Commercial Real Estate Investment
Property
The Perfect Storm
Today's economy creates favorable conditions for sale-leaseback
sellers.
By Mark T. Samples, CCIM
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. |
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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.
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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.
Original source: http://www.ciremagazine.com/article.php?
“Perfect Storm”
© CCIM Institute.
Reprinted with permission from
Commercial Investment Real Estate, volume XXIV no. 4, p.34-37.
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