March 2002By Anwar Elgonemy
Jones Lang LaSalle Hotels - Miami
In the current economic downturn, businesses need to raise cash and to cut debt. As equity investors and bank lenders grow more scarce, companies, primarily those with low credit ratings, can no longer afford the risk premiums demanded by those sources of capital. Companies that have limited access to debt and equity markets are typically the firms opting for real estate-based financing and off-balance sheet financing.
Given the financial contagion emanating from September 11, offloading non-core assets, such as real estate, can be a good option. So, a company sells its large luxury hotel in San Francisco or a Class A office complex in Chicago, to an investor and signs a long-term lease – 10 years at the minimum – to rent the property.
Apart from the immediate injection of cash, the company moves the slowly appreciating property asset off its balance sheet, eliminating a “burden” on earnings. Properties usually return an average of 10% a year, while a listed company may want 25% gains. In the meantime, the buyer acquires a stable asset and a guaranteed tenant.
Sale-leaseback deals have been part of the U.S. property markets since the early 1970s. It is estimated that only 33% of U.S. corporate real estate is owner-occupied, compared with approximately 40% in Latin America and 60% in Europe.
In recent years, retailers have been the most frequent users of sale-leasebacks because their businesses are dependent on expanding into new outlets, but direct ownership implies tying-up much-needed cash. Companies with industrial, office and hotel properties have used sale-leasebacks during mergers and acquisitions, but they were not as worried about moving properties off their balance sheets, particularly in the halcyon years of 1997-1999, when stock prices were spiking and capital was sloshing around. But since March 2001, the pool of money available to the average company has declined by some 75%, and the need for creative real estate financing techniques to boost earnings is now in demand.
Overview of Real Estate Sale-Leasebacks
Owners of real estate generally finance the property in order to reduce their cash investment. The two principal disadvantages to owning real estate that is subject to debt are: a) The debt shows up as a liability on the owner's balance sheet, and b) Financing is generally limited to a specified percentage of the fair market value. The sale leaseback transaction offers owners another financing alternative.
A sale-leaseback is basically a technique in which a seller deeds a property to a buyer for a consideration, and the buyer simultaneously leases the property back to the buyer. The seller then becomes the lessee, and the buyer the lessor.
Typically, individual sale-leaseback investments range in size from $5 million to $50 million, with portfolios of sale-leaseback properties ranging from $50 million to more than $300 million.
Real estate sale-leaseback investments have bond-like characteristics. They typically provide a stable, predictable cash flow, act as a moderate inflation hedge and have lower volatility than multi-tenanted property investments, due to the long-term contractual nature of their income stream. In addition, long-term leases generally minimize the frequency of re-leasing risk, the cost of commissions and tenant improvements, and, frequently, downside exposure in a weak real estate market.
Because of the lengthy term of most of the leases tied to these investments and their consistency of income stream, real estate sale-leaseback investments typically do not offer significant upside (appreciation) potential. However, during downturns in the property market such as the current one, sale-leaseback investments commonly outperform core real estate due to their income orientation and credit quality of the tenants. During periods of real estate market recovery, these investments are likely to trail the benchmark indices because there may be limited opportunity to quickly re-lease a sale-leaseback property for higher rents.
The typical criteria for sale-leaseback investments are summarized in
the following table.
The Inherent Risks of a Sale-Leaseback
Before entering into a real estate sale-leaseback, the parties involved
need to first assess the inherent risks.
Why Do a Sale-Leaseback? – A Corporate Finance Perspective
There has been the view that companies with investment-grade credit ratings have unlimited access to capital, and can borrow at small spreads over Treasury rates. So why would they consider transactions that expose them to higher costs of funds?
To assess this fundamental question, assume that a multinational company headquartered in New York has identified a need for a new office in Los Angeles and plans to occupy the building for 20 years. Management has two alternatives: a) Owning the facility after it is built, or b) selling the asset to an investor and then leasing the property. To compare the risk and cost implications of the two alternatives, the CFO of the company would need to discount the relative “costs of occupancy” for the 20-year term.
The CFO would most likely discount the annual interest expense and depreciation tax shield to determine the present value cost of occupancy for the owned building using the after-tax debt rate for its discount rate. Then the CFO would identify the property’s residual value in year 20 (at the end of the term), interpreting the value as a percentage of the asset’s original cost (could range from 50% to 150%). The next step would be to discount that figure as well back to the present at the company’s after-tax debt rate. This is where misunderstandings occur, because by applying after-tax debt rates to assess a property’s value, the company assumes that the asset’s value is a function of the entity’s credit. Discounting the residual value with the after-tax debt rate, which tends to be lower than the weighted average cost of capital (WACC), can dramatically overstate the value of the property
However, take the example where a developer builds two office towers in Miami that are identical - one building is owned by Fortune 500 Company X, and the other by Fortune 500 Company Y. If both companies leave their buildings in comparable condition at the end of the 20-year term, the value of the two properties would not vary by the difference in the tenant’s credit ratings. Rather, the residual value, and, therefore, the risk associated with occupying both facilities, will reflect current real estate markets at the end of the 20-year term.
As such, what companies should do is discount residual values at a rate that reflects real estate risk, namely WACC, identifying values that fall substantially below corporate assumptions. As a result, a sale-leaseback strategy is often revealed to be a particularly attractive alternative, even for companies with very good credit.
Sale-leasebacks, which are typically structured as operating leases, receive different accounting treatment. To qualify as an operating lease, the present value of lease payments must be less than 90% of the property’s fair market value, the lease term must be less than 75% of the usable life of the asset and property ownership cannot revert to the tenant, nor can the tenant receive a “bargain” purchase price for acquiring it at the end of the lease term.
