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A triple-net threat

As private equity firms increasingly invest in businesses with valuable real estate assets, the sale-leaseback is becoming an increasingly handy—and popular—financing tool. By Aaron Lovell

The old adage tells us a rising tide lifts all boats. The same seems to be true of real estate investing. While large pools of capital are chasing deals via private equity real estate funds, the sale-leaseback market is also flush with capital. That means it's tough times for sale-leaseback providers and just the opposite for those looking to monetize their real estate holdings.

Market participants say that sale-leaseback transactions have become increasingly popular in recent years as general interest in the real estate sector grows and alternative investors such as private equity firms and hedge funds place capital in property-heavy operating businesses like retailers, restaurant chains and industrial concerns. Last year saw a number of high-profile private-equity retail deals—Toys ‘R’ Us, ShopKo and Neiman Marcus, to name but a few—in which the value of the companies' real estate was a major factor in the transaction.

In a traditional sale-leaseback transaction, a company—or the private equity firm that owns it— will sell off its real estate assets to an investment group, oftentimes organized as a REIT; at the same time, the investment group signs a long-term lease with the operating company, renting the property back to them. There are plenty of obvious advantages to the lessee: property is moved off the balance sheet, cash is freed up, debt is reduced and—perhaps most importantly—the owner gets out of the real estate game and can focus on its core business.

Sale-leaseback transactions usually employ what is known as a “net lease”—a lease document stipulating that the tenant bears the operating responsibility for the property, which normally includes the taxes, maintenance and insurance, otherwise known as a triple-net lease. So while the property is off the balance sheet, the operating company remains responsible for many of the day-to-day operations of the building, from paying the heat bill to fixing the roof.

Because lease terms vary from transaction to transaction and sellers and buyers have different objectives—maximizing the future revenue stream for the buyer, generating the highest possible sale price for the buyer—sale-leasebacks can often bring up a number of prickly legal issues as the two parties try to share the risk. Some of these points include the baseline value of the property, the timing and size of future rental increases, and change of control provisions. For example, while a private equity owner would want maximum flexibility to sell the underlying business to whomever they see fit, the sale-leaseback provider may be reticent to have their real estate occupied by a company with a less stable financial profile.

“For us, real estate trumps credit. We underwrite each property based on the fundamentals of the location”

Despite the increased use of sale-leasebacks, not all types of net-lease transactions were popular last year. A real estate survey released in January by accounting firm PricewaterhouseCoopers points out that the number of saleleaseback transactions continued to rise due to high property prices and the continued availability of equity. At the same time, however, the overall market for net-lease transactions, which also includes triple net leased properties and 1031 exchange deals, may be slowing down. In the third quarter of 2005, there were 6,898 net lease offerings valued at around $23.1 billion. That represents a decline of 27 percent from the previous quarter, which saw 9,324 transactions completed at a total value of $27.9 billion.

THE RATIONALE
There are a number of reasons why a private equity firm acquiring a chain of convenience stores, fast food restaurants or discount retailers might consider asset-backed financing. Because many private equity deals are highly leveraged, a saleleaseback allows the firm to reduce its senior debt levels and interest payments. The downside, of course, is that the added rent expense is a drag on EBITDA. But given the frothiness of the current sale-leaseback market, private equity firms have been able to not only negotiate reasonable terms, but also generate a hefty valuation on their property.

As Benjamin Harris, executive director and director of investments at New York-based real estate investment firm WP Carey, points out, “[The private equity firms] can get proceeds that are at historic highs,” he says.

Sale-leasebacks also allow private equity firms to refocus on the operational side of their business, generating value through EBITDA improvement rather than property management. “Pricing for high-quality real estate assets is as aggressive as it's ever been,” says Craig Macnab, chief executive officer at Orlando-based investor Commercial Net Lease Realty (CNR). “Operators are realizing that the best use of their capital is to grow their business, not own real estate. It's not their core competency.”

Macnab, whose firm focuses on the US retail sector, says leaseback groups can help the firms with entitlement, permit and construction issues. He adds that his firm, having access to US real estate markets, can be a valuable partner when private equity clients expand and open new locations.

Despite the benefits available to private equity firms, providers of sale-leaseback transactions point out that these deal are rife with risk—and require the same level of due diligence as other types of property investments. Factors that are important, financiers say, include the resale value of the property, the comparable market rents and the lessee's credit status.

Richard Reuben, a partner and head of the property finance division at London-based law firm Macfarlanes, points out that both parties to the transaction must consider the financial health and future performance of the lessee, as it is one of the primary factors underpinning the basic deal. “If you are a company, you are sort of offering a bond against performance,” he notes. “As an investor, you must understand that is what you're getting.”

