Sale Lease-Backs Gaining Momentum
A sale lease-back is a real estate transaction where the owner of a property (often a corporation) sells the real estate it is using to an investor and the investor leases it back to the seller. Often the lease terms are long periods of time such as 20-30 years and have renewal options for the seller. With interest rates and cap rates at historic lows, there are more reasons than ever that a credit-rated corporation would want to consider such a transaction. Just last week, it was just announced that Traverse City’s second largest employer, Hagerty Insurance, sold its corporate headquarters buildings in downtown Traverse City and entered into a 20-year lease with a buyer from Chicago.
One of the main advantages to a seller is that the sale lease-back frees up capital that the seller can use for its core business. If a business is earning 8-10% on its capital investments (or often 10-20% in many growing businesses), then it may benefit from selling off its real estate assets. Currently many sale lease-backs are occurring at 4-7% cap rates, making the return on the company’s real estate investment much lower than it would get by investing those funds in its core business. Another advantage is that the business can expense 100% of a lease payment, but can only depreciate the building and not the land, if it owns the property. This can be a significant tax savings for a profitable company. The sale lease-back also enables the seller to eliminate or reduce the debt it has on its balance sheet and this may offer opportunities for the seller to borrow funds for its business more easily.
Often the value of the property is higher in a sale lease-back transaction than the property would be worth vacant or with a short term lease. This is because the credit rating of the tenant and the long term nature of the lease can entice investors to take very low cap rates, which increases the sale price of the building. Recently I sold a vacated restaurant building to a Denny’s franchise owner. They are completely renovating the building and signing a 20-year lease for the building and they put it back on the market at a price that is 3 times more than they paid for it, offering an investor a 20-year lease at a 6.5% cap rate. The sale will allow the owners of the franchise to draw additional funds from the property sale that can then be used to finance future acquisitions and help them obtain a higher rate of return than they would receive if they retained the real estate.
A company thinking about selling its core business will often benefit from a sale lease-back as well. The company can maximize the value of the real estate in the transaction and then when they go to sell the business, the real estate does not become part of the negotiated price. When real estate is included, it often is sold at book value or an appraised price that is below the sale-lease-back value. By selling the real estate before the business is put up for sale, the full value of each can more easily be realized.
Last year Darden restaurants sold 430 of its 1500 Longhorn Steak house and Olive Garden restaurants in a sale lease-back. Sears sold 2.7 billion of real estate last year and is leasing back the majority of the properties. While these headlines are typical on a national level, we have seen more sale lease-backs offered on a local level as well. There have been numerous drug stores, retailers and medical office properties sold or offered for sale over the past year.
Individuals and institutional buyers are eager to purchase properties with long lease terms and good tenants, creating a large pool of buyers for these transactions. The buyer will receive a higher rate of return on a lease than he would if he were loaning money to a borrower. When he finances the purchase, he can increase his return on his investment even more by using leverage. These are very easy transaction to finance because the lender knows the tenant will be there for a long time (20+ years), the tenant usually pays all the expenses and maintenance of the property (a triplet net lease) and if the tenant defaults, the buyer will typically keep paying the mortgage to protect the asset. The Buyer also receives an inflation hedge through the benefit of increases in value of the property he is purchasing.
When contemplating any real estate transaction, all facets of the deal should be carefully analyzed before any decisions are made and sale lease-backs are no exception. The buyer has to consider the chance that a tenant may default and make sure the return on the investment justifies the risk being taken. The seller must consider the fact that a lease may not be renewed at the end of the lease term or that future modifications to the building are not solely their decision. When structured correctly there are significant financial advantages to both buyer and seller in these transaction and we will probably continue to see more transactions like the Haggerty deal as long as cap rates remain at record lows.
Dan Stiebel, CCIM