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How Sellers Can Maximize Value During Times of Inflation
Driven by the economy reopening and increasing consumer demand, the US economy is experiencing the biggest surge in inflation in over a decade. The Fed expects higher-than-usual inflation to continue throughout the year, but believes it is transitory and will level off next year as supply chain bottlenecks caused by the pandemic resolve. Although inflation is often associated with negative factors such as higher prices for consumer goods and higher labor costs, corporate owner-occupiers can benefit from a surge in demand for hard assets through a sale-leaseback of their corporate real estate. In a sale-leaseback, a company sells its real estate to an investor for cash and simultaneously enters into a long-term lease. The seller works with the buyer to structure a lease for a period that meets its needs without having to worry about refinancing. The seller can then use the cash to grow its business, reduce debt or execute on other higher-return core business initiatives. While there are numerous reasons to leverage this cost-effective financing tool in all market conditions, there are added benefits for sellers amid rising inflation: Increased property values: During inflationary periods there is higher demand for hard assets such as commercial real estate, as it is a natural inflation hedge due to its appreciation over time. This means that more buyers are in the market, increasing competition and driving real estate prices higher. Less supply: Inflation leads to increased material and labor costs, which disincentivizes developers from building new properties and limits supply. This puts a premium on existing, high-quality properties, which reinforces the fact that sellers can unlock more value out of their real estate. Higher borrowing costs: The cost of borrowing is typically impacted during inflationary periods, as inflation devalues the currency and forces lenders to raise interest rates. As a result, loans will be a more expensive option for companies when compared to long-term sale-leaseback financing from all-equity buyers who are better positioned in an inflationary environment. Favorable rents: Before the Fed’s anticipated hike of interest rates next year, sellers have the opportunity to lock in current low rates on a very long-term basis. The lease term on a sale-leaseback is typically anywhere from 15 to 25 years compared a five- or even 10-year term on a commercial mortgage. Sale-leasebacks also enable the seller to unlock 100% of the value of the real estate compared to a bank mortgage, where 70% to 75% loan-to-value ratio is more likely. For corporate sellers seeking working capital this means now is the time to act. When considering a sale-leaseback, it’s important to partner with an experienced, all-equity buyer with both the expertise to close quickly and the capital to support its tenants’ long-term business objectives. W. P. Carey has specialized in sale-leasebacks for nearly 50 years and prides itself on being a long-term partner to its tenants. If you or your client are interested in selling your corporate real estate, contact us today.
Sale-leaseback 101
What is a sale-leaseback? The concept is simple. For many companies, their real estate represents a significant cash value that could be redeployed to fund their core business operations and growth strategies. Through the “sale and leaseback” model (or sale-leaseback), a company sells its real estate to an investor for cash and simultaneously enters into a long-term lease with the new owner. In doing so, the seller extracts 100% of the property’s value and converts an otherwise illiquid asset into working capital, while maintaining full operational control of the facility. What are the benefits? There are many reasons why a company would consider monetizing its owned real estate. Sale-leasebacks offer companies an alternative to traditional bank financing. This is particularly advantageous during periods of uncertainty—as seen during COVID-19 when conventional financing was limited, especially for sub-investment grade companies. Whether a company is looking to invest in R&D, expand into a new market, fund an M&A transaction or simply de-lever, sale-leasebacks serve as a strategic capital allocation tool to fund both internal and external growth in all market conditions. Key benefits include: Immediate access to capital to reinvest in core business operations and growth initiatives with higher equity returns. We like to say that most businesses are not in the business of owning real estate. A sale-leaseback enables companies to focus on its core competencies, while capitalizing on the value arbitrage between the real estate valuation and the company’s EBITDA multiple. 100% market value realization of otherwise illiquid assets compared to the 65% to 75% of the appraised value that a typical mortgage would garner. Limited financial covenants, unlike some debt instruments, providing the seller with greater control over its operations. Alternative capital source when conventional financing is unavailable or limited. Retainment of operational control with no disruption to day-to-day operations. Potential tax benefits by deducting rental payments rather than being subject to interest limitations for traditional debt as defined by tax laws. Why now? Record level dry power, coupled with today’s low interest rate environment continue to drive investor demand for alternative investments such as real estate, pushing property values to all-time highs. These conditions make now an opportune time for sellers to maximize their proceeds and secure favorably priced, long-term capital via a sale-leaseback before interest rates rise again. In conclusion Key to the success of a sale-leaseback arrangement is finding an experienced and well-capitalized investor who can understand the unique requirements of each seller and structure the lease accordingly. When working with an investor like W. P. Carey, sellers have the added advantage of gaining a long-term partner who can support its tenants through long-term flexibility and additional capital should they wish to pursue follow-on projects such as expansions or energy retrofits as their business and real estate needs evolve.
