When people think of a sale and leaseback transaction, they think about a company that owns some real estate or equipment and then agrees to sell it to a buyer and continues to use the asset sold by leasing it back.
And because of the simplicity of this arrangement, this is an extremely popular form of asset mergers and acquisitions for investment banking professionals. Companies can broker a transaction to sell their real estate to a buyer and structure the transaction so that they pay rent at a predetermined amount to the buyer for the next 20 years.
Real Estate and Infrastructure Private Equity and Sale-Leaseback Transactions
A big theme in today’s asset management world is stable cash flow that can be locked in – fixed income or bond like returns for long periods of time. Infrastructure funds (whether independent or the infrastructure arms of larger private equity firms), pension funds and family offices are eager to use these as alternatives to their fixed income mandates by trading lower returns on bonds for illiquidity – something that the average person cannot do.
As such, there is a lot of buzz around snapping up infrastructure and real estate. Funds that specialize in these are having no problems raising capital to deploy. The result of this is that assets are bid up – something expected to trade at 10x EBITDA or cash flow when marketed may end up going for 12x.
This means that there is a healthy sellers market for sale leaseback transactions. Investment bankers will tell sellers that this is a good way to “crystallise value” and redeploy the proceeds for capital spending and expansions, return of capital initiatives to shareholders (such as dividends or share repurchases) or for debt repayment.
Additionally, onerous capital charges have led to financial institutions such as banks or insurers to offload real estate as they do not get rewarded for them in their capital ratios. Retailers have long been spinning out their real estate into REITs with high dividends/distributions to shareholders.
Multiples Arbitrage for Sale-Leaseback Transactions
When investment bankers talk about “crystallising value” or the “arb opportunity” from sale-leaseback transactions, an easy way to conceptualize this is via the “conglomerate discount”. Generally speaking, investors are lazy and do not like to do sum or the parts analysis – they will generally take the riskiest part of the business and discount cash flows there. A conglomerate accordingly will suffer a valuation discount versus the net asset value. The more convoluted the company the more of a discount.
For an industrial firm with a co-generation power plant, the market does not ascribe any sort of value to the plant. In fact, the cost savings from having a plant versus purchasing power from a counterparty is muddied for investors because there is no revenue associated with it.
By entering into a sale-leaseback transaction where a power company purchases the power plant and agrees to sell power to the factory for 25 years in a take-or-pay agreement, a defined EBITDA is associated with this. The industrial firm could be trading at 5x EBITDA and sells a previously invisible power plant for a 10x EBITDA multiple.
Controlling Interest in REIT/Drop-down Entity
Even better is when the selling entity actually controls the new financing vehicle – a lot of real estate investment trusts (REITs) were formed when companies that owned a lot of real estate wanted to realize value for the spin-out but retain control, ensuring that there would be favorable terms for the underlying business while REIT unitholders pay a premium for a steady stream of income (retirees, pensioners, income hungry investors).
This makes a lot of sense for high cost of capital businesses such as oil and gas – where they can end up getting value from low cost of capital businesses such as energy infrastructure. This is supported by the number of midstream dropdowns at large oil and gas producers in the United States.
Lower Cost of Capital Financing via Sale-Leaseback Transactions and Credit Implications
Presumably, there is a use of proceeds associated with this crystalisation of value via a sale-leaseback. This capital can be deployed in mergers & acquisitions, debt repayment and expansion capital expenditures.
If looked at from another lens, this is remarkably similar to issuing debt and having to pay interest on a regular basis.
Despite the M&A associated with it, investment bankers also look at sale-leasebacks as a financing decision, similar to the issuance of debt or equity.
In fact, credit rating agencies generally agree and will simply capitalize the future lease obligations and treat it as debt. A sale-leaseback could essentially mean that you are issuing debt, albeit on different terms.
