The boom in so-called hybrid real estate investments – such as sale-leasebacks and build-to-suit transactions – is being driven by the resurgence of US manufacturing, and the looming debt maturity wall, according to private equity real estate firm LCN Capital Partners.
The ability of operating companies to build critical facilities without having to incur expensive credit in the midst of a liquidity crunch has made these hybrid deals an attractive proposition, and for investors they provide considerable downside protection, according to LCN’s white paper, Financing the Resurgence of American Manufacturing and Addressing the Debt Maturity Wall, published in October.
In a build-to-suit transaction, a developer/landlord agrees to provide a property to the specific needs of a prospective tenant. This might entail the construction of laboratory facilities for a biotech firm, or refrigerated warehouse space for a perishable goods retailer. The rent payments for a fixed, non-cancellable term will be calculated with the landlord’s return-on-investment in mind.
This can be a boon to the operating company that moves into the newly constructed premises, not only because it is built to specification, but because the rent does not require a cash outlay or traditional borrowing.
The white paper notes that construction for US manufacturing facilities has doubled between 2021 and 2022. The causes are not mysterious: geopolitical fractures have combined with recent pandemic-related supply chain pressures to induce many corporations with US-based consumers to bring their manufacturing onshore. What’s more, President Jo Biden has added to the incentives with funding and tax advantages.
As the white paper observes, building a US manufacturing facility is capital intensive. It involves the cost of the land, building, equipment and adjacent facilities. Some of the companies involved go the build-to-suit route, either out of necessity or in response to a market preference for “asset light” balance sheets – their investors may not want them to own title.
This manufacturing trend and the capital it requires, LCN points out, coincides with the economy’s arrival at a debt-maturity wall. Over the next two years, $1.8 trillion in corporate debt is coming due. This includes more than $500 billion in high-yield bonds and leveraged loans. Corporations seeking to refinance this debt are finding that credit is less available and more expensive than when they borrowed it.
A desire to avoid driving into the ‘wall’ leads companies that already have the necessary land and buildings in place to sell and lease back their existing facilities rather than to refinance.
Both sale-leaseback and build-to-suit deals can unlock capital for companies to repay maturing debt or to contain their leverage. In addition, the tax treatment for the payments is favourable. They are – from a tax perspective – lease payments, and therefore fully deductible, unlike interest payments.
LCN also observes that these hybrid transactions offer considerable downside protection. “In a typical primary market transaction in today’s market, an investor would need to see a 900 basis point increase in a property’s cap rate in order to experience a loss on that investment.”