A variation of credit tenant lease financing, where the primary focus of the lender is on the credit standing of the tenant as opposed to the real estate, a sale-leaseback involves the property owner selling the property to an investor for a long term - typically 15 years or more. The former owner then assumes the role of tenant, leasing back the property from the investor. This is preferably arranged (from the investor's standpoint) on a "net" or "triple-net" lease basis, where the tenant remains responsible for taxes, insurance, maintenance and other property-specific operations.
A popular financing vehicle Sale-leasebacks began more than 50 years ago, when the Safeway grocery store chain began using the financing mechanism, according to Paul M. Domb, vice president of asset management for Miami-based United Trust Fund. The company, in partnership with Metropolitan Life Insurance Co., has specialized in corporate sale-leasebacks since 1972. "Today, more than 50% of corporate America utilizes sale-leasebacks to obtain capital," he says.
The use of the sale-leaseback mechanism is widespread, agrees Gary Ralston, president of Orlando, Fla.-based Commercial Net Lease (CNL) Realty Inc., an equity REIT focusing on the development, acquisition and ownership of freestanding retail properties.
"Most of CNL's transactions are either sale-leasebacks to retailers, or build-to-suits pursuant to a retailer's prototypical specification for a store," says Ralston. "We think of a build-to-suit development as tantamount to a pre-construction sale-leaseback. Our leases are typically triple-net, credit-tenant leases that run 15 to 20 years in the initial term."
During the past several years, notes Ralston, CNL has done this type of build-to-suit/long-term lease transaction with a variety of retailers, including Eckerd, OfficeMax, Barnes & Noble, Bed Bath & Beyond, The Sports Authority, Robb & Stucky, HomeLife and Blockbuster. "Many of today's retailers are seeking to apply the principles of strategic performance - fewer vendors, lower cost and increased predictability of performance - to their new-store expansion programs," he adds.
A typical example of a sale-leaseback transaction is one completed by Escondido, Calif.-based Realty Income, a company that specializes in net-lease, sale-leaseback transactions with regional and national retail chains. Last year, retailer Pier 1 Imports came to Realty Income for its services.
"We acquired 19 Pier 1 properties for an average cost of $1.3 million per store," explains Realty Income CFO Gary Malino. "This meant that Pier 1 was able to expand its business to new areas, without having to tie up capital in $25 million worth of real estate." In turn, Realty Income secured ownership of 19 prime retail properties with leases that will generate revenue for the next 15 years.
"As more and more retailers choose freestanding formats as the preferable choice for new growth, we see opportunities growing at a significant rate," says Ronald Max, CIO of Ann Arbor, Mich.-based Captec Net Lease Realty, another REIT specializing in retail sale-leaseback transactions.
"Our niche is the retailer that has a credit rating at, or just below, the level considered investment grade," Max says.
On the investor interest side, he adds, "We have recently established two joint ventures with large institutional investors, each expecting to acquire up to $100 million of net-leased property."
Auto parts sellers, video stores and fast-food outlets have dominated the recent sale-leaseback business handled by Chris Marabella, head of Escondido, Calif.-based Marabella Commercial Finance. The company arranges sale-leaseback transactions for single-tenant retail and restaurant properties, specializing in smaller loans of $400,000 to $2 million.
"Most of the companies we deal with are less than investment grade but are rapidly expanding," says Marabella. "They're the heartbeat of the economy, and they all need cash to grow. A lot of these companies can't go to a bank for funds, so often, the best alternative for them is a sale-leaseback."
Benefits abound Sale-leaseback transactions offer a variety of benefits to all involved parties. The advantages to today's retailer are clear, according to Jonathan Molin, president of New York-based U.S. Realty Advisors, an advisor to institutional clients that buy single-tenant, net-leased properties.
"We think there are compelling reasons for tenants to enter into sale-leasebacks and not own their own real estate," says Molin. "We don't think it makes sense for them to speculate on the future value of real estate. They are much better off taking their money out of facilities and putting it back into their business operations."