The Appeal of Industrial Sale-leaseback Transactions
Let’s start with the foundation: if you’re unfamiliar with the term sale-leaseback, you should go here- The Ins And Outs Of Sale-Leasebacks| W. P. Carey. For a more focused explanation relating to industrial properties, let’s turn to Erik Foster, principal with Avison Young and head of the firm’s industrial capital markets practice. “A sale-leaseback is when a user of real estate who owns their premises chooses to monetize that real estate. They stay in [the property], occupy it for a long term and sell it to a third-party owner who becomes the landlord, and the occupier becomes a tenant,” Foster told LoopNet. According to Foster, sale-leaseback transactions for industrial assets have been surging over the past several years, with interest in North American industrial properties emanating from across the world. “It’s truly become a global marketplace,” Foster said. This interest in industrial real estate is neither new nor particularly surprising. As Foster noted, the sector has been experiencing record low vacancies amid historic levels of investment activity. And these factors, which have intensified during the pandemic, have created what Foster described as “a very exuberant investment atmosphere.” And industrial users are increasingly taking note of this enthusiasm. Historically, industrial users have been more apt to own their facilities than their office or retail counterparts. Where most office and retail properties are typically developed with the expectation that multiple tenants will occupy the property, some types of industrial properties are more commonly utilized by a single user. Moreover, industrial properties are often heavily customized to meet the manufacturing or specialized logistical requirements of a particular business. But industrial users are beginning to realize that they may be able to possess their proverbial cake and consume it too. “Industrial users are finding that they can reap the rewards of the sale of their building at record pricing, but still maintain occupancy and the use, so nothing really changes for them,” Foster said. Of course, few things in commercial real estate are without caveats. To gain a better understanding of the industrial sale-leaseback phenomenon, LoopNet spoke with Foster — as well as Gino Sabatini, head of investments and managing director of W. P. Carey — and they walked us through the attributes and challenges of this process for both users and investors. An Opportunity for Industrial Users to Acquire Capital and Flexibility According to Foster, for the industrial user, most of the advantages of a sale-leaseback transaction can be reduced to two concepts: working capital and flexibility. Foster noted that most industrial users that own their property have some kind of financing tied to the building. Perhaps they have a loan that represents 50%, or even 60% or 70% of the building’s appraised value. This loan provides them with operating capital to reinvest into the business — for the purchase of equipment or materials, for instance. Through a sale-leaseback transaction, a user can derive 100% of the value of their property, and reallocate that capital to other aspects of their business. Depending on the company’s accounting structure, this could vastly improve their balance sheet. “You can pay down debt, you can reinvest into your business,” Foster said. Meanwhile, the company in question retains use of the asset. The user “gets a ton of capital out of the real estate and continues to use [the real estate] the way they always have,” Foster added. The industrial user also enhances their flexibility in the process, trading their real estate asset for “a leasehold obligation. It’s not an illiquid asset,” Foster said. Between record-setting industrial investment activity and equally historic low interest rates, this can seem like the ideal moment for industrial users to relinquish ownership of their facilities. “W.P. Carey, and most other sale-leaseback and net-lease buyers, operate on a spread over interest rates,” Sabatini said. This means that as interest rates potentially rise in the near(ish) future, cap rates could climb alongside them. Currently, Sabatini said that cap rates range from 4% to 7%, depending on the location and nature of the facility (more on that in a moment). Foster said that he was even “hearing about sub-3% cap rates on the coasts.” All of these factors may make an industrial sale-leaseback transaction seem like a “best of both worlds” scenario for the user, but it’s not quite that simple. For one thing, as most industrial users are typically real estate novices, they need to make sure they carefully consider all potential suitors. “The user needs to make sure that they don’t talk to the first person that knocks on the door,” Foster said. According to