Sale-leasebacks Have Become a Critical Tool for PE Firms. Here’s Why.
Learn how GPs are making sale-leasebacks a cost-effective part of the capital stack
Growing PE Fund Sizes
2019 first quarter middle market private equity deal activity slowed compared to 2018, with declines in public markets and the government shutdown creating adverse pricing for PE backed IPO exits. Despite decreased deal volume and exit values, fundraising figures remained steady in the quarter, boosting dry powder available for new investments. Strong investor demand led PE firms and sponsors to grow the scale of their funds, with vehicles between $1 billion and $5 billion accounting for over three-quarters of capital raised. In fact, the average PE fund in 2019 has raised 70% more compared to the whole of 2018, demonstrating the substantial increase in fund size, based on data compiled by Pitchbook.
Elevated Deal Multiples
Multiples on new deals have remained elevated, fueled by the swelling dry powder base. The challenge for PE fund managers is to be competitive on securing new investments while meeting investor return expectations. Consequently, dividend recaps and add-ons have become more common as GPs endeavor to boost returns in the current elevated pricing environment.
Increased Deal Sizes and Longer Holding Periods
Along with larger funds, deals have grown in size and complexity, and longer holding times for investments are becoming more prevalent. Traditionally PE portfolio companies have been held for three to five years before being exited. Fewer than 50% of middle market exits occur in under five years, with the median holding time currently at 6.8 years. The top 25% of exits are hovering around a decade. As a result, there are increasing numbers of long-dated funds with investment periods extending to 15 years or more.
Sale-leasebacks: An Innovative Capital Source to Mitigate Risk and Increase IRR
To mitigate the risk of larger deal sizes, higher multiples, longer holding periods and uncertainty around longer-term interest rates, many GPs are turning to sale-leasebacks as a critical component of the capital stack. Because land and buildings tend to sell at higher valuations than the company itself, PE firms can sell a portfolio company real estate asset and rent it back under a long-term lease, thereby capturing a multiple arbitrage and blending down the initial purchase price multiple. Post-acquisition, a sale-leaseback can create liquidity, allowing an earlier return of cash to investors, thereby boosting IRRs.
Conclusion
In the current environment a sale-leaseback can effectively decrease acquisition multiples and allow PE firms to be more competitive in bidding for new acquisitions. A well-structured sale-leaseback with an experienced capital partner like W. P. Carey provides PE firm portfolio companies with access to an efficient, alternative and flexible source of long-term capital. In addition to helping PE firms achieve targeted investor returns, W. P. Carey works with its tenants on an ongoing basis to support their longer-term operating objectives through follow-on projects including expansions, building upgrades and build-to-suit funding for new facilities. W. P. Carey’s net lease portfolio comprises diverse property types and a range of asset classes in 31 industries and 25 countries, enabling us to work with a wide range of companies.
Related Topics:
You May Also Like:
Sale-leaseback vs. Traditional Debt: A Company’s Guide to Evaluating the Options
For companies seeking capital to fund growth, finance an acquisition, reduce leverage or pursue other strategic priorities, traditional debt financing is often the first option considered. But companies that own significant real estate may have another source of capital available: a sale-leaseback. In a sale-leaseback, a company sells its real estate to an investor and simultaneously enters into a long-term lease, allowing it to continue operating at the property while unlocking capital otherwise tied up in a fixed asset. Unlike traditional corporate debt, a sale-leaseback does not add another loan that ultimately needs to be repaid. Instead, it converts owned real estate into liquidity while creating a long-term lease obligation. Neither approach is inherently better. The right choice depends on a company’s capital needs, strategic objectives, balance sheet priorities and long-term plans for its real estate. For companies evaluating the options, it is important to look beyond the headline cost of capital and consider the broader implications of each. Here are five factors to consider. 1. How much capital does the business need? A fundamental question is whether the financing approach can generate enough capital to accomplish the company’s objectives. Traditional debt can provide an efficient source of liquidity, but the amount a company can prudently borrow may be influenced by its existing leverage, credit profile and broader capital structure. For companies with substantial value tied up in owned real estate, a sale-leaseback provides another potential source of capital. By selling the property, the company can monetize the value of the asset and redeploy the proceeds elsewhere in the business. Those proceeds can be used for a range of strategic purposes, including funding growth initiatives, new acquisitions or reducing debt. The analysis therefore extends beyond the relative cost of capital and should focus on the company’s overall capital needs and which structure best aligns with its objectives. 