The company would produce a statement of lease payments (typically a schedule showing annual lease payments for five years and a lump sum that represents the remainder of the lease commitment). Rating agencies then discount these figures back at WACC (i.e. 12%) to arrive at the present value of occupancy cost, which is placed back on the balance sheet as a liability.
If the rental stream used to derive the present value is less than 90% of the property’s fair market value, the company receives a financial benefit when the rating agency discounts its lease payments. The result is to reduce the size of the assets on the balance sheet, enhancing financial ratios such as return on assets (ROA), return on equity (ROE) and the debt-to-equity (D/E) ratio in the process.
Advantages and Disadvantages of a Sale-Leaseback
With too much equity tied up in commercial property, a sale-leaseback can help in freeing up cash, unlock the value in real estate assets and provide capital to help a business grow.
Sale-leasebacks are particularly desirable for corporations intent on reducing balance sheet assets to improve financial ratios. The financial statements of companies owning real estate without corresponding mortgage debt show the value of each asset on one side of the balance sheet, and the related equity investment in the property on the other.
Unlike mortgage financing, where the amount financed is typically less than the full value of the property, a sale-leaseback affords financing equal to 100% of the market value. Because sale-leasebacks can be treated as “off-balance-sheet”, financial ratios are improved. Return on assets and on invested capital increase, improving the company’s credit profile and widening the range of alternative vehicles available for future financing.
For private companies that plan to sell or go public, the sale-leaseback provides more flexibility with regard to future financing options by decreasing the need to give away equity. For venture capital, private equity and LBO firms, the ability to source additional capital without diluting their holdings has proven important in achieving targeted returns.
There are downsides to sale-leasebacks, however. Companies may
find they can be more flexible with a property they own than lease.
Companies that have recently sold property can have their credit downgraded
as a result.
Sale-Leasebacks in the Lodging Sector
Although the sale and leaseback structure has been widely used for the property sector for decades, it is only recently that this technique has been utilized by the lodging sector.
In Latin America, one of the larger users of the sale-leaseback is Club Med, with its Americas regional headquarters in Coral Gables, Florida. Club Med operates seven resorts in the Caribbean, five in Mexico and two in South America. Three of their resorts are currently under the sale-leaseback structure: Ixtapa, Cancun and Turks & Caicos. The paramount reason for Club Med committing to these three sale-leasebacks is for tax purposes, receiving tax deductions on the rental payments.
In Europe, such deals have been gaining use recently. In 2000, over £2.5 billion was invested through variations of the sale-leaseback structure. The highest profile deal was Nomura’s sale-leaseback of the major part of the Meridien chain. The Royal Bank of Scotland (RBS) invested £100 million of equity in the portfolio and entered into a £1.25-billion sale-leaseback of the hotel assets, enabling Nomura to win the contested public bid to acquire this chain. Prior to this transaction was the Hilton sale-leaseback (also backed by RBS), where Hilton’s rent is based on 25% of turnover of which only approximately 4% is guaranteed. The interesting characteristic of these transactions is that the linking of the lease rental obligations to turnover (with a low guaranteed rent) enables RBS to benefit from the above-average growth prospects they see in the lodging sector.
The upside for Hilton is a cash infusion that could be used for acquisitions, paying down debt and engineering a jump in EBITDA. The upside for RBS is a share in capital and real estate appreciation, the bond-like income of the 20-year lease and the potential for amortizing the debt. The downside from the operator side is that it is committed to a 20-year lease obligation, which in the U.S. would need to be classified as a contingent liability on its balance sheet. In addition, such a structure would result in the operator not participating in the capital growth of the asset.
The tax laws governing leases are based on a number of complex rules, and each transaction needs to be reviewed in light of these rules. That is especially important in Latin American transactions, since the treatment of sale-leasebacks varies from one country to another, although the basic parameters are generally similar. Before entering into a sale-leaseback, management should therefore consult with financial and tax advisors.
Marriott is a good example of a balanced approach by using its pure asset-owning company Host Marriott to enter (as owner) into a management agreement with its operating company Marriott International, where there are no long-term financial obligations of either party that might adversely affect the credit rating of either entity.
In sum, the highlights of a sale-leaseback investment are as follows.
Jones Lang LaSalle Hotels, the world’s leading hotel investment services group, provides clients with value-added investment opportunities and advice. In 2001, its success story includes the sale of 7,972 hotel rooms to the value of US$1.3 billion in 39 cities and advisory expertise on 100,550 rooms to the value of US$26.3 billion across 255 cities. Jones Lang LaSalle Hotels’ services include transactions, mergers and acquisitions, financial advice and capital raising, valuation and appraisal, asset management, strategic planning, operator assessment and selection and industry research. Jones Lang LaSalle (NYSE: JLL) is the world’s leading real estate services and investment management firm, operating across more than 100 key markets on five continents.
Top Ten Pitfalls in Hotel Development / Jones Lang LaSalle Hotels / March 2002
Hedging Currency and Interest Rate Risk for Latin American Hotel Investors / Jones Lang LaSalle Hotels / Oct 2001
Overview of the Miami Lodging Market / Jones Lang LaSalle Hotels Miami Office / August 2001
Hotel Investment Forecast for Argentina, Brazil, Chile and Mexico / Jones Lang LaSalle Hotels - Focus on Latin America / Aug 2001
Anwar R. Elgonemy
Jones Lang LaSalle Hotels
2655 Le Jeune Road, Suite 1004
Coral Gables, Florida 33134
Tel: (305) 779-4958
Fax: (305) 779-3063