Foster, taking the property through a traditional investment sales process generally garners terms that are more beneficial to the user — both for the sale and the subsequent lease. “When we go out and we make a market for assets like this, we’re amazed at how the terms continue to become better as we work through the process. Foster mentioned that it’s also important to find the right investor match for each particular industrial user. “Sometimes this is their only location and its critical to the [tenant/seller], so having an owner who doesn’t have any forethought or care about the user is an issue too, so you’ve just got to find the right match.” Industrial users also need to be comfortable with the control they’re surrendering by entering into a sale-leaseback transaction. For users that are accustomed to having sole authority over their premises, that adjustment could potentially be challenging. And, as frenetic as the industrial sales market is at the moment, there are reasons to believe that prices could continue to rise. “With the shortages in the commodities markets and the difficulty in getting steel and lumber and other materials, there’s a bit of a governor on the amount of development that can happen. So, the supply of assets is also muted, which is continuing to drive scarcity pricing,” Foster said. Ultimately, the viability of a sale-leaseback transaction for an industrial user will come down to that particular company’s priorities and whether they value working capital and flexibility over control and security. For investors, the calculus is a bit more fraught with risk, but potentially equally rewarding. Conducting Due Diligence on an Industrial Sale-Leaseback Opportunity It’s probably fair to say that W.P. Carey has more experience in industrial sale-leasebacks than any other property owner; after all, that’s been the firm’s primary focus since it was founded in 1973. As Sabatini described it, “Sale-leasebacks of industrial buildings for sub-investment grade companies is really our bread and butter.” When LoopNet asked what made these investments so appealing to W.P. Carey, Sabatini explained, “The facilities are often very critical to the company that is doing the sale-leaseback, and that’s very important for us; because we’re a long-term holder and we want to own something that the company is planning on using for a long period of time.” In an ideal scenario, Carey [Note: have requested that they change to Sabatini] said that W.P. Carey’s investment thesis is relatively simple. “We’re making a bet alongside the equity investors in that company that the company is going to be successful for a long period of time. If we’re correct, then we’ll collect rent for a 15- or 20-year primary lease term for starters, and potentially [execute] renewals as well.” But what happens if they're wrong? According to Sabatini, that depends largely on the market and asset in question. A highly customized property, one that will be challenging to adapt for a new tenant — such as a food or biotech manufacturing facility — represents a greater risk than a relatively generic property, like a last-mile fulfillment center. That risk expands in smaller markets and is somewhat ameliorated in larger markets. In terms of how Sabatini approaches the due diligence process, he said that the first portion of his methodology involves elements that are fairly consistent across any real estate asset class or deal type. He advised that prospective investors commission an environmental phase I study (and a phase II study if the initial report reveals any areas for concern); have an engineer walk the property to appraise its structural integrity; and review the property survey and title. “Make sure you’re purchasing a clean piece of real estate,” Sabatini said. After that, you need to undertake what Sabatini says is often the more challenging facet of the process: reviewing the company who will first sell you the property and then become your tenant. Sabatini likens this phase of due diligence to the process credit organizations like Moody’s undertake when they’re rating companies. “You try to understand the industry, the company’s position within it, as well as any threats to either the company or the industry,” he said. “You really need to dig into the credit and understand why the building is important to the company, and what the company’s financial prospects are in the short-term, the medium-term and the long-term.” Sabatini also said that it’s important to carefully review the company’s balance sheet. Specifically, you should assess their attitude towards leverage and how they have fared during downturns. As this process illustrates, in many respects a sale-leaseback transaction isn’t a simple real estate deal; it’s more analogous to the creation of a (hopefully) long-term, mutually beneficial partnership.