2. What is the highest and best use of the company’s capital? Owning real estate can serve a business well, particularly when ownership is an important part of its long-term strategy. But it also means that capital remains invested in buildings rather than being deployed elsewhere in the company. That creates an opportunity-cost question: Could the capital currently invested in real estate generate greater strategic or financial value somewhere else? For example, a company may determine that investing in new equipment, expanding production, completing an acquisition, entering a new market or reducing existing debt better supports its strategic priorities than continuing to own its facilities. The key is to assess real estate ownership in the context of the company’s broader capital priorities. If capital invested in owned facilities could generate greater value elsewhere in the business, a sale-leaseback may be worth considering as part of the overall financing strategy. If ownership itself provides strategic value, retaining the property while raising capital through traditional debt may make more sense. 3. How does each option affect the company’s balance sheet? Financing decisions cannot be evaluated in isolation from a company’s overall capital structure. Traditional borrowing introduces additional debt and associated interest and repayment obligations. A sale-leaseback, by contrast, monetizes an existing asset and introduces a long-term lease obligation. The resulting accounting, tax and credit implications will depend on the business and the specific transaction, so companies should evaluate each structure with their accounting, tax and legal teams. Strategically, however, the distinction is important. A company looking to preserve debt capacity or reduce existing borrowings may evaluate a sale-leaseback differently from a company comfortable adding incremental leverage. The key is determining how each source of capital fits into the company’s broader financial strategy, rather than evaluating the transaction on its own. 4. What does the company’s long-term strategy look like? The appropriate financing structure also depends on where the business expects to be several years from now. A company taking on traditional debt should consider its ability to repay or refinance those obligations alongside its other capital needs. A company considering a sale-leaseback needs to think differently. Because it will enter into a lease, management should have conviction that the facility will continue to support the business's operations over that period. That makes the expected future role of the property an important part of the decision. A mission-critical facility that a company expects to occupy over the long term may be well suited to a sale-leaseback. A property that could become unnecessary as the company’s footprint changes may warrant a different strategy. 5. What flexibility will the company need in the future? Companies evolve. Production capacity changes, operations expand, facilities require modernization and sustainability investments become necessary. When weighing a sale-leaseback against traditional debt financing, companies should consider the flexibility each provides as the business evolves. A sale-leaseback can offer a different type of flexibility by pairing access to capital with a long-term real estate partner that may be able to support future property needs. W. P. Carey’s Carey Tenant Solutions platform, for example, is designed to support tenants beyond the initial acquisition through follow-on investments, including build-to-suits and expansions, redevelopment and renovations, and energy solutions. That makes the selection of a buyer-landlord an important component of the sale-leaseback decision. Just as companies consider the terms, capacity and flexibility of a lending relationship when evaluating traditional debt, they should assess whether a prospective real estate partner can support their longer-term needs. The economics at closing matter, but so does the ability of the partner to accommodate the business as it grows and changes. Looking beyond the cost of capital The decision between a sale-leaseback and traditional debt financing is ultimately bigger than the cost of one source of capital versus another. It is a decision about capital allocation. Companies should consider the amount of capital the business needs, its existing capital structure, the strategic importance of owning its real estate and how effectively newly available capital can be deployed. Interested in exploring whether a sale-leaseback could complement your broader capital strategy? Contact W. P. Carey to learn more.