Retailers, like other users, have to make some hard decisions when it comes to the relationship with their real estate facilities, notes Paul McDowell, senior vice president and general counsel for New York-based Capital Lease Funding Corp., a direct lender of credit-tenant loans.
"Companies have two choices," says McDowell. "They can either hold real estate and keep it on their balance sheets, or remove it from the balance sheet by selling it and leasing it back."
Stockholders of major retailers assume that the retailers will make returns on equity well in excess of the 6% to 8% return on real estate, he adds. "So, instead of holding $100 million worth of property generating real estate returns, the company can sell the real estate and generate $100 million cash to reinvest in the business - and earn returns that stockholders expect," he says.
Both developers and users benefit from a "reverse build-to-suit," reports Brian Tracy, principal of Manhattan Beach, Calif.-based Net Lease Properties, a firm that specializes in financing stand-alone retail stores. Under this scenario, a retailer builds its own facility, later selling it to an investor for a pre-arranged price.
"The advantage to retailers is that they can design their own facility and build it exactly the way they want," says Tracy. "And at the same time, the retailer's cost of funds for developing the property on its own is typically less than paying a developer to do it."
For investors, the advantage is that they own the real estate and enjoy the cash flow at acheaper cost of capital than developing it themselves. "They also don't have to get involved in a variety of development issues, including site selection and zoning," he adds.
Potential drawbacks There are several drawbacks involved in the sale-leaseback process, though.
Investors who become landlords in sale-leaseback transactions need to be careful, says Molin.
"There are many deal points a landlord has to be aware of in structuring the lease," he notes. "If it is anything less than a pure triple-net or bond lease, there can be all sorts of pitfalls that can diminish the value of the transaction."
>From the owner's perspective, the downside is that you have a fixed income >stream, reports McDowell, or one that may rise gradually, for the term of >the lease. "So, if the real estate market suddenly takes off," he adds, >"and rents go from, say, $14 to $30 per sq. ft. in your area, you could >lose out; what the owner has is a very, very stable source of income, like >a corporate bond."
On the user side, the drawback of the sale-leaseback is that the tenant loses control of the real estate, says McDowell. "You do have the right to use it with relatively unfettered discretion," he says. "But, you don't have the ability to walk away during the term of the lease - unless, of course, you come up with a substitute tenant."
Emerging market trends "A growing number of retailers are seeking ways to release capital tied up in real estate," says Ralston, "and are re-deploying it to their core business at higher rates of return." In addition, many retailers, such as drugstores, are closing in-line strip center stores and opening freestanding locations in the same trade area.
These two trends bode well for the future of the sale-leaseback, according to Ralston. "We believe that other retailers will follow suit," he says, "which will create increased demand for turnkey, build-to-suit services, as well as sale-leaseback financing for retailers that develop in-house."
Captec's Max agrees. "More and more retailers are realizing the benefits of the freestanding format, which is fueling the growth of retail sale-leaseback transactions and single-tenant retail development," he says. "Virtually every major drug chain is not only relying on freestanding stores for new growth, but also moving their in-line stores to freestanding."
Traditional mall retailers such as Sterling Jewelers have been able to create entirely new businesses. "Another trend we see," he adds, "is the extension of sale-leaseback financing to areas of retail that have not been traditionally served, such as automobile dealerships."
Still, a couple of factors may work to slow the pace of sale-leaseback transactions, forewarns Malino. "Many chains are taking advantage of the Internet by establishing their own commerce sites," he says. "It may be that the use of the Internet as a place of business could slow down retailers' plans for real estate expansion - and also the need for financing to fund these expansions."
The consolidation taking place in many retail concepts could also lead to slower growth and demand for net lease. "Many retail chains are adding units by acquiring other companies," he adds, "rather than building and investing in new locations."
Some less-than-investment-grade users may have problems in the net-lease financing marketplace, according to John Palmer, director of Boston American Financial Group, a lender that specializes in financing for corporate sale-leaseback and other credit-tenant lease transactions. "The inclusion of credit tenant lease (CTL) loans in CMBS conduits enabled Wall Street to expand the credit spectrum of potential net-lease tenants to non-investment grade," he says.