Sale-leaseback providers, however, also take a very hard look at the underlying property. “Our biggest concern is the role the real estate plays in that tenant's operation,” notes WP Carey's Harris, adding that his firm is looking for “critical” property, regardless of sector. At the same time, however, he adds that the real estate must have value on its own in the open property market.

“Your contract rent is your cash flow,” Harris says.“We have to be considerate of how that [contract rent] compares to market rent, if that [contract rent] goes away.”

Macnab agrees, pointing out that while financial health of the company is always a factor when considering a sale-leaseback, the fundamentals and merits of the individual stores or location are as important as the larger macro-economic factors.

“It's become more [of the] deal du jour”

“For us, real estate trumps credit,” Macnab says. “We underwrite each property based on the fundamentals of the location and the store business.”

He notes that, in addition to judging each location, his firm must also evaluate the company's ability to pay the rent.“We need to protect our downside, as well,” he says. “We ultimately need to be comfortable…that we can re-lease it.”

For example, CNR was able to get comfortable with the location and underlying fundamentals of the 74 Circle K-branded convenience stores it purchased late last year for $170 million. The seller was SSP Partners, a Corpus Christi-based convenience store group that is a subsidiary of the Susser family, which owns more than 300 convenience stores.

Outside of retail, another sector that has generated interest is the casual dining arena. Ethan Nessen, a principal at Boston-based CRIC Capital, a co-venture between Corporate Realty Investment Company and Prudential Real Estate Investors, points out that his company has completed sale-leasebacks transactions with restaurant chains like Applebee's, Acapulco, El Torito and Casa Gallardo

It is a sector that, while perhaps not as headline-grabbing as its retail cousins, has found a place with investors. “There's been a fundamental trend that people eat out more than they used to,” Nessen says. “Casual dining sector has become a lifestyle choice for some people. They're very property intensive.”

Nessen notes that, like retail, the first consideration is the value of the actual real estate. “What you layer onto that is a more detailed understanding of the lessee,” he says, adding that individual site operations are also very important. “You want to know how important that location is to an operator. Is the location good for the business it is in?”

Despite the amount of due diligence a firm may perform, there is always the chance that a company may go out of business, leaving the lessor with a vacant property. Nessen sums it up: “If you go in and buy a property and rents are over market and the company goes [out of business], you've got a problem.”

But he notes that firms can guard against this setback by making sure the real estate could be of value to another operator in the same business line or, failing that, the property could be converted for an alternate use. In an ideal situation, Nessen adds, the property could either be reused or converted.

While a rental stream failure is how a sale-leaseback transaction could go south, Macfarlanes' Reuben says the risk is still on par with that of any commercial real estate investment.

“If it is good real estate, you'll be able to sell it and you'll be OK,” he says.

SELLING THE FAMILY SILVER
There are a number of important issues potential sellers must consider before entering into a saleleaseback deal, including their cost of capital, their future operating performance and their relationship with the building. “You have to impress upon [the seller] that they are changing their status in terms of the property,” says Macfarlanes' Reuben. “They have to accept that they have a different relationship to the property and a different relationship to the landlord.”

But the primary factor they must consider is the fact that they only get one shot to do so. That's one reason the Macfarlanes report calls a company's real estate the “family silver.” While the firm gets the real estate off its balance sheet—a good thing in a certain economic environment—it also no longer has those assets as a cushion in the case of a downturn.

Market participants also stress that, like private equity and real estate, there is a tremendous amount of capital chasing these sorts of deals. “From an investor standpoint, we feel that people are a little too optimistic,” says WP Carey's Harris. “Other markets tend to have high barriers to entry, but because sale-leaseback financing is a little less developed, you're seeing people enter the space from different backgrounds.”With these different backgrounds, he adds, there are varying levels of sophistication.

Harris does not point to any one property sector as being overfunded; rather, he says, his firm is picking its fights in terms of US acquisitions — a n d making up for a dearth in US deal flow with investments overseas.

“Private equity firms can get proceeds that are at historic highs”

WP Carey reportedly plans to invest €1 billion in Europe this year, building on some of the investments it made in the region in 2005. Late last year, for example, the firm purchased 16 stores from German do-it-yourself retailer Hellweg for €126 million. Another deal included the acquisition of a building used by the French government and Paris police department for €88 million.

CRIC's Nessen says there are still plenty of deals out there, adding that the space has always been competitive. “It's become more [of the] deal de jour,” he says.

Given the current state of the real estate markets, it could well be the deal of 2006 as well.