Why Institutional Capital Continues to Embrace Sale-leasebacks
As more corporate and private equity firms have turned to sale-leasebacks, deal volume has continued to grow compared with 10 or 20 years ago. That growth has caught the attention of institutional investors, such as J.P. Morgan Asset Management and Goldman Sachs, who may have previously viewed net lease or sale-leaseback as a niche asset class. “I think as the market has grown, those asset managers have realized that there’s real scale to this market and a real opportunity even for the largest firms,” says Tyler Swann, co-head of North American investments at W. P. Carey. For investors considering sale-leaseback strategies, that growing interest raises questions about how these assets hold up through market cycles and whether increased investor demand is changing pricing. How Critical Real Estate Weathers Market Cycles Swann explains that the sale-leaseback market has an investment track record long enough for investors to see how well assets performed during past market cycles. He also notes that the assets are usually very important to the companies operating them. As a result, even during downturns, companies need the real estate and tend to stick with it. “If you buy highly critical real estate under well-structured leases, that asset tends to remain essential to a tenant’s business,” says Swann. He notes that you can’t necessarily say the same for debt or equity investments, which are more heavily impacted by economic cycles. Swann adds that W. P. Carey is a long-term investor and is less impacted by short-term market downturns, given the company’s leases generally run 15 years or longer. Rising Rates Haven’t Yet Cooled Sale-leaseback Demand Large institutional investors entering the sale-leaseback market suggests that interest continues to grow, but Swann suggests its impact may be minimal on pricing or deal terms. “It seems at this point that every large asset manager has realized that they need a net lease platform in order to offer a full suite of investments to their clients,” says Swann. When considering the months ahead, Swann acknowledges that continued long-term rate increases may affect future deal flow, but notes that demand from tenants and capital sources has remained strong. “The rise in rates that we’ve seen over the last six months hasn’t really had a major impact so far,” says Swann. He points to one area where capital may be getting ahead of itself, which is the trend of very aggressive pricing for assets leased to investment-grade credits. However, he also notes that because W. P. Carey’s core focus is primarily on sub-investment-grade credits, that trend hasn’t had much of an impact on its business to date. Overall, Swann views market pricing as fair and reasonable. And because recent rate increases haven’t had a major effect, he remains optimistic about deal flow over the next 12 months.
Sale-leasebacks Earn a Bigger Role in Capital Strategies
Corporate operators and private equity sponsors are increasingly using sale-leasebacks in their capital strategies, whether to fund acquisitions, manage costs, or improve their balance sheet position. When companies own significant real estate, this structure provides access to the full property value without disrupting operations, says Zachary Pasanen, managing director and co-head of North American investments at W. P. Carey. "Companies often have significant capital tied up in real estate, so a sale-leaseback allows them to monetize the real estate fully, lock in a very long-term contract, and fix their rent for a sustained period of time," Pasanen says, adding that proceeds are commonly used to shore up balance sheets, fund growth initiatives, pay down expensive debt, or address near-term obligations coming due. As more companies weigh their options for unlocking the value of their real estate, the structure's appeal comes down to how well it fits broader capital goals. Private Equity Sponsors Find Value in the Multiple Gap Private equity firms have become steady users of sale-leasebacks to finance corporate acquisitions, Pasanen notes. This structure provides an opportunity to capture value from the gap between the real estate multiple and the acquisition multiple. "You can often find strong accretion by utilizing the sale-leaseback," Pasanen says. He adds that prudent CFOs and sponsors are factoring it into M&A strategies as an additional way to capitalize acquisitions. Corporate operators are also using this structure for other balance sheet purposes. For example, companies looking to pay down near-term or expensive debt may apply sale-leaseback proceeds while maintaining operational control of their facility. "The way we structure a lease gives them effectively the same controls they had when they owned the facility," Pasanen says. He explains that tenants can make alterations within reason, and they remain responsible for taxes, maintenance and insurance, much as they were before the deal closed. Pasanen also notes that W. P. Carey is a long-term capital partner to its tenants and can support their real estate needs as they evolve, with the ability to finance expansions, renovations or energy retrofits at their leased properties. Capital Flows In as Appetite Stays Strong Companies holding real estate often find the structure attractive because it helps them unlock a property's full market value. Pasanen notes that mortgage financing, by contrast, typically returns around 50 to 70 cents on the dollar. Corporate demand for sale-leasebacks is met by a market with no shortage of capital supporting it. Pasanen expects the sale-leaseback market to remain active, noting that a growing pool of investors are entering the space. For specialized facilities where tenants have invested heavily and relocation is expensive, Pasanen says investor demand remains particularly strong. This suggests the structure will remain a viable option, particularly for companies whose real estate is critical to their operations.