The Perfect Storm
Today's economy creates favorable conditions for sale-leaseback sellers.
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.
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.
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.
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.
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
and Lease Structures
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.
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.
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.
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.
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.
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.
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
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.
of Low Interest Rates
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.
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.
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.
this perfect storm of change, sale-leaseback financing still offers several
• the availability of capital for growth,
which is helping certain industries, such as hospitality, meet their needs for
• fixed occupancy costs at historically low
• flexible leasing terms because of the demand
for real estate, which means sellers are able to negotiate terms more favorable
• 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
• earnings-per-share considerations that
operating companies can achieve through sale-leaseback financing’s
• 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.
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.