Opportunity in a nascent market

With a potential size of €1.1trn, investors have good reason to examine sale and leaseback deals for strong risk-adjusted returns. By Max Mitchell and Chris Nichols of ICG.

This article was sponsored by ICG.

Q. What is a sale and leaseback transaction? 

Max Mitchell: In the simplest terms, if a company undertakes a sale and leaseback (SLB) transaction, it sells some or all of its real estate assets to a third party and remains in the premises as a tenant, most often via a long-term lease. Leases are triple-net in nature, meaning that the lessee is responsible for repair, maintenance, insurance and property taxes. 

Q. Why would a business be motivated to undertake an SLB transaction on its real estate assets? 

Chris Nichols: SLB is an alternative form of financing available to corporates. In our experience, a corporate is typically using the capital raised to positive effect within the business by reinvesting proceeds into growing it.   

When comparing potential sources of financing, there are a number of good reasons for management teams and shareholders to consider an SLB transaction. Perhaps the most obvious is the fact the full value of the assets can be realised, whereas capital raised by taking out a commercial mortgage would only unlock a portion of that value (typically 50-60 percent of its value versus 100 percent with SLB).  

The other major consideration that we hear a lot from shareholders and management teams is that they see SLB as a “long-term” financing solution as there is no refinancing horizon and therefore no refinance risk associated with traditional bank financing. 

Additionally, recent regulatory changes have created further benefit for certain corporates when thinking about financing solutions. The European Union’s BEPS action plan includes an Anti-Tax Avoidance Directive which came into force at the start of 2019 and essentially reduces the level of financial interest expense that can be deducted for the purposes of calculating corporate tax from 100 percent of EBITDA to 30 percent of EBITDA. Lease payments, by contrast, are operating expenses and are fully deductible. 

Q. What market opportunity do you see for SLB in Europe? 

CN: The SLB market in Europe is set to grow significantly, as traditional corporate lenders continue to operate in an increasingly challenging regulatory environment and businesses look to alternative funding sources such as SLB in order to drive growth.  

A fundamental part of the market opportunity relates to owner occupation of corporate premises. In Europe it is high at over 69 percent whereas in the US, where there is a long-established SLB market, that figure stands at 50 percent. There is no good reason for this structural disconnect and in parts of Europe (eg, Scandinavia), we have recently seen a significant reduction in owner occupation, a trend which we believe will continue throughout the rest of Europe. 

MM: There is a huge market opportunity for SLB in Europe. In numerical terms (excluding the UK) we estimate the value of the owner-occupied corporate real estate market to be €5.5 trillion. When considering average annual SLB volume in Europe is approximately €7.5 billion, it would take the equivalent of 147 years just to normalise the European market to current US levels. 

Q. Why is the European SLB market relatively under-penetrated in comparison with the US market? 

CN: There is not a definitive answer to this question. What’s clear is that we can’t find any structural reason for the difference. Largely we think it relates to a cultural difference in as much as European companies are used to owning their assets and because of this, tend to have more of an attachment to them. Whereas in the US, people are much more comfortable with the idea of taking a commercial view and monetising their business premises in order to optimise the efficiency of their balance sheet.  

MM: Of course, Europe is also fragmented on a regional basis, requiring a much greater breadth of expertise in order to successfully navigate the individual markets and legal jurisdictions. To be successful in SLB in Europe, investors really require the necessary local presence for origination as well as local expertise in order to maximise their returns. This fundamental requirement has proved (and we believe it will remain) a significant barrier to entry for SLB investors. 

Q. Do you anticipate the SLB space becoming more competitive in Europe? What would the implications of this be for ICG? 

MM: In our view, yes, it is unlikely that the market will remain as under-penetrated as it is now. As mentioned above, however, barriers to entry are higher in Europe than in the US, so we do not foresee a transformation overnight. While increased competition is never at the top of my wish list, we believe that having more professional asset managers active in the space would benefit everyone; the opportunity is so massive that having more people actively developing the market should help to endorse the benefits of SLB transactions to businesses that might not otherwise have considered it, thereby expanding the universe of potential deals. We are confident that as a first mover in the space in Europe, we will benefit the most from the market growth. 

Q. What attributes are you particularly looking for when sourcing an SLB deal? 

MM: A number of things, but one crucial factor is the importance of the property to the ongoing operations of the business. We want access to and occupation of the property to be essential to the lessee company for the ongoing success of their business. This results in a true partnership and alignment of interest between lessor and lessee. 

In terms of other considerations, ideally the business would be engaged in activity that has limited cyclicality and operates in a market with high barriers to entry. We are inclined to focus on sectors such as storage and logistics, healthcare, education and manufacturing. We look for a low concentration of customers and suppliers and pay close attention to a company’s financial track record and corporate strategy. It is also important to consider downside scenarios and evaluate what alternate use a property might have should it be vacated by the incumbent lessee. 

Q. What are the attractions of such an investment strategy from a returns perspective?  

CN: SLB is a high-cash-yielding investment. Typically, over 70 percent of returns are generated from highly predictable cash dividends arising from a diversified portfolio of long-term leases. Unlike traditional real estate investment, the long-term leases minimise leasing risk and rental voids.  

SLB also produces inflation-protected returns because the underlying rents benefit from annual contractual uplifts either through CPI or pre-set increases. The rental uplifts can enhance value leading to a capital appreciation of the underlying asset and increased returns. 

Q. What are the exit options for an SLB fund? 

MM: If a manager is careful to negotiate long-term, triple-net rental agreements, or ensure that there are terms that oblige the extension of those agreements, then there should still be a long-term lease in place at exit.  

A well run SLB fund will benefit from a diversified portfolio of long-term inflation protected income secured against corporates’ mission-critical real estate, which should also have the potential to benefit from a credit enhancement during the initial holding period.  

With the bulk of returns taking the form of a cash coupon, such a portfolio would present an attractive opportunity for an institutional investor looking for a package of long-dated cashflows.