Market analysis

The Perfect Storm

Today's economy creates favorable conditions for sale-leaseback sellers.

Three decades ago, the sale-leaseback environment was clearly positive for buyers. However, today’s “perfect storm” of low interest rates, stock market uncertainty, a flood of investors, and available debt financing has created a sale-leaseback atmosphere that clearly favors sellers.

What’s the best way to stay the course, or better yet, ride the winds ahead of everyone else in this changing environment? Begin by taking a closer look at the available sale-leaseback properties, changes in lease terms and structures, the impact of today’s interest rates, and the advantages of sale-leaseback financing in the current market.

Today’s Properties

Demand for traditional sale-leaseback properties — national credit tenant retail and restaurant properties in the $1 million to $10 million range — is overwhelming the supply. For years, private investors, real estate investment trusts, and institutional buyers have preferred these properties for their predictability and cash flow. Often located on the main retail strips in every city and suburb, these properties also are easy for investors to understand because they drive by them every day.

The leases on these properties — typically triple-net with a single tenant on a free-standing fee property — also are preferred by investors, particularly 1031 exchange buyers, because they are considered the “cleanest.” Understandably, these properties’ owners are taking advantage of this demand and getting strong valuations, low lease rates, and flexible lease structuring.

Due to very aggressive capitalization rates, REITs and institutions as well as private 1031 investors now are forced to consider other asset classes to meet their targeted yields. These include hospitality properties, lifestyle and shopping centers, office and industrial buildings, marinas, campgrounds, and condominiums. In the past, these asset classes have not typically used sale-leaseback financing and, unlike the better-known national credit retail tenants, these properties are more challenging for investors to understand. And finally, predicting their performance over the next 10 to 20 years is more difficult.

Terms and Lease Structures

Thirty years ago very few sale-leaseback financing providers existed, and there was a limited amount of capital in the marketplace. Many top franchisees were in the early growth stages and wanted to expand rapidly. Major sale-leaseback financing companies provided the needed capital to fund expansion. It was a buyer’s market, and these institutional buyers were able to obtain attractive yields and favorable lease terms for their investors.

Today’s perfect storm of factors has created a seller’s market that is forcing sale-leaseback providers to adjust to changing market conditions. Stock market uncertainty has made corporate bonds and equities less attractive and created a flood of investors interested in the more predictable income stream of traditional sale-leaseback properties such as restaurant and retail. This along with historically low interest rates and attractive available debt financing has created overwhelming demand, putting the advantage in the seller’s court. Institutional sale-leaseback providers have been forced to change their investment policies. Here are a few of the changes to which they are adjusting.

Assignment Provisions. In the past, if franchisees sold their businesses to other operators, they often were not allowed out of their lease obligations. The new tenant was obligated on the lease as well as the seller.

Today, franchisees that sell their businesses using sale-leasebacks are testing the market with very liberal assignment language. For example, a 50-store owner/operator may insist on assignment language that allows him to sell his stores in pieces to four- and five-unit operators or even to one-store operators and be released from the lease obligation. The result: Buyers are paying for the credit of a 50-store owner/operator that potentially could sell the business to an inferior-credit tenant.

In the past, Trustreet and other sale-leaseback financing providers have applied tangible net-worth tests or size requirements to the company being assigned a lease. The underwriting requirements for tenants included a fixed charge coverage ratio, or debt coverage ratio. At one time, leases included an FCCR requirement of 1.2 to 1. Today that requirement no longer can be included as 1031 buyers often acquire properties without an FCCR or DCR covenant.

Insurance Provisions. Because of soaring insurance costs sale-leaseback providers are allowing new tenants much higher deductibles than in the past, which creates more risk. In addition, existing tenants are demanding to amend their leases because they can’t afford their insurance premiums.

Environmental Indemnification. Sale-leaseback providers also must be more liberal with environmental language, which again translates into taking more risks. For instance, AFC Enterprises recently sold Church’s restaurants for a purchase price of $390 million. Fortress Investments provided $161.5 million of sale-leaseback financing in this transaction without requiring Phase I environmental reports. “We approached the environmental risks with a variety of tools and mitigants,” says Joshua Pack, managing director of Fortress Investments. “Our approach included the tenant sharing in the risk and utilizing a secured creditor policy for our lender. We used an internal assessment and a limited database search and deemed the environment risk manageable.”

Percentage Rents. Prevalent in the mid- to late 1970s through the 1980s, percentage rents were perceived to be a good hedge against inflation during a period of double-digit inflation and historically high interest rates. For example, Pizza Hut grew very quickly in the 1970s and most of its sale-leaseback leases included percentage rent language. Today a significant portion of Trustreet’s total annual rent from these Pizza Hut properties comes from percentage rents. But lower inflation has lessened the importance of percentage rents. Today’s leases include fixed or consumer price index rent increases. However, if inflation increases, percentage rents could very well reappear.

Effects of Low Interest Rates

Historically low interest rates have created attractive debt financing and allowed investors to buy real estate and create positive leverage for their returns. This has produced lower cap rates and higher valuations that, in turn, have affected appraised values. An appraisal component is the income approach that applies a cap rate to a rent factor based on comparable sales. Appraised values have increased dramatically due to the income approach.

For example, in a sale-leaseback transaction five years ago, Trustreet bought a portfolio of properties from a casual-dining company. The appraisal indicated that the value of the real estate was approximately 80 percent of sales. Today the value of that same portfolio would be more than 100 percent of sales.

Both the reality and the fear of rising interest rates have created a “call to action” for sellers that are contemplating sale-leaseback transactions to lock in long-term financing at today’s low rates. They are realizing that as rates increase, the value of their real estate will decline.

Sale-Leaseback Advantages

Despite this perfect storm of change, sale-leaseback financing still offers several advantages including:

• the availability of capital for growth, which is helping certain industries, such as hospitality, meet their needs for capital;

• fixed occupancy costs at historically low rates;

• flexible leasing terms because of the demand for real estate, which means sellers are able to negotiate terms more favorable to them;

• equity cashout potential for franchisees that have owned real estate for several years and have quite a bit of equity trapped in that real estate. If they want to monetize the equity, they should do it before interest rates rise and subsequently decrease the real estate’s value;

• earnings-per-share considerations that operating companies can achieve through sale-leaseback financing’s off-balance-sheet treatment;

• attractive financing vehicles for private equity companies because they are less expensive than equity; and

• a source of capital for certain industries and asset classes that previously was unavailable.

By understanding the factors behind today’s perfect storm of market conditions, sale-leaseback providers must adjust to the changing market to ride the wave of long-term profitability and commercial real estate professionals can better advise their clients on the opportunities sale-leasebacks offer.

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