetites for multi-building portfolios that often feature single tenants with long-term, triple-net leases.
“A few years ago, a large dollar amount would have been a non-starter,” says Brian Scott, a senior managing director in the sale-leaseback group at CB Richard Ellis in New York. “But these days, the larger size is not much of an impediment because of all the capital looking for investments,” Scott says.
One would think that the higher prices would lessen the field of potential bidders. Yet it seems that the reverse is true. In fact, portfolio real estate is an increasingly crowded and competitive niche.
Portfolio sale-leasebacks involving a tenant with strong credit and quality real estate can receive upwards of 30 to 40 bids. Even portfolios of lesser-quality properties and non-investment grade tenants are receiving five to 10 offers.
Despite some of the high-profile sales, what is surprising is that a lot of these portfolio transactions are being done off the radar screen. “There are so many net lease funds out there that they are contacting companies directly, so sale listings are not even hitting the street,” says Jonathan Hipp, president and CEO of Calkain Cos. Inc., a brokerage firm in Reston, Va. For example, Hipp recently brokered the sale-leaseback of six Advance Auto Parts stores in the Northeast for $15 million. Despite the fact that it was an off-market deal in which the bids were unsolicited, the deal attracted seven bidders.
Another reason that investors are drawn to larger portfolios is the incentive to diversify the risk geographically. “The bulk of our transactions are portfolio acquisitions, meaning two or more properties,” says Ben Harris, managing director and head of domestic investing at W.P. Carey (NYSE: WPC), a New York-based investment firm.
The company expects to acquire about $1 billion in commercial real estate in 2007. For example, W.P. Carey recently purchased three cold storage facilities in Atlanta from Nordic Cold Storage LLC for an undisclosed price.
Both portfolio and single-building sale-leasebacks are popular among investors because the properties are known for generating steady returns with very little hands-on management responsibilities due to the long-term, triple-net lease structure. Oftentimes, pricing is based as much on the tenant's credit quality as the quality of the real estate.
Net leases are often described as buying bond income in the form of real estate. “It's definitely a predictable income stream that is bond-like in structure from a number of different perspectives,” Hipp says. Although returns vary widely, top deals typically trade about 200 basis points over the 10-year Treasury.
Booming portfolio sales
Both industry data and anecdotal sources agree that portfolio deals are on the rise. “We're definitely seeing an increase in portfolios coming to market,” says David M. Ledy, chief operating officer at New York-based U.S. Realty Advisors.
In 2007, U.S. Realty Advisors expects to leverage about $150 million in equity to purchase sale-leaseback investments. Although it is difficult to pinpoint what percentage will involve portfolio deals, the firm is in the midst of closing the purchase of a $120 million portfolio, and is also bidding on a second portfolio valued at more than $200 million.
Portfolio transactions, including both sale-leaseback and non-sale-leaseback deals, have experienced significant growth in recent years. An estimated $84.2 billion in investment real estate portfolios changed hands during the first four months of 2007, nearly twice the $44.8 billion in single-asset sales, reports New York-based Real Capital Analytics (RCA).
The 2007 portfolio statistics may be weighted slightly due to the inclusion of the $39 billion Equity Office Properties acquisition in February by The Blackstone Group, a private investment firm. However, even excluding that mega deal, portfolio transactions of $45.2 billion reflect a growing market segment. Portfolio deals generated $63.7 billion in 2006 and $45.2 billion in 2005.
Overall, sale-leasebacks generated $11.2 billion in sales in 2006, representing about 5% of the $228.6 billion in total real estate sales for office, industrial and retail properties, according to RCA.
“We are seeing a fair amount of portfolio transactions,” says Fred Berliner, senior vice president and director of acquisitions at Miami-based United Trust Fund, an investment firm that has completed more than 400 sale-leaseback transactions since its inception in 1972. UTF is currently chasing two major portfolio deals, including a portfolio of 48 retail properties valued at about $130 million.
“It is just as easy to buy 30 buildings from one entity as it is to buy a single building,” Berliner says. Getting a large chunk of money invested all at one time — with a company that you like — is a huge incentive to pursue these portfolios. Although the larger portfolios do require more due diligence, the financial part of the transaction is much the same regardless of the size of the deal, he adds.
