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Market conditions are producing sale-leasebacks with surprisingly favorable terms.
Don Durfee, CFO Magazine
October 1, 2004
Last May, Wachovia quietly struck a $546 million deal that received little mention in the financial press. It wasn't one of the acquisitions that the country's fifth-largest bank has become known for. Instead, it was a giant sale-leaseback: 8.2 million square feet of real estate, in 150 facilities concentrated in the eastern United States.
Other than its sheer size, what is noteworthy about this deal is its lenient terms. Instead of leasing back all of the space from the buyer, as was once usual, Wachovia will lease only 6 million square feet. The buyer, American Financial Realty Trust, will attempt to sell the rest, much of which is hard-to-sell space in partly vacant facilities. In addition, the bank has secured the right to give back certain properties to the landlord early if it chooses.
"This leaseback will save us approximately $22 million a year," says Ginny Schlosser, CFO for Wachovia's corporate real estate function. The savings result primarily from freeing up excess space and taking that asset off its balance sheet, as well as reduced costs associated with ongoing property maintenance.
Market conditions have made investors surprisingly willing to cut such deals, and a growing number of companies are seizing the chance to pull capital out of their real estate assets. Examples abound. Earlier this year, Bank of America did a $546 million leaseback of bank branches in a transaction similar to Wachovia's. And in May, Amerco concluded a $312 million leaseback of its U-Haul self-storage and truck-rental facilities. The trend is even extending to European companies, which have traditionally been more reluctant than their American peers to enter into sale-leasebacks. In 2003, for example, the British Broadcasting Corp. completed a mammoth $1 billion leaseback for one of its facilities in London.
"Leasebacks are definitely on the rise — we've seen a huge pickup in business," says Steve Van Amburgh, CEO of Koll Development Co. (KDC), a Dallas-based commercial developer.
Two changes in the market have made leasebacks more attractive: lower rents and higher property values. According to Reis Inc.'s Andrew Wright, a senior consultant based in New York, the corporate leasing market is still suffering the aftereffects of overbuilding in the late 1990s and 2000, and demand for leases has yet to catch up with supply. Figures from Reis show that average rental prices in the United States have slid from their peak of $29 per square foot in 2000 to just $24 today.
At the same time, low interest rates and uneven returns in the stock market have driven investors — many of them new to the real estate market — to buy properties. "There is a lot of capital looking for real estate, but there isn't enough property to go around," says Steve Tinsley, senior vice president of corporate finance at Equis Corp., a corporate real estate services firm based in Chicago. "So we're seeing some of the highest prices paid for real estate, but some of the lowest lease rates." These investors are taking on more risk in pursuit of returns — they are willing to accept shorter leases than usual, take on partially vacant properties, and do business with non-investment-grade corporates. "They've loosened their investment parameters, and that's an advantage for corporations," says Tinsley.
Companies, meanwhile, are using leasebacks for a number of reasons, some old and some new. One is a desire to improve capital efficiency. If a company has investment opportunities that exceed its blended cost of capital, then it may make sense to pull money out of real estate holdings.
Reuters, the London-based information services firm, has taken this attitude. The company recently concluded a few leasebacks for facilities in St. Louis. According to Glenn J. Elliott, senior vice president of real estate services, Reuters considers leasebacks "in cases where we want to be in a property long term and can do a leaseback for less than our aftertax weighted average cost of capital."
Ed McLaughlin, chairman of USI, a Stamford, Connecticut-based corporate real estate services firm, argues that more growth companies should view leasebacks in this light. "The concern when you move from an owned position to a leased position is your lease rate," he says. "But with low interest rates driving very low lease rates, asset monetization is attractive."
Since bank credit remains tight, leasebacks can also be an alternative form of long-term financing. Indeed, many companies are using them to finance acquisitions or even help pull themselves out of bankruptcy. Amerco, for instance, is paying off debt with the proceeds of its sale-leaseback as part of its plan to exit Chapter 11. And with synthetic leases on the wane as a result of accounting rule changes, even more companies may start looking to leasebacks as a financing alternative (although real estate executives note that the decline in synthetics has yet to prompt a rush to leasebacks).
For companies that need more flexibility in their real estate holdings, sale-leasebacks may be the solution. "If you are a telephone company that sees many of its customers moving to wireless and Wi-Fi in the next five years, you may find yourself stuck with real estate connected with the wire business," comments Michael Silver, president of Equis. "You need a tactic to address it."
Traditionally, the leaseback wouldn't have been appropriate for such a situation — lease terms were between 10 and 20 years. Now, however, the average length of a lease has shrunk to between 10 and 15 years, with some companies even securing leases as short as 3 years. This makes leasebacks more attractive to a greater number of companies — you don't have to be certain of your long-term plans.
Companies are also securing giveback rights, such as those Wachovia negotiated in its leaseback deal. "Companies want an 'accordion plan' for their real estate — the ability to shrink or swell," says KDC's Van Amburgh. "And we're saying, 'If you give us a large enough number of buildings, we'll give you the ability to withdraw from some of those.'" While such an option adds to the cost of the lease, it can make financial sense. For example, Wachovia's strategy of growth through acquisition makes lease flexibility especially valuable. "If we do another merger and find that some of our existing space is excess to our needs, we can return some of that space to American Financial Realty Trust," comments Schlosser.
According to Equis's Tinsley, some developers are also agreeing to leasebacks where they will share the proceeds of the eventual sale of the property with the original seller. "Because of all the money coming into real estate, we're seeing many more creative ideas," he says.
When to Own
Leasebacks aren't for everyone, of course. After all, the flexibility they afford comes at a price — a 10-year lease may prove more costly than simply owning the property, even with the cheaper leases available today. "We don't do leasebacks, because they tend to be more expensive in the long run," says Ron Zappile, director, global real estate operations, at Hartford-based United Technologies Corp.
Also, for some companies, it makes sense to own real estate. "Some like to own because the building is an icon; some companies generate so much cash that it doesn't matter; and for others it may be mission-critical real estate," says Bill Rafkin, KDC's senior vice president of investments. "Even so, we're seeing many CFOs say, 'If I can sell my building and lease it back at 9 percent, I can take that capital and reinvest it at 14 percent or greater.' "
In any case, now may be the time to act. Although investors are unlikely to leave the real estate market anytime soon, lease rates won't remain low forever — according to Reis, there are signs that rates will soon begin to rise. "Sometimes leasebacks make sense and other times they don't," comments USI's McLaughlin. "But right now, with lease rates so low, they make a whole lot of sense."
Don Durfee is research editor of CFO.