Interest Rates
How Sale-Leasebacks Help PE Raise Capital in a Tight Market
Funding for growth, refinancing corporate debt, and merger and acquisition activities are top priorities for many private equity firms. A recent PwC report noted that 60% of CEOs plan to make at least one acquisition in the next three years. The report further explains that lower levels of M&A activity during 2023 created “pent-up buyer demand” moving into the current year. However, tapping into capital isn’t always easy when it is locked in assets. “It’s quite inefficient for private equity firms to have capital tied up in real estate assets that aren’t earning for them,” says Tyler Swann, managing director, investments at W. P. Carey. “An alternative is doing a sale-leaseback, which provides a much lower cost of accessing capital than traditional financing methods.” Understanding sale-leasebacks and their advantages can help private equity firms strategically manage growth funding, debt maturities and other capital needs. The advantages of sale-leasebacks With traditional financing strategies such as mortgages, terms are often shorter and exposed to higher market volatility. Accessing capital can also be time-consuming, a challenge for firms that need to move quickly for acquisition deals. That’s not the case with sale-leasebacks, notes Swann. “Sale-leasebacks are very flexible,” says Swann. “The processing time can be as short as 30 to 45 days between the initial call and the actual funding. It’s not unusual for us to get a call from a private equity firm saying, ‘We’re closing on a business in 30 days; can you be there to close with us as acquisition financing?’ And that’s something we can do.” He explains that capital uses also have very few restrictions, with the most common purposes being acquisition financing, dividend payments, and refinancing maturing debt. Misconceptions about sale-leasebacks As private equity firms consider sale-leasebacks, questions often linger regarding who qualifies for this type of financing. Many believe that because their real estate is in a secondary or tertiary market, or their asset doesn’t have a huge value, they won’t qualify. But according to Swann, that’s not necessarily true. “If you have a specialized manufacturing facility in a small market, you may think it won’t qualify because it’s not a high-quality warehouse in a market like Southern California,” says Swann. “Despite where an asset is located, if it’s profitable and contributing to the bottom line of a business, it could be a great candidate for a sale-leaseback.” As the market progresses through 2024, Swann expects sale-leaseback activity to continue upward, partly due to M&A activity and its flexibility to tap into capital quickly. “Every year, sale-leasebacks become a little more accepted in the private equity community as a source of financing,” says W. P. Carey’s Swann. “Ten or 20 years ago, corporate debt was by far the dominant option, but we continue to see an increase in sale-leaseback deals every year.”
Expectations for MIPIM 2024
MIPIM, the world's largest real estate conference, will get underway in Cannes next month with over 20,000 delegates expected to attend. As in years past, many will be looking for the conference to bring some clarity on what the real estate industry should be looking out for in the year ahead. While the industry outlook remains murky, investors entered 2024 with a sense of optimism. Here are the biggest questions delegates will be looking to answer at MIPIM 2024. Have Eurozone interest rates reached their peak? The market consensus is generally that the European Central Bank (ECB) has completed or is nearing the end of its rate hiking cycle. However, much to the disappointment of the market, the ECB did not give an indication on when rates would be cut. As a result, a continued upward pressure on yields and downward pressure on real estate valuations is expected through 2024. On a positive note, interest rates reaching their plateau should help jump start the investment market. Greater predictability will contribute to value discovery, cap rate stabilization and tightening bid-ask spreads. This will result in greater transaction activity and hopefully many discussions around prospective deals at MIPIM! What's the outlook for the European sale-leaseback market? Given borrowing costs are expected to remain high in 2024, sale-leasebacks will continue to be an attractive solution for companies to unlock the value of otherwise illiquid real estate assets. Furthermore, with a large share of speculative-grade debt expected to mature in 2025 and 2026, more companies will likely leverage sale-leasebacks for additional proceeds to get refinancing done. Sale-leasebacks offer permanent, long-term capital with no refinancing risk or balloon payments, which remains a very attractive alternative for companies in need of extra cash. In addition, M&A activity is expected to increase in 2024, with private equity firms sitting on over $2.5 trillion in dry powder. Typically when M&A activity increases, there is an uptick in sale-leaseback opportunities, as private equity firms are increasingly leveraging sale-leaseback financing as part of the capital stack for new acquisitions. How can the real estate industry make ESG commitments a reality? The rollout of the EU’s Corporate Sustainability Reporting Directive (CSRD) has put increased pressure on real estate companies to both implement and report on their ESG initiatives. As a result, companies are developing strategic plans to create and maintain sustainable real estate portfolios while also preparing to meet upcoming compliance standards. The challenge the real estate industry faces today is turning commitments into reality. One of the most important steps companies can take is creating more efficient and automated processes for the procurement and management of ESG data. The use of business intelligence and building technology significantly enhances the data collection process, allowing companies to evaluate potential building improvements, review opportunities to reduce emissions and meet future reporting requirements. MIPIM offers a valuable platform for the industry to discuss new ideas and possible solutions related to ESG.