Growing inventory
The good news for investors is that the pipeline for portfolio deals continues to look promising. According to a CoreNet Global Experts Survey conducted last October, more than one-third of respondents indicated that they have had experience with portfolio sale-leaseback transactions or plan to initiate one in the near future.
“Given the improving fundamentals in the real estate market, and the availability of money, we are seeing a lot of sale-leaseback activity,” says Eric Bowles, director of global research for CoreNet Global, the Atlanta-based association of workplace and corporate real estate executives.
The survey was sent to 95 registered experts, with 29 completed surveys returned for a response rate of 30%. The large majority of respondents, 87%, were from Fortune 500 firms, their global equivalents, or their service providers.
Another key finding of the survey is that responses point to a greater shift from owned to leased property. Respondents expect the balance of leased property to increase from the current 48% to 54% in five years. At a glance, 6% may not seem like a significant move. But in reality that volume is quite compelling, Bowles notes. CoreNet Global members alone manage $1.2 trillion in worldwide corporate real estate. So that 6% shift could translate to about $72 billion in owned assets that will likely be sold and leased back.
Shifting corporate strategy
A number of factors are driving the surge in portfolio activity. The tremendous availability of investment capital has given companies incentive to sell now.
Solid investment grade credits with a typical 10- to 15-year lease term are generating cap rates below 7%. Those deals with stellar credit and “A” real estate are generating even lower caps of around 6%, or even sub-6%. “By the same token, the word is out that sale-leasebacks make good corporate sense,” Ledy adds.
Sale-leasebacks have long been a tool that companies have used to access capital tied up in real estate. In most cases, companies have turned around and pumped that money back into operations or financed expansion plans.
In April, RathGibson sold its headquarters and principal manufacturing facility in Janesville, Wis. to the new net lease group of Angelo, Gordon & Co. for $9.4 million. The firm, which manufactures a variety of stainless steel products, is owned by Castle Harlan Inc., a New York-based private equity firm.
“Oftentimes, sale-leaseback programs, especially when multiple facilities are involved, are useful in financing major spending programs or expenditures,” says Bill Pruellage, a managing director at Castle Harlan.
Although the RathGibson sale-leaseback was not a substantial transaction, it will provide added capital to improve the firm's balance sheet and pay for expansion of the facility. “We view sale-leasebacks as a way to maximize value for our shareholders,” Pruellage says.
“The main reasons for corporations doing sale-leasebacks, individually or portfolios, is to pull capital out and put it to work where it can earn more for them and their shareholders,” says Scott of CBRE. “Speculative real estate is not going to throw off the kind of returns that are beneficial to their shareholders.”
In addition, sale-leasebacks also are being used more frequently to finance mergers, acquisitions, and leveraged buyouts. “It has become an important piece of the overall capital structure of a transaction,” Ledy says.
For example, Cardinal Capital recently executed a $100 million sale-leaseback transaction with select Bruno's Supermarkets and BI-LO stores located throughout the Southeast. The proceeds constituted a sizeable component of Lone Star Funds' acquisition financing for Bruno's/BI-LO from Ahold.
“There has been a lot of interest in corporate real estate as a way to unlock value for the equity holders,” says Harris of W.P. Carey. For example, real estate sales played an integral part in the recapitalization of K-Mart and in the acquisition of Toys R Us.
Real estate has become a larger part of the investment piece among a lot of hedge funds and equity funds that are acquiring a company, and then selling a lot of the real estate — either through a sale-leaseback or outright sale — to add value, he adds.
Corporations also are motivated to conduct sale-leasebacks to reduce residual risk. A company that sells a building and agrees to lease it back for 10 years can cash in on the top real estate prices being paid for fully occupied buildings.
Ten years from now, if that property is obsolete or no longer needed, the company can walk away from the lease without looking back. If the firm had retained ownership, the company would likely have to sell the vacant building at a significantly discounted price.
“CFOs, treasurers and real estate executives are realizing they may be very exposed on residual value if they no longer need a property,” Scott says. At the same time, companies can lock in occupancy if they need it for a long period of time through lease renewals.
Fighting for deals
Although buyers and sellers alike are keeping a close eye on interest rates and debt markets, the potential for higher rates has yet to affect the flurry of portfolio sale-leasebacks. In fact, the threat of rising interest rates is spurring sale-leaseback activity.