So net-net, the availability of credit in the markets (what yield could you sell a bond or go into private debt markets for – if there is even demand) versus the frothy multiples offered by infrastructure funds has to be considered. As such, sale-leasebacks to stay within defined credit thresholds for Moody’s or S&P will require some pro-forma math.
On one hand, debt may actually be cheaper – however, it comes with a much faster maturity and may have onerous covenants. Conversely, a lease may have to be more expensive, but has a much longer payback period (usually) with renewal options by design. The buyer will also have to be compensated for the illiquidity and inconvenience of the asset (versus a bond that you can sell via a broker investment bank). Lease payments are similarly tax deductible like interest payments.
M&A Considerations of a Sale Leaseback Transaction
For the investment banker, helping the seller structure the transaction is very important in terms of valuation. Depending on what terms the seller wants, this can lead to protracted negotiations.
While a seller is generally focused on the price or the “headline number” to see what proceeds they can get, the financial buyer is generally thinking in terms of an IRR. If there is an acceptable return for their mandate, they will be interested. For infrastructure and real estate funds, hurdle rates for investment are lower than general private equity because of the lower risk associated with these assets and the increased certainty of payment. They can look at returns from as low as 8% but usually 10-15% on an unlevered, before-tax basis.
Generally people do well to think about these assets on a before-tax basis because it is impossible to consider all the financing mechanisms available to financial buyers – however when there is an obvious, small number of potential buyers, potential levered, after-tax analysis should be considered as well.
All of these following levers can be pulled to get to the right purchase price/enterprise value, toll or contract life that the seller desires:
Contract Life for Sale-Leaseback
Generally speaking, the buyer will want long-term contracted cash flows – so a term of 20 years will entice a buyer to accept a higher price or lower IRR moreso than 10 years
Renewal Options After Initial Term
After the contracted period, there will be negotiation on renewal options – should the seller be forced to pay market pricing and can they force renewal? Additionally, does the buyer have recontracting risk if the lease term expires and the seller finds cheaper rent elsewhere?
Rent or Lease Payments
As you may surmise, revenue generally is a function of volume x price.
So for real estate, this may be a rent per square foot multiplied by square feet (or floors or any other defined quantum).
This is where it gets a little tricky – although buyers obviously care about higher rent in terms of the cash flow they will receive, they will run pro-forma math on the seller to make sure that the lease payments would not become a burden for meeting their fixed charges or obligations. There is no point having a very high rent if your tenant cannot pay it.
Lease or Rent Inflation
This is to protect the real returns of the buyer, but obviously results in a higher cost for the seller. This can be negotiated to be an arbitrary number like 1% or match with CPI. Generally, real estate contracts will have defined step ups for rent.
Third Party Revenues
If there is a frothy market and the building is not fully utilized by the seller, are there opportunities to fill the building with other tenants?
A building in the central business district (CBD) will always trade higher than a quiet suburb. However, the seller, if it expects its business to grow, may want to have priority over other tenants if it needs and preferably at the same rent metrics.
This would increase the buyer’s IRR requirement as they are less well positioned to benefit from upside.
Expansion Options for Sale Leaseback
If the sale parcel includes undeveloped land and the seller anticipates the business growing, they may require the buyer to spend money to build additional real estate – albeit for a return of capital that is acceptable to the buyer.
Counterparty Credit Risk
The seller is contracted to pay the buyer no matter what for 20 years – but can they pay it? If they go bankrupt and abandon the lease, the buyer is on the hook for a vacant building. If the seller has poor credit, a risk premium will need to go into the IRR consideration. This could also preclude certain buyers with lower risk tolerances from making a bid
Cost Flowthroughs and Triple Net Leases
Depending on who operates and takes on the associated maintenance capital, the ultimate stream of cash flows to the buyer will change. Cost flowthroughs to the seller means that the buyer will accept a lower IRR. If the buyer assumes this risk, they will demand a higher IRR. This concept is especially popular in real estate with “net leases” and “gross leases” and “triple net leases”.