But, he continues, "With the market dislocations of the fall of 1998, we expect that tenants financed on a CTL basis will be limited, for the most part, to those rated B+ or better."
Palmer also anticipates that institutional investors - buyers of CMBS - will be paying closer attention to the "as vacant" value and appraisal methodology used for credit-tenant leaseloans. With regard to lenders, Palmer says, "We expect that due diligence as to the strength of the underlying collateral of these loans - the real estate - will take on a more central role in the underwriting process. Rating agency guidelines for credit-tenant lease loans will emphasize the 'as dark' value of the underlying real estate."
The storm that hit the financial markets late in 1998 has changed the profile of the chief source of funds for single-tenant net lease transactions, according to Marcus & Millichap senior vice president John Kerin, director of the Palo Alto, Calif.-based firm's National Single-Tenant Net Lease Group. "Prior to fall of last year, we did nine out of 10 of these deals with conduit lenders," he says, "and now, nine out of 10 are with life companies."
"The credit crunch of late 1998 definitely had its effect on the net lease business in general, but it's coming back," says R. Jeffrey Gwin, COO of New York-based Merchant Equity Group, which provides vertically integrated financial and construction services.
"This business, like the stock market now, is, to an extent, demographically driven by the baby boomers," he notes. This group, many of whom are retiring in the next few years, are exiting from real estate investments such as apartments, and doing 1031 exchanges into single-tenant retail facilities as a means to achieve income and avoid capital gains taxes.
"There are a tremendous amount of these buyers," Marabella agrees, "and it's getting harder to find sellers."
The role of Wall Street in commercial real estate lending has resulted in a more efficient flow of capital in the market and a standardization of loan documentation packages, says Jeffery R. Wakeman, principal of Charlotte, N.C.-based Centurion Development Corp., a developer of single-tenant, net-leased retail properties.
"Going forward, I believe that financing will become more of a commodity, differentiated by service rather than pricing," says Wakeman.
Developers are also becoming more of a commodity in the eyes of tenants, and must differentiate themselves on the basis of service. "Developers must decide whether they are in business to provide investments for their own portfolios," he notes, "or if they are in business to be service providers."
"The biggest trend we're seeing is that many more retailers are warming up to the sale-leaseback concept," says Charlie Corson, senior vice president/director of Retail Investments, The Staubach Co., Dallas. A division of the company, Wolverine Equities, purchases sale-leaseback portfolios, and has done deals with retailers such as Circuit City, Rite Aid, CVS and Saks Inc.
Noting that there are major retailers with billions of dollars worth of owned real estate, Corson says, "I wonder if the average owner of their stock really feels they are benefiting from that owned property." These funds could be better deployed, he adds, "into more technological advancements, such as e-commerce."
Internet impact The retail sale-leaseback market is hot for now, but that may change with the advent of Internet retailing. "We are currently riding the crest of a seller's market," says Domb, "and there is not a day that goes by where I don't get a call regarding investors wanting to purchase net-leased real estate, retail and otherwise."
At the same time, the ability of consumers to sit in their living rooms and shop for essentially anything via the Internet could have an adverse effect on retail real estate, creating more vacant space and driving down rents. "It is becoming a 'dot.com' world out there," he continues, "and like most trends, it has both its up and down sides."
"One has to wonder who the long-term winners and losers will be with respect to the future of retailing and the Internet," Molin concurs. "You may think people will always want to get in their cars and shop at a store where they can see and touch the merchandise, but I think there will definitely be an increase of sales over the Internet."
The Internet has already affected the world of sale-leasebacks and net lease financing in at least one way. Those interested in doing deals can point their bro wsers to www.net-properties.com, where partners Henry Hanna and Blair Rinnier have set up a site to bring dealmakers together.
"We have more than 250 brokers and investors registered with us," says Hanna, who notes that the site also has links to retailers. Open since the end of 1998, the site has brought buyers and sellers together for six transactions so far, averaging more than $2 million per deal.
While the Internet trend has a potentially negative impact in store for retail real estate, Hanna says the death knell hasn't sounded just yet. "People also predicted the demise of movie theaters when television first came into existence."