The Importance of ESG for Net Lease REITs
Nearly three-quarters of institutional investors are factoring ESG into their investment decisions, up 18% since 2019 according to a recent report. As the importance of responsible investing continues to grow and more investors evaluate companies based on ESG-related criteria, REITs are recognizing both the benefits and necessity of a holistic ESG strategy. Despite the increased focus, the net lease industry has lagged behind. In a recent WMRE survey focused on the net lease sector, only six percent of respondents said ESG was a significant factor in their investment decisions. While net lease REITs have developed robust governance policies and social initiatives, environmental has been more difficult to address—largely due to the triple-net lease structure whereby tenants are responsible for the day-to-day operations of the property, including energy usage and environmental practices. While net lease REITs don’t directly control property operations, there is an enormous opportunity to work with tenants to reduce their environmental impact and implement sustainability initiatives to support the ‘E’ in ESG—here’s how. Integrate ESG into underwriting ESG criteria can be integrated into the underwriting of new investments both at the property and tenant levels. In assessing properties, factors to consider are the types of energy used, equipment age and waste management standards. Most importantly, considering not only the current state of the building, but what improvements can be made in the future, is critical. On the tenant level, it’s important to understand the company’s broader ESG goals and ensure they are committed to reducing their carbon footprint. For build-to-suit investments—where REITs fund the construction of a new facility— taking a proactive approach to engaging with tenants on sustainable design decisions early in the process is crucial and a great way to turn a conventional investment into a green one. Source sustainability projects from within Net lease REITs can source sustainability-focused opportunities from their own portfolio. REITs with industrial properties are particularly well suited to working with tenants on sustainability projects that improve carbon footprint, reduce operating expenses and enhance asset quality. Such projects include, renewable energy opportunities, green building certifications (ie. LEED, BREEAM), building efficiency retrofits or energy audits. By identifying owned properties best suited for certain projects and proactively reaching out to tenants, net lease REITs can build a steady pipeline of sustainable investments while helping tenants decrease operating costs and advance their environmental goals. Finance investments through green bonds As more investors look to increase their allocation to ESG-related investments, public net lease REITs may be able to secure attractive financing to fund their pipeline of sustainable investments through the issuance of green bonds. Green bonds are designed to support strategies and initiatives that have a positive environmental benefit and can help net lease REITs appeal to a wider investor base and raise the capital needed to fund green investments. In closing Implementing environmental initiatives as part of a broader ESG strategy is possible for all REITs, net lease included. At W. P. Carey, we take a proactive approach to reducing our global carbon footprint, partnering with our tenants to reduce their environmental impact and meet their own ESG goals. These initiatives are not only beneficial to the planet, but to a REIT’s broader portfolio. Green buildings generally increase property value, drive higher rents, attract higher-caliber tenants and often improve renewal outcomes, which can all lead to enhanced cost of capital and accelerated growth.
What’s Behind Food Production’s Interest in Sale-leasebacks
The food production sector has been a significant source of recent deal flow for W. P. Carey – in 2020 we completed five investments in the sector totaling $210 million. In part, this is due to the overall stability of the industry. Even amid a global pandemic, food is essential, and most food companies have continued to perform well – particularly those with a diversified customer base. As a result, many food production companies are seeking capital to keep up with demand and discovering the opportunities a sale-leaseback presents – the ability to quickly unlock the capital tied up in their commercial real estate to reinvest into their core business. In a sale-leaseback, a company sells its real estate to an investor like W. P. Carey for cash and simultaneously enters into a long-term lease, while maintaining full operational control of the facility. For food production companies, a sale-leaseback can be a critical tool to increase cash flows and support long-term growth. Here’s how: Lock in low rates with a long-term lease and recapitalize balance sheet The COVID-19 pandemic forced many companies to take a hard look at their balance sheets and find opportunities to recapitalize and add working capital. For food production companies that aren’t in the business of owning real estate, those real estate assets can be a significant weight on their balance sheets. A sale-leaseback, particularly in the current low rate environment, can enable them to monetize these assets at a cost that creates a positive arbitrage, given what the capital can earn when those proceeds are invested in their core business. In October, we completed a $34 million sale-leaseback with a food production company in the Midwest where proceeds were used both to pay down debt and add working capital to the balance sheet. In addition, while interest rates currently remain at historic lows, they are expected to rise in the years to come. By pursuing a sale-leaseback and signing a long-term lease now, companies can lock in attractive rental rates for 15 to 30 years. Unlock capital to support new acquisitions and future growth Food production has remained one of the most resilient sectors during the pandemic, with some companies even benefiting from the trends that have emerged – including a greater demand for e-commerce and at-home grocery deliveries. To capitalize on these trends, food production companies are looking to shore up capital for new acquisitions that will support their future growth. Sale-leasebacks are a great method to supply companies with this dry powder, enabling them to act quickly on opportunities and take advantage of the market. Proceeds can also be used for other growth initiatives, including investments in new technology or equipment that will help increase efficiency, improve delivery capabilities and help meet growing demand. Earlier this year, we completed a $75 million sale-leaseback of two packing, production and distribution facilities in California with a leading grower-packer of seasonal, high-value summer fruit in which the proceeds were used to help fund growth initiatives for the company. Secure a long-term capital partner If companies choose the right buyer in a sale-leaseback, not only can they unlock immediate capital, but they can also secure a long-term partner to support ongoing growth and real estate needs. These can be add-on acquisitions, build-to-suits of new facilities or expansions of existing facilities. Particularly as demand for e-commerce is expected to increase, having a long-term capital partner can be a critical component to a company’s growth strategy and give them an edge against competitors. We completed several projects with our existing tenants in the food production sector last year to help support their growth. In June, we completed a $75 million build-to-suit of a brand-new, state-of-the-art food production facility in San Antonio, Texas with our existing tenant, Cuisine Solutions, the largest manufacturer of sous vide food. The facility enabled Cuisine to address growing demand and expanding operations. In addition, we completed a warehouse expansion in an accelerated timeframe in Portugal with our tenant, Sonae MC, a leading Portuguese food retailer, to help them meet rapidly growing demand as a result of the pandemic. In closing As food production companies continue to recognize post-pandemic opportunities for growth and enhanced profitability, demand for attractively priced sale-leaseback capital as a long-term source of funding will increase. The liquidity provided by a sale-leaseback can support a range of corporate initiatives, including balance sheet recapitalization, paying down debt and shoring up working capital for future growth. Thoughtful lease structuring along with timely execution are crucial factors requiring an established sale-leaseback partner with recognized experience, relationships and reputation. In addition, it’s critical to find a partner with a long-term outlook to help fund both current and future needs. At W. P. Carey, we’re a long-term investor and endeavor to support our tenants throughout the duration of their leases so they have the capital and real estate they need to remain successful. If our tenants do well, we do well – it’s a symbiotic relationship.
Why Food Retailers Should Consider Sale-leasebacks to Support Growth Strategies
As many retailers nationwide are forced to close down and reduce property footprints due to the ongoing coronavirus pandemic, one particular sector is looking to grow – food retail. Driven by changing consumer habits such as eating more at home and the desire to “stock up” on groceries, food retail has seen growing demand in recent months. In fact, a recent survey showed that consumers are spending 37 percent more per grocery trip than they did before the pandemic. In addition, while in-store shopping trips have declined, digital sales continue to boom – with US online grocery sales hitting a record $7.2 billion in June, up 9 percent from May’s $6.6 billion. Despite many food retailers being spared from the financial repercussions of the pandemic, the swift shift towards online shopping has driven savvy retailers to bolster their omnichannel shopping strategies and capitalize on the newfound demand for online delivery. To implement these changes and adapt to growing demand, food retailers will need growth capital for critical projects like investing in their online-ordering capabilities and/or expanding their distribution centers to keep up with online orders. One of the simplest and most effective ways retailers can secure this capital is by leveraging their existing real estate assets and pursuing a sale-leaseback transaction. In a sale-leaseback – or “sale and leaseback” – a company sells its real estate to an investor for cash and simultaneously enters into a long-term lease. In doing so, the company extracts 100 percent of the property’s value and converts otherwise illiquid assets into working capital to grow its business, while also maintaining full operational control of its facilities. One major benefit of a sale-leaseback is that it is generally a long-term commitment, meaning companies can realize high prices for their assets in the current low-yield environment and also lock in low rent for years to come. In addition, companies can gain a long-term capital partner that can fund future expansions and development of new facilities. Because of these benefits, it’s not surprising that several savvy food retailers have already pursued sale-leasebacks as part of their growth strategies on a stand-alone basis or in conjunction with private equity firms and other investors. W. P. Carey is one of the largest diversified net lease real estate investors, with a portfolio comprising over 1,200 properties across both the US and Europe. W. P. Carey has nearly 50 years of experience partnering with creditworthy companies on sale-leasebacks ranging from $5 million - $500 million to help unlock otherwise unused capital tied up in their critical real estate. As consumer habits continue to change due to the pandemic – likely for the long haul – there’s never been a better time for food retailers to undertake a sale-leaseback. Those that do will be able to secure the growth capital they need to expand and meet growing consumer demand and expectations – putting them ahead of the curve and onto the path of long-term success.
