If a company makes widgets, it will typically strive, on a continual basis, to make the
manufacturing of its widgets more efficient. It will know the cost of every part and every process down to a thousandth of a penny. Meanwhile its largest single asset is sitting there with very little, or no, attention given to it: the company’s real estate.
Why? Because real estate is not its core business...and “it ain’t broken.” Besides, there are so many pressing issues to deal with that demand immediate attention.
Nevertheless, most companies have plans that require capital. If the company owns the building out of which it operates, then a corporate finance solution that should be considered is a sale-leaseback.
Bank Loans
When the company needs capital an obvious place to look is to the company’s bank. Interest rates are low and banks are eager to lend to its healthy corporate customers. However, the CFO may want to keep his lines of credit available to him. And the company’s plans may require more capital than its lender would comfortably loan.
A sale-leaseback sells for 100% of the real estate’s fair market value. A mortgage loan to a
healthy middle-market company is typically 60% to 70% of its market value. That means that the proceeds from a sale-leaseback are 43% greater than a 70% LTV mortgage (and 67% greater than a 60% loan)!
Other important differences include:
it is not variable
it has a fixed, or known, long-term rental schedule
a sale-leaseback will have little, or no, impact on the company’s lines
unlike a bank loan, it will not have financial covenants, or restrictions, attached to it
and it will not require personal liability
Equity
Equity capital is expensive and difficult to raise, especially for middle-market companies on the lower end of the spectrum. Such firms are private, usually family controlled and often headed by the person who grew the company. Giving up a portion of his ownership interest in the company (a requirement of most equity investors) to a third party is usually met with strenuous resistance.
Sale-leaseback investors do not require any ownership of the operating company and they do not desire any involvement in the company’s business operations, or the building’s management. They just want to collect the agreed upon net, net, net rent. If the company pays its rent, management may never hear from the sale-leaseback investor.
Increase ROA and ROIC
Investors will accept a 6% to 9% return (rent) on the amount they pay for a well-run middle-market company’s real estate. The company’s core business invariably has a higher return, often much higher (percentages in the teens, 20s, 30s...?). Sell the firm’s large, illiquid
asset for, say, 8%, then take the net proceeds and reinvest the capital into a use with a higher return (such as the core business, or buy another company, buy an expensive new piece of equipment, hire more employees, enter new markets, etc.) and improve the company’s return on assets and return on invested capital. Many CFOs have hurdle rates for large capital investments. Similar investment return expectations should be applied to the company’s real estate. Goldman Sachs, Credit Suisse and JP Morgan Chase have done sale-leasebacks on some of their company occupied properties. These international institutions have access to huge amounts of inexpensive capital. They also understand leverage and arbitrage.
You Write the Lease
You and your advisors draft the lease. You get to put in the terms that are important to you (such as, length of lease, extension options, right to repurchase) and omit those that are detrimental to you and your company (e.g., dramatic, or unknown rent increases, expansion rights, eviction provisions, high insurance requirements, etc.). The “art” to drafting the lease is balancing 3 driving economic forces that are in conflict with each other:
the desire to maximize the sale proceeds (achieved with high rental rate, low cap rate), with
the long-term rental stream that the company must pay (it wants low rental rates), with,
the terms that make the transaction attractive to sale-leaseback investors (such as, high rents, high cap rate, strong credit, quality real estate).
With today’s low interest rates and cap rates, companies have an opportunity to lock in a long-term rent schedule with lower than usual rents. Thereby it eliminates the risks of rents increasing rapidly due to such factors as increases in interest rates and changing real estate market conditions.
The Beginning, the Middle and the End
Sale-leasebacks have been effectively used to acquire companies, fuel mid-stream growth and as an exit strategy.
The value of a middle-market company’s real estate is often more than 50% of the acquisition price of the company. Consequently, sale-leasebacks have been used in management and leveraged buy-outs; private equity and strategic acquisitions; and, buying public company spinoffs.
Companies with aggressive expansion plans have used sale-leasebacks to fuel their growth. Examples: when they expand by acquiring other companies, buying another or adding on to their building, adding equipment, or employees. Sale-leasebacks have been a corporate finance solution for many expanding public companies, as well as smaller private firms.
And in the end, when the senior stake-holder nears retirement, sale-leasebacks are an excellent mechanism to provide the capital needed for Dad’s move to Florida. It has also been used to convert the principal owner’s interest in a large, illiquid asset into capital that is available to fund family trusts.
It’s Not a Secret, but Still Unknown
Real Capital Analytics tracked 765 sale-leaseback transactions in 2017 with an aggregate value of $16,462,000. These figures do not include any transaction below $2.5 million Therefore, thousands of retail and quick service restaurants are excluded. For example, Dollar General does more than a thousand sale-leasebacks a year. Deals like Auto Parts, Dunkin Donuts, Arby’s, Verizon Wireless, Jared’s and dental clinics are less than $2.5 million, not to mention the thousands of private credits sold and leased-back each year.
Nevertheless, many middle-market C-Offices do not consider sale-leasebacks when they are faced with a capital requirement. Often it is because the firm’s trusted advisor, such as its corporate lawyer, or accounting firm has not done one. Consequently, they are reluctant to recommend it.
A sale-leaseback is not always the best solution for every company's capital needs... but it should always be carefully evaluated as a finance strategy and compared to the firm’s other corporate finance options.