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A Sale-Leaseback Conundrum: Elevated Valuations Could Mean Later Problems

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The Federal Reserve’s October 2023 Financial Stability Report was not the sort of reading for CRE professionals to quell their fevered concerns about the industry’s immediate future.

As the Fed wrote, “Valuation pressures arise when asset prices are high relative to economic fundamentals or historical norms.” An apt description for commercial real estate. And elevated valuation pressures can “increase the possibility of outsized drops in asset prices.”

The implications might apply to any CRE property, but on reflection, sale-leaseback transactions seem like they might be particularly prone to adverse effects under the current conditions. The problem that appears for both buyer and seller is the potential longevity of the arrangement. Getting caught by an erroneous valuation is bad enough in the short term. Over a longer period, the effect can be magnified, with more to regret over an arrangement that will run years and possibly decades.

Under a sale-leaseback, the initial owner of a property is also the occupant. That owner decides to sell the property to an investor that will become the new owner and landlord.

The initial owner wants to use the property, often over a long period of time because that party prefers to keep control for years at least or perhaps decades. So, as part of the deal, that party agrees to remain a tenant, often on a net lease basis.

It’s a common type of arrangement. The first owner wants the sale to free capital locked in the building that might be put to better use, like R&D, acquiring another business, or expanding into a new sales territory.

In normal times, understanding the true value of the property is fairly straightforward. But currently, that isn’t possible because there is a lack of price discovery. If, as the Fed suggests, properties are overvalued, then the seller might seem to get a premium, assuming that an experienced buyer won’t recognize the danger, which a bit of a stretch.

However, say the transaction happens on that valuation. The buyer will need rents going forward that justified the price it paid, and they would need to be higher than true market rents. Overly high valuation likely means higher taxes that are paid by the seller. It could be that taxes would eventually come down, but it would require the local government to reassess the property.

This doesn’t mean that a sale-leaseback with net lease can’t make sense, but it might require more thought and negotiation for changing conditions.

 

Source:  GlobeSt.

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Sale Leaseback Transaction Volume Rises 8.3%

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Dollar volume of sale leaseback deals rose 8.3% to $5.1 billion in the second quarter over the first, while the transaction count remained in line with 165 versus 173 in comparing the same two quarters, according to SLB Capital Advisors.

Two significant transactions helped spur the dollar volume in the second quarter: Realty Income’s acquisition of EG America’s convenience store portfolio for $1.5 billion and Benderson Development Company’s acquisition of Kiewit’s corporate offices for $500 million. But most deals continue at lower numbers or in the $2.5 million to $25 million range.

Specific sectors fared differently and are worth noting. Industrial property transactions decreased from historical levels and represented only 39% of all transactions for the quarter. In contrast, retail, which many observers have worried about, represented an uptick and increased to its highest contribution level since the pandemic. 

Pricing trends. Sale leaseback cap rates have moved up 100 to 200 basis points from two years ago in 2021. The cap rate increase has been more pronounced in non-core markets for smaller credits with lower quality facilities. The impact has been less pronounced in core markets for higher quality facilities with stronger credits. Financing headwinds and inflation have been the two primary drivers, which have resulted in a risk-off environment for most buyers. Because the cost of capital has increased in the last 18 to 24 months, sale leaseback cap rates remain well inside company weighted average cost of capital or WACCs.

M&A arbitrage opportunity. In the second quarter, average purchase price multiples dropped across all deal sizes. While the M&A valuations have declined, this provides increasingly attractive sale leaseback value arbitrage across various industry sectors driven by the delta between business and real estate multiples. Attractive arbitrage opportunities are prevalent for the most part across many middle-market sub-sectors.

North American M&A activity. Deal value fell in the second quarter for a total of those closed or announced at a combined value of $467 billion. But the report said it should not be viewed as a dead market, just below the average pre-pandemic first half levels. The key reasons for less M&A activity are a risk-off financing environment and a mismatch between seller and buyer valuation expectations. Yet, corporate buyers who have strong balance sheets and sizable platforms are likely to benefit in this climate.

Net lease REIT snapshot. Net lease REITs reported $5.4 billion in acquisitions for the second quarter, a rebound from the first when they were $3.1 billion. The reason is attributed to REITs taking a good share of acquisition volume. The net lease REITs reported $2.8 billion of equity offerings in the second quarter, up from $1.6 billion in the first quarter.

By region. The South led in sale-leaseback activity by deal count, comprising 40% of all transactions. The Northeast led in dollar volume with $1.6 billion. In comparing dollar volume, the West closely followed the Northeast with $1.4 billion, then the South came in with $1.3 billion. Last place went to the Midwest with $0.8 billion. When looking at last year’s results, the West experienced the biggest decline in activity, dropping from $7.4 billion to $1.4 billion. The markets that face the most challenges are tertiary rather than core markets. But the good news is that sale leaseback pricing continues to be attractive across all geographic areas for those with strong credit and who are experienced operators, the report said

 

Source:  GlobeSt.

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Sale-Leaseback Is Quickest Path to Debt Restructuring, Panel Says

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Sale-leaseback deals are offering property owners a stable, long-term solution to restructuring their debt when the lending window for refinancing mortgages has been slammed shut.

Increasingly, sellers are flocking to long-term net lease deals as the first step to cure their balance sheets, using the proceeds from the sale-leaseback to jump-start their debt restructuring, according to a panel of experts at the GlobeSt. Net Lease Spring 2023 conference in NYC this week.

“Sale-leasebacks are uniquely positioned to recapitalize existing mortgage yields,” said Bryan Huber, director of SAB Capital’s Sale-Leaseback Group.

For companies that still want to do deals but find the current cost of debt prohibitive, sale-leasebacks offer a less expensive, alternative form of borrowing that can close faster, the experts said. Sale-leasebacks deals also don’t require back-end balloon payments that often come with traditional financing.

