Capital markets favor lease securitization over debt financing on core owned real estate assets

This article originally appeared on RE Journals.

Companies that own commercial real estate critical to core business operations have a compelling financing and liquidity vehicle which has been underutilized: the sale-leaseback.

Most large corporations rely on mix of short-term and long-term senior debt, revolving credit lines and free cash flow to fund operations. Much of the debt in the corporate financial ladder is subject to a balloon payment or refinancing at a specific date down the road.

Sale-leaseback transactions, long used by private equity sponsors, is now growing in popularity among publicly traded corporations, as evidenced by the 30.5 percent year-over-year increase in single-tenant office and industrial transactions in the previous twelve months. Much of this growth can be attributed to corporations seeking the advantages created by recent fundamental changes to interest rates and spreads in the capital markets and the resulting increase in real estate values.

In April 2019, ten-year U.S. Treasury interest rates fell below 30-day and 90-day LIBOR. Prior to this, there had not been an inverse relationship between long-term U.S. Treasuries and short-term LIBOR rates in more than 12 years.

Since April, Treasury yields have continued on a downward trajectory while spreads also narrowed. At the same time, short-term LIBOR yields increased and their spreads widened, negatively impacting many U.S. corporations, as its estimated that U.S. corporations have over $200 trillion dollars in LIBOR-based exposure. This structural yield shift between short- and long-term debt instruments has led many corporate treasurers to re-evaluate the collateral used in refinancing outstanding debt.

Treasury-based debt is a significant benchmark for commercial mortgages in the U.S. and has an indirect correlation to property values. In general, as Treasury yields go down, the cost of mortgages become cheaper, cap rates slide down and under the market practice of cap-rate-derived valuation models, property values rise. Corporate-owned real estate benefits from the rising tide of the resulting market value increase.

The combined effect of lower long-term interest rates and the rising property values they bring presents real opportunity for corporations to replace LIBOR-based corporate debt with long-term paper secured by a leaseback of owned core real estate. Given the lower overall cost embedded in this shift from shorter to longer term tenors, the overall cash flow of the company improves while eliminating refinancing and interest rate risk.

Financing real estate with LIBOR-based debt typically yields 50 to 70 percent of asset value on a five- to seven-year loan term. Even shorter tenors (three to five years if core real estate assets are collateral for a revolver that also claims receivables and inventory as collateral).

Through sale-leaseback, corporations can leverage their financial strength to receive 110 to 115 percent of typical MAI appraised value and maintain corporate control, leasing the property back for 15 to 20 years. With extension rights under the lease, the company can control the real estate for 40 to 50 years. Further, sale-leaseback prices act as interest-only debt without any principal amortization or balloon. The proceeds from closing are not repaid or refinanced.

Another and often underestimated benefit of a sale-leaseback is that tax reform and new accounting lease rules provide further incentives to consider when analyzing if you should monetize core real estate assets.

Under the new tax law, corporations are subject to the “30 percent limit” on interest expense deductions which, especially in the case of highly leveraged businesses, increases the interest cost on this nondeductible debt. Conversely, rent expense on an operating lease has no such income tax deductibility restriction.

Rating agencies favor sale-leaseback over debt financing when evaluating the credit profile of a company. This boils down to lease financing being less asset-intensive and generally preserves debt capacity of the company. The new FASB accounting rules have not materially affected the favorable treatment from ratings agencies.

In recent months, sub-investment grade companies have received 13 to 14 times EBITDA for the sale and leaseback of core real estate assets. Meanwhile, because it is a credit-driven transaction, investment grade companies have realized greater values in the range of 16 to 18 times EBITDA.

While capital markets favor long-term U.S. Treasury fixed rate debt, growing numbers of corporations sold core real estate assets and leased them back over the last 12 months.

During the previous 12 months (through third quarter 2019), there was a 30.5 percent year-over-year increase in single-tenant office and industrial transactions collectively reporting a staggering $227.0 billion in closed transactions.