The perception that there is a window of opportunity that will close once interest rates rise has actually pushed more corporations to initiate deals in the past couple of years, Scott says.
Like other real estate investments, most sale-leaseback deals are financed off the 10-year Treasury, which registered 4.86% at the close of business on May 24.
Although rates have moved little in the past six months, many industry observers believe that an increase at some point in the near future is inevitable. “As rates increase, sale-leasebacks may look less attractive relative to other sources of debt that a company may have,” Scott adds.
“You always have to watch the debt market for changes that can have ripple effects throughout the equity market as well,” notes Ledy of U.S. Realty Advisors. To some extent, lenders and rating agencies are starting to tighten underwriting standards due to widening in CMBS pricing among lower-rated levels.
“That's the negative trend to keep cognitive of,” Ledy says. “Yet the sale-leaseback is a well recognized financing tool. Companies will continue to use it because it has become an important part of their arsenal for financing their business.”
The biggest challenge for buyers in this intensely competitive arena is finding a way to land deals without driving prices out of reach. One strategy is to carve out an even more specialized niche within the sale-leaseback sector.
American Financial Realty Trust (NYSE: AFR), for example, focuses solely on the acquisition of financial institutions. “Their whole angle to generate additional deal volume and be competitive is to offer tremendous flexibility to banks,” Harris says.
AFR recently purchased 13 fully occupied bank branches and three multi-tenant office buildings in Texas from Sterling Bank for $28.3 million.
Other firms such as U.S. Realty Advisors rely on service and experience. “Companies that do business with us are not necessarily looking to shake the last dollar out of the tree and lose professionalism,” Ledy says.
U.S. Realty Advisors typically buys sale-leasebacks with a long-term hold strategy. “We are service oriented and we want the company to realize we are here to problem-solve with them,” says Ledy. “So when the deal is closed, the end result is that they have a very responsive landlord on the other side of the table.”
Beth Mattson-Teig is a Minneapolis writer.
Wholesale buyers face pricing barriers
Premium pricing on portfolio sale-leaseback assets may sideline some “wholesale” buyers. Investors who have been snapping up portfolios for lower prices and then selling off individual properties for a retail mark-up may need to adjust their strategies.
“The wholesale market is very tough right now because of the stiff competition for portfolios,” says Jonathan Hipp, president and CEO of Calkain Cos. The strategy is simple. Investors buy a portfolio of triple-net-lease properties in a sale-leaseback, and then sell off individual properties at a higher price. The practice has been dominated by opportunistic investors, including both private groups and large, publicly traded REITs.
“As residential values appreciated, this was a very lucrative trade to make,” explains Ben Harris, managing director and head of domestic investing at New York-based W.P. Carey. Rising values among apartment and other rental properties fueled demand among the 1031 investor niche.
A wholesale investor could buy a portfolio of properties at a 10% cap rate, hold it for a short period, and then turn around and sell individual properties to 1031 buyers at a 7% cap. “That trade, in my opinion, is becoming much harder to do,” Harris says.
One reason the wholesale deals are less attractive is that the softening housing market has reined in demand from 1031 buyers. Owners of rental housing are not realizing the same appreciation of past years and are less likely to initiate a sale and pursue a 1031 exchange.
A second reason is the pricing gap between the wholesale and retail market has been shrinking. Wholesalers now run the risk of buying a portfolio at a lower cap rate than the cap rate they can get on the re-sale of the individual properties.
“A lot of times people want a pricing concession for buying in bulk as opposed to a one-off transaction. But in the market that we're in today, that isn't always the case,” Hipp says.
W.P. Carey is steering away from high-profile portfolios that attract more bidders and focusing on smaller, lower-priced portfolios of two to five properties.
W.P. Carey recently acquired two cold storage and distribution facilities in Ringwood, N.J. and Alameda, Calif. from CheeseWorks Inc. for $10.5 million. W.P. Carey often buys properties priced at a cap rate of 7.5% to 10.5%.
Some experts contend that buyers are not as aggressive as they have been, but it's still a seller's market. “This marketplace is very advantageous to the seller or tenant,” Harris says. “They are able to get much more aggressive pricing, lease terms, more flexibility — a whole variety of things.”
— Beth Mattson-Teig