Curious about sale-leaseback transactions? We asked portfolio strategist, Meghan Donoghue to break it down below.
1. Can you describe a sale-leaseback transaction in real estate – who are the counterparties and what is the typical structure?
A sale-leaseback occurs when a company sells a property to a buyer and simultaneously signs a lease to remain as the tenant in that property. The leases signed are often structured as triple net, whereby the tenant is contractually responsible for property level expenses (such as insurance, property taxes, and maintenance), and the lease is longer duration, typically with 15+ years of lease term.
2. Why might a company consider entering into a sale-leaseback transaction? What benefits might this solution present to them?
For a corporate tenant, a sale-leaseback is effectively a means to unlock the value from a non-earning asset held on their balance sheet in pursuit of their unique business goals. Companies may consider a variety of flexible capital solutions when making decisions, and monetizing real estate is one such option.
At Blue Owl, we’ve observed some common themes as to why sale-leasebacks may rank as an attractive option for a company.
First, a sale-leaseback can unlock 100% of the value of real estate, vs. 50-65% of fair market value for traditional mortgage financing. For a company which views its core competency as something other than real estate, executing a sale-leaseback can provide them the opportunity to invest the proceeds towards something that can be more accretive to shareholder value.
Second, a sale-leaseback effective “interest expense” can be ~150 - 200bps lower than traditional debt interest when you consider the way the liability is capitalized on the balance sheet of a company. When a company takes out a loan or issues bonds in the market, there’s a liability that is created on the balance sheet which is typically structured as interest only. Before the end of the term, the company will refinance, and that liability continues to exist. Contrast this with a sale-leaseback, where future lease payments are also capitalized as a liability, but it decreases over the life of the lease and ultimately goes to zero. It’s akin to an amortizing loan, where each payment is comprised of both interest and principal, and results in a lower effective interest rate when compared to an interest only loan.
Lastly, rent payments may have better deductibility from a tax perspective as compared to interest expense, which is typically limited to 30% of EBIT. Rent payments are typically fully deductible.
3. Why would a company structure this type of lease as long duration and triple net?
By locking in long-term leases with fixed annual rent escalations, companies have clarity on future expenditures, allowing them to make appropriate plans as their business needs and goals evolve. We’ve observed that a company is generally interested in a long-term arrangement for assets which can be defined as mission critical to their business, and thus they have confidence they will continue to occupy the asset for many years to come.
The triple net structure allows the tenant to maintain significant control over the asset, which is critical given the importance of these assets to the company’s business model. And of course, because prior to the transaction they own the asset, these are costs that they are already paying, not incremental expenses that they take on because of the sale-leaseback
4. Once a sale-leaseback has been executed, can you offer some insight as to how a company might utilize the capital generated by the transaction?
At Blue Owl, we’ve partnered with over 150 companies to help them unlock the value of their assets, and observed a variety of uses for the proceeds. It can be as simple as a company recognizing that they have accumulated real estate over time and that they can optimize their balance sheet, but there are several more specific use cases.
First, companies often use the capital to fund M&A by monetizing real estate alongside the transaction at accretive multiples to support both organic and inorganic growth. Today, we are seeing the M&A market slowly thaw and anticipate this being an attractive capital solution for companies looking to finance growth.
Second, companies utilize the proceeds to finance capital expenditures for both current and future projects. We’ve done several transactions with a large ecommerce provider who have utilized the proceeds to invest in the latest robotic technology in their warehouses.
Third, the proceeds allow companies to de-lever their balance sheets, pay down outstanding debt, and add incremental liquidity. For companies looking to recapitalize and pay down debt, a sale-leaseback is an attractive option versus rolling over upcoming maturities with new debt, at a potentially higher interest rate.
Lastly, companies may utilize sale-leasebacks as a means of sourcing programmatic capital, providing flexible financing and working capital for planning purposes. Utilizing sale-leasebacks in a more scheduled or programmatic nature, aims to provide more stability of cash flows, while enabling companies to maintain control of top performing assets.
5. How do you think about quantifying the opportunity set for sale-leasebacks?
There is over $12T of property, plant, and equipment (PPE) on the balance sheets of investment grade rated companies in the United States and Canada.1 A meaningful amount of that is real estate, which leaves a lot of room for a firm like Blue Owl to partner with these companies to optimize their balance sheets.
6. What attributes make sale-leaseback compelling for investors?
We believe there are three main attributes derived from investing in sale-leasebacks.
First is exposure to the potential of long-term, predictable income derived from contractual rent. In most cases, a long-term lease of 15+ years is utilized on a triple-net lease basis with tenants. In triple-net leases, the tenant is responsible for taxes, insurance, and maintenance of a property throughout the life of the lease. This means that the gross rent received from the tenant is equal to the net rent received by the investor less fees. Most leases also have annual increases built-in, providing investors with visibility into their future cash flows and capital appreciation. For example, a triple net lease property with 50% leverage and 2% annual rental increases may result in 4% annual capital appreciation from rental increases alone. For taxable investors, distributions may be potentially offset by the underlying depreciation within properties, affording investors a high degree of tax-efficiency relative to other investment opportunities like corporate bonds.
Second, this cash flow stream is secured by ownership of the property itself. This idea of collateral in the real estate is really important for investors as it allows them to participate in the upside value of the real estate over time as well as seeking to mitigate downside risk in the event of a potential tenant default. At Blue Owl, we focus on mission-critical assets that are core to a tenant’s business operations which, we believe, can help reduce the likelihood of tenant vacancy. In a sense, investors have two forms of collateral – first, the tenant credit, and second, the underlying real estate itself.
Lastly, investing in sale-leasebacks can provide investors with a yield premium potential versus owning a corporate bond of the same or similar credit with a similar maturity as the underlying lease. This yield premium can potentially deliver an attractive return to investors relative to corporate bonds, with tax-efficiency, all while having the underlying real estate as additional collateral.
About the author:
Meghan Donoghue is a Principal at Blue Owl and member of the Private Wealth Team. In her role, she focuses on supporting the growth of the firm’s Real Estate platform acting as a conduit between the real estate investment team and global private wealth distribution channel.