Looking into the Crystal Ball
2023 was undoubtedly a challenging year for the net lease sector. High inflation, rising interest rates and other economic uncertainty caused a notable decrease in overall transaction volume, sparking apprehension about the trajectory of the industry. However, there have been some signs of renewed life in the market. Most experts believe we have hit the interest rate peak and expect cuts to be made in 2024. In addition, dealmakers generally anticipate that the M&A environment will improve given the market has stabilized, which could bring more investment opportunities to the market. While no one has a perfect crystal ball about what the future will hold, there are certainly reasons for optimism in 2024. Here are three net lease market predictions for the year ahead. Boost in net lease deal volume fueled by projected interest rate cuts The U.S. Federal Reserve indicated in its latest summary of economic projections that three cuts may be coming in the year ahead. The cuts are expected to be slow and gradual and will be dependent on the state of the economy, but investors reliant on third-party debt are hoping for a much-needed reduction in borrowing costs to remain competitive. The signaling of rate cuts is positive news for the market as it means interest rates have most likely reached their peak. This should help the market stabilize therefore narrowing the bid-ask spread between buyers and sellers, leading to a more active deal environment in 2024. In addition, many investors who have stood on the sidelines in anticipation that there will be more favorable opportunities down the road are likely to start jumping back into the market in 2024 and new entrants are expected to join in. Uptick in private equity sale-leasebacks as M&A surges The dealmaking environment in 2024 is already off to a better start than 2023. Inflation has declined, interest rates have likely reached their peak and private credit has become more widely available for more kinds of deals, while traditional credit markets are starting to improve. Private equity firms are also sitting on an unprecedented amount of dry powder – $2.59 trillion – with mounting pressures to deploy that capital into new investments. As a result, M&A activity is expected to increase in 2024. Along with an uptick in dealmaking, savvy private equity firms are expected to continue looking for alternative strategies for growth given lingering economic and geopolitical uncertainties. One effective strategy is through the sale-leaseback of their portfolio company real estate, which allows private equity firms to unlock immediate capital to redeploy into other initiatives, such as new acquisitions or portfolio company growth. Typically, when M&A activity surges, sale-leaseback opportunities follow, so more private equity-backed real estate deals will likely emerge in 2024. Pandemic office trends remain while industrial holds steady More than three years since the start of the pandemic, the real estate industry has finally accepted that the office sector will not return to the way it was before – and hybrid- and- remote work models are here to stay. As a result, offices have lost much of their appeal for investors, with transactions declining more than twice as much as any other property sector in 2023. W. P. Carey announced its strategic plan to exit office last year, through the spin-off of 59 office properties into Net Lease Office Properties and an office sale program to dispose of the remaining on-balance sheet assets. This trend is expected to continue into 2024 and some office investors will likely start to look for alternative uses for office assets – such as residential or industrial. Industrial, on the other hand, will continue to perform well into 2024, as re-shoring and nearshoring provide a boost to the sector. While the asset class is showing some signs of softening post-pandemic as the need for robust inventory decreases, the long-term outlook remains positive. Moody’s Analytics CRE forecasts that annual rent growth for warehouse and distribution properties will track at approximately 5-6% per year over the next 10 years, suggesting that the sector has moved on from its huge boom into a steadier state of growth.
Where Will Net Lease Go in 2024?
In 2023, higher debt costs, a looming $2 trillion-plus wave of corporate debt coming due and other economic uncertainty have clouded the CRE outlook. And while the net lease sector, with its low risk and steady income, has weathered recent economic headwinds better than most, it’s not immune. Execution uncertainty was a central theme in 2023, reports Zachary Pasanen, managing director, investments at W. P. Carey. “With the ramp-up in interest rates, buyers and sellers have struggled to meet at a price that made sense,” he says, noting that a lot of deals after the first quarter had repricing challenges or re-trade concerns. In a competitive market, those who rely on debt financing have been constrained by higher rates. Investors, however, are still seeing cap rate expansion within certain sectors. Shifting Rates & Fundamentals With deals more difficult to come by, investors have re-focused on fundamentals. Pasanen notes that, with industrial, this has meant a refocus on rent growth and the assets “criticality.” There remains good demand for industrial assets, but investors should realize the changing fundamentals of the sector: it is no longer the “darling” product, attracting unlimited cheap capital in pursuit of properties requiring lower capex. Pasanen uses the word “retrenchment” for the asset class as people are getting smarter with rent growth projections following their internal modeling. “With the sector still offering a lot of attractive elements, there is no desire to move out of the sector,” he says. “Unlike office, we view industrial, particularly manufacturing, as profit centers: it’s where the widgets are made. We focus on good, underlying fundamentals but also where there’s criticality in the real estate.” The sudden shift in rates has caused a break in investor expectations, Pasanen says, with one-off, syndicators or family offices still pursuing at compressed numbers. Meanwhile, institutional investors are focusing on tenant credits and cap rates at 8% and higher. Outlook Pasanen notes there’s opportunity in sale-leasebacks for companies looking to raise capital. He says W. P. Carey has a successful history here, taking the time to understand a business to ensure they will be a good investment for the long haul. “No one has a perfect crystal ball, but we try our best and we've got a long history of underwriting credits that are sub-investment grade in nature, and we have a good track record in doing so.” Market expectations are leaning toward interest rate cuts in 2024, an outlook reaffirmed by the Fed’s latest announcement on December 13. Smart investors, however, should prepare for all situations and also have contingency plans for a long pause or even a rate hike if inflation kicks up again. With inflation and increasing interest rates making borrowing more expensive, will CFOs and fund managers continue to strategize on how to recalibrate their business and find that new normal? “I think it will actually be a big year in 2024,” he says. “The rise in interest rates happened quickly so if we have a long pause [on rate movement] the deal environment should become more normalized. When the behavioral element settles in we’ll see more normal investment activity.”