Higher interest rates that have become an impediment to transactions in the broader commercial real estate investment sales market are having the opposite effect in the sale-leaseback sector.
According to SLB Capital Advisors, which tracks sales greater than $2.5 million, the sale-leaseback market was on pace for a record-high year with 660 closed deals valued at $23.9 billion that were completed during the first three quarters of 2022. That dollar volume is shy of the $24.7 billion in transactions completed in the full year of 2021. The firm is forecasting another strong year ahead for 2023 given the current stance on Fed policy that suggests rate cuts are unlikely in the coming year.
“The big story in the sale-leaseback space in 2023 is that, on a relative cost of capital basis, sale-leasebacks are even more attractive now than they were 12 months ago, even though cap rates have risen,” says Scott Merkle, a managing partner at SLB Capital Advisors.
Operating companies that are looking to raise capital have a menu of different options, such as high-yield bonds, bank debt, convertible debt, equity or sale-leasebacks. Some of those alternatives have been more negatively affected by higher interest rates. For example, high-yield bonds and bank debt have both increased by more than 400 basis points over the past 12 months. Cap rates on sale-leasebacks also have increased, but not as dramatically—100 to 200 basis points over the past year.
“On a relative basis, even though cap rates have expanded from the record lows of a year ago, the pricing on sale-leasebacks is still that much more attractive compared to other forms of capital raising right now,” says Merkle.
Although the sale-leaseback activity slowed in the fourth quarter as buyers and sellers tried to figure out new pricing amid higher interest rates, the sector has continued to generate solid activity, agrees Jeff Tracy, a senior vice president for Northmarq in Tulsa. “What we have seen, historically, is that the sale-leaseback category tends to bounce back the quickest and isn’t as sensitive to interest rate impacts,” he says.
Even on deals where cap rates may have increased from a 6% to 8%, it is still better than the financing rates some of these middle market companies can get on their business in the current market, notes Tracy. “That’s why you’re really seeing this pick up steam, because people realize the value to sale-leasebacks and that it is a nice alternative to traditional financing,” he says.
Business owners are hungry for capital
The strong deal flow is especially notable given the decline in M&A transactions, which is typically a big driver for sale-leaseback transactions. Companies that are buying a business often execute a sale-leaseback on the real estate assets of that business to help finance the transaction. According to S&P Global Market Intelligence, M&A deals in the U.S. and Canada declined to $1.48 trillion in 2022—a 41% drop compared to the recover high levels seen the prior year.
“We are seeing fewer sale-leasebacks than we saw 18 months ago when private equity M&A was white hot,” says Tyler Swann, a managing director on the Investments Team at W.P. Carey Inc. On the other hand, sale-leaseback cap rates have probably never been more attractive than they are now compared to the cost of corporate debt, says Swann.
Business owners also like using sale-leasebacks as an alternative financing mechanism, because it allows them to “monetize” capital tied up in their real estate. They can pull 100% of their equity out of real estate and use it to reinvest in their business, finance expansion, pay down debt or increase liquidity with a potential recession ahead.
Another aspect to the sale-leaseback story is that some businesses are still coming out of the pandemic and are looking for capital to aid in their recovery. “If you think about what’s happened over the last three to four years, it’s really been pretty traumatic from a perspective of upending businesses,” says Tracy. Starting in mid-2022, there was fundamental recovery even in some of the more severely impacted businesses. Businesses that took on significantly more leverage during the pandemic are now looking to clean up those balance sheets, and a sale-leaseback is an attractive way to do that, he adds.
Plenty of investor interest
The pool of sale-leaseback buyers remains active across the spectrum from REITs and large institutions to family offices and even high-net-worth individuals. Buyers have capital to deploy, but they also want to deploy that capital in a smart manner, notes Merkle. “They are being selective, but they are being appropriately aggressive when they want to win an opportunity that they feel is a good fit for their investment platform,” he says.
One of the prevailing themes on the buy side is more of a flight to quality due to economic uncertainty. As a result, cap rates have moved less for the best-in-class assets, such as Amazon or FedEx occupied facilities. There have been bigger moves in cap rates for lower credit companies or weaker locations that have more risk. For example, Northmarq brokered $250 million in transactions last year involving multiple convenience store portfolios. Cap rates for deals done early in the year compared to those done later in the year moved 150 basis points higher for the same c-store tenant.
W. P. Carey is an active acquirer of industrial sale-leaseback assets. The company closed on more than $1.4 billion in single-tenant net lease assets globally last year and anticipates reaching a greater volume in 2023. At year-end, the company had a strong near-term pipeline with over $500 million of opportunities that were in advanced stages or under letters of intent. The firm invests primarily in high quality, single-tenant warehouse and industrial properties, and corporate sale-leasebacks are a big source of investment opportunities.
One of the reasons behind W.P. Carey’s positive outlook for buying opportunities in 2023 is because it has a better read on its capital costs with more stability in financing rates, notably the 10-year Treasury.
“That stability is key because it allows us to know what our cost of capital is, and therefore offer cap rates and terms to potential tenants that make sense to us,” says Swann. W.P. Carey is accessing capital in the bond market versus the mortgage market. The firm’s stock price also has rebounded significantly from lows experienced in September and October, which also puts the company in a stronger cost of capital position on the equity side.
In addition, higher interest rates have kept some investors on the sidelines. “Especially for competitors that relied so much on cheap debt, it has really hamstrung their ability to get deals done, and we’ve taken advantage of that,” says Swann.