Ross Prindle, global head of Kroll’s Real Estate Advisory Group, said buyers are using their resources, including financing and cash deals, to make sale-leaseback transactions more attractive to sellers by making it less expensive to execute the deals.

“The winners will be [the buyers] who do the best underwriting,” Prindle said.

 

“Eight is the new six in cap rates,” said David Grazioli, president of US Realty Advisors. “The cost to capitalize these rates is making a 20-year deal with 3% bumps look a lot better.”

According to Grazioli, an increasing number of sellers are opting for sale-leaseback deals because they have an urgent need to rehabilitate their cash flow and can’t wait for cap rates to compress again.

However, several experts on our panel warned that buyers must take care to make sure sellers actually are creditworthy before they ink sale-leaseback deals, which are extending to terms as long as 25 years in the current environment.

During Tuesday morning’s State of the Industry roundup session, Gary Baumann, CEO of NJ-based ARCTRUST Properties said the current credit climate is creating opportunities for sale-leaseback transactions.

“Where the credit climate is creating an advantage for all of us now is that it’s opening the window for the sale-leaseback market, larger than it’s been for a long time,” Baumann said. “Because of what’s happening with the banks, we’re seeing opportunities to acquire net leases that weren’t there before.”

On the opening night of our annual Spring Net Lease conference, W. P. Carey announced the largest sale-leaseback transaction in the NYC-based company’s 50-year history, a $468M sale-leaseback of a portfolio of four pharmaceutical R&D and manufacturing campuses in the Greater Toronto Area (GTA).

The portfolio represents the lion’s share of the global operations of Apotex Pharmaceutical Holdings, the largest generic drug manufacturer in Canada.

“This deal would have been a lot tougher to do when there were $200m to $300M CMBS deals available that could close simultaneously,” Gino Sabatini, head of investments at W.P. Carey, said during our sale-leaseback panel discussion.

According to Zachary Pasanen, managing director, investments at W. P. Carey, sellers are flocking to sale-leaseback for a less-expensive cost of capital and extra liquidity during tough times. A sale-leaseback offers a “naturally accretive” alternative funding source, Pasanen told GlobeSt. last month.

Holders of fungible, mission-critical real estate that are willing to sign a long-term lease with market or better rental increases built in can establish an underlying rate that lets them monetize those assets and is inside the going long-term borrowing rate, Pasanen said.

 

Source:  GlobeSt.

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Sale Leaseback Cap Rates Continue To Attract Investors

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While pricing has widened, early indications in 2023 point to a growing return to confidence for the sale leaseback market, according to a market update report from SLB Capital Advisors.

The report cites “strong credits and robust business models achieving successful processes with large interest from investors”, even in non-core markets, particularly industrial.

Due to the current interest rate environment and companies’ overall cost of capital, the SLB cap rates offer a more attractive cost-of-capital solution than ever, according to the report.

“SLB rates remain well inside of many companies’ WACCs and today, in more cases than not inside companies’ current cost of debt financing, making the sale leaseback an incredibly attractive financing alternative,” it stated.

There continues to be an attractive value arbitrage across various industry sectors driven by the delta between business and real estate multiples. The multiple implied by average SLB cap rates (i.e., 6.25% to 8.25%) implies a multiple of over 12x to 16x.

This compares favorably to general middle market transactions which averaged 6.9x LTM EBITDA for 2022. Attractive arbitrage opportunities are generally prevalent across many middle-market sub-sectors, the report said.

 

Source:  GlobeSt.

 

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Sale-Leaseback Market Comes In Hot To End 2022

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The sale-leaseback market continued to shatter records in November despite declining M&A activity and rising interest rates, according to new research from SLB Capital Advisors.

There were 237 discrete transactions in the third quarter nationally, pushing the period to the strongest quarterly performance in deal count since Q4 2019. Dollar volume was down, however, over Q2 figures as no large casino transactions closed.

The Northeast led sale-leaseback dollar volume with $1.6 billion in deals, while the South had the most number of transactions at 87, followed by the West region with 72. Industrial was a major driver for sale-leaseback activity and accounted for 58% of all such transactions in the quarter.

The majority of all sale-leaseback deals are in the $5 million to $25 million range. However, marquee deals for Q3 included Boston Properties’ acquisition of Biogen’s HQ for $592 million and Oak Street’s acquisition of a QVC/HSN distribution portfolio for $443 million.

SLB analysts say the fourth quarter of 2021 was the ”best pricing environment to date,” with pricing holding strong throughout most of the first part of the year. Cap rates began to widen in Q3 as buyer caution ramped up, however. But “while pricing has widened, strong credits and robust business models are still driving attractive pricing from investors, even in non-core markets, particularly in the industrial real estate sector,” SLB analysts say.

In addition, net lease REITs had a banner quarter, reporting $4.4 billion in acquisitions for Q3 2022, a figure in line with the previous four quarters. Net lease REITs also continued capital formation in Q3 with $1.9 billion in equity offerings.

“Rising interest rates may lead to less competition as levered buyers sit on the sidelines; some analysts expect the REITs to take share over the near term as many maintain a highly favorable cost of capital,” SLB Capital Advisors analysts say.

M&A activity also declined across the quarter, though SLB says “a massive amount of capital” estimated at $800 billion remains available for attractive acquisitions. M&A deal value for Q3 fell by 50% from the peak set in Q4 2021, and “with future earnings of companies discounted at higher rates, there is a significant impact to valuations across sectors,” SLB analysts say.  All told, 4,457 deals closed for a combined value of $490 billion, declines of 19% and 4%, respectively from Q2 to Q3.

 

Source:  GlobeSt.

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