Sale-leasebacks Have Become a Critical Tool for PE Firms. Here’s Why.
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.
When Alternative Strategies Make Sense
The M&A market is busier than ever. As dealmakers compete to close deals that will be profitable down the road, many are looking more carefully at their financing options. To explore this notion, M&A put together a roundtable, which focused on what financing options private equity firms are using, what role sale-leasebacks and other financing tools are playing in today’s market, and how private equity firms are taking advantage of their different options to win deals and create value. Fugazy: How do you characterize the private equity industry today? Bryan Cummings: Capital superabundance. There’s $1 trillion to $1.8 trillion out there looking for a home, depending on the source you look at. As a result, we are seeing tremendous competition in the market for quality assets. There is a lot of creativity being deployed to give investors the opportunity to win these businesses. Capital is not the constraint. We see a lot of processes where you have one outlier bid at the top, who may or may not get there, and then two to five folks within a relatively narrow five to 10 percent band. Sure, you’d like to be that guy at the top, but if you aren’t you’ve got to have an approach that distinguishes you from the competition. Joseph Marger: Historically, in the real estate business, if you were representing a developer or someone who’s vying for the space, there was a smaller universe of people willing to invest in that risk. But now, because of the abundance of capital, there are either family offices who never used to dabble in the space coming in, or hedge funds and highnet- worth individuals who don’t know what else to do with their money to get yield. They are now willing to throw crazy prices at real estate today. Gino Sabatini: If you’re a private equity firm that owns the portfolio company that has real estate on its books that you know will be important to the company long-term and for the next owner, taking advantage of that multiple arbitrage makes a ton of sense. It makes sense to do a sale-leaseback transaction ahead of the sale of the company so you can take the dividend yourself, and then put the lease in place long-term. If it’s a critical asset, a buyer will not see it as a problem. Fugazy: What are some key components of the capital stack for the initial buyout and for add-on acquisitions? Eric Korsten: Building the ideal capital structure is an art and it’s unique to the buyer and the underlying company. Anyone who’s been around a long time has a deep appreciation for getting it right and not having to renegotiate with lenders in a down market. Today you can almost always refinance; likely not a problem. However, the music can stop quickly and you can be the last in the line. As a result, you need to make sure that what you’re doing today likely works for at least the duration of your expected hold period. Fugazy: How do you think about finding the right partners who will work well with you in a downturn? Korsten: Ideally, you have good past experiences with them, although that’s not always going to be the case. There’s a certain amount of gut instinct involved. Properly structuring your credit agreements and all of the ancillary agreements that go along with it is essential. If the covenants, and other restrictive terms, feel really aggressive today, they probably will be even worse when things aren’t going right. Marger: As a lawyer, I would want to counsel someone by noting that even if you don’t have prior experience with that company yourself, you can look at the track record and make some inferences. A company with 40 years of long-term investment history and many years of working with their tenants to see them grow is quite different than a Johnny-come- lately that’s just looking for instant yield because they can’t find it anywhere else. Who knows how they’re going to react in the next down cycle. Korsten: A 40-year history, like you just mentioned, is definitely an important lender selection consideration. Somebody who started lending recently can potentially buy our deal if their terms are materially better than everyone else; but they likely only get one chance to do right by us. Fugazy: How do the capital stacks for deals differ depending on the asset? Korsten: I looked at information provided by GF Data. Going back to 2016, specifically for lower middle-market deals, there’s no clear, conclusive trend that leverage has really gone up or down much during that time. There’s always been about three to four turns of leverage available. Sometimes it’s slightly more and sometimes it’s slightly less. It doesn’t necessarily follow the bigger market trend, which is that available leverage has gone up a lot. Our smaller-end of the market hasn’t changed much, which means there is likely only a reasonable amount of available debt. As a result, we have to make our returns not just from financial engineering but by really growing the business and taking them to the next level. If you’re just counting on higher leverage to generate returns, that’s just not going to consistently do it in the lower middle-market. Cummings: How are debt providers competing for that business? Leverage really isn’t that different between groups, and most folks are in that three and a half, four times range. Rates are what they are and you don’t necessarily want to choose the cheapest guy out there. How do they think about convincing you to work with them? Korsten: We’re often getting one percent per year amortization on debt deals. That makes you say, ‘okay, this company can just basically choose to pay interest only.’ They can always voluntarily choose to pay down debt but today it’s their choice.’ Having that high degree of flexibility makes us feel more comfortable. We’ll often pay a bit more for that flexibility because we want the company to be able to grow and not feel like they have their hands tied generating liquidity and meeting covenants. Sabatini: The stability of the cash flow has a lot to do with the capital stack and what the market will allow you to put together in terms of the capital structure. If you have a very long history of very steady cash flows, both on the leverage side and certainly on the sale-leaseback side, that will allow you to lever up a bit more. With regard to a sale-leaseback, we often look at rent coverage, and the longer the history we have, the better. Even a very levered company, for example, a building products supplier, if they’ve shown the ability to go through a cycle in the last 10 years and maintain their cash-flow generation, that gets us more comfortable that they can handle it, and we’re willing to take a bit more of a risk on the credit side. Korsten: Lender diligence doesn’t seem to be getting too much lighter. Even though the market is a bit frothy, lenders are still trying to take their time on diligence because they know things can be cyclical. Especially if their terms are great, they’re going to make sure they dot their “i”s and cross all of their “t”s. It’s not uncommon in private equity to provide the lender a quality of earnings report in conjunction with an acquisition or refinancing. Often lenders will do their own homework on the quality of earnings report. They don’t just take the report as-is, put it in a folder and move on. They ask real, hard questions. Questions that tell me that they’re really thinking about the “what-if” scenarios. Fugazy: What is the ideal capital stack? Sabatini: I would say the ideal capital stack has changed over time. W. P. Carey was part of one of the first sale-leaseback financed LBOs in 1982 when William Simon bought Gibson Greetings. The sponsors — there were three of them — each put $330,000 into the deal and within two years they each pulled out an estimated $70 million, making it one of the highest return deals of all time. We provided approximately $34 million of capital proceeds to Simon and his partners through a sale-leaseback of Gibson’s corporate real estate totaling three million square feet. By arranging a pre-closing sale of the assets, the investment group was able to secure the balance of the financing required to complete the LBO. That was at a time when private equity shops could do that and generate enormous returns on equity, which has changed. Clearly, it’s a much more competitive business today, but for the last 45 years W. P. Carey has been a cost-efficient part of that initial capital stack in deals where there’s real estate involved. It always makes sense to do a sale-leaseback at essentially a 13 or 14 times multiple if you’re paying six, seven, eight times for the company. That hasn’t changed. Korsten: I’d agree with you, the multiple arbitrage is potentially compelling; unless you’re paying 13 or 14 times for a business. Absent that, you have to look and say ‘okay, we have added considerable rent expense to the business. We are now effectively more levered. The business now really has to perform.’ One bad investment can take a lot of your time and energy so you have to be very thoughtful. Marger: The extra cash that a sale-leaseback provides to the capital stack that a mortgage wouldn’t could be the difference between the success or the failure of the company going forward. And so you say, I’ve got the rent obligation, but now I have the cash to grow the company beyond the rent obligation. Sabatini: That’s the idea. Furthermore, rent payments are fully tax-deductible, so the multiple arbitrage, coupled with the value of the full deductibility of rent payments may in many cases be a critical factor in structuring a successful bid for a new investment or in refinancing an existing portfolio company. The capital can then be put to higher and better use than staying trapped in your real estate and generating eight percent or nine percent. Fugazy: Does it matter whether that sale-leaseback happens before or after a sponsor buys the business? Sabatini: Sale-leasebacks can happen at any point in time with a company. We’re happy to participate on the front-end like we did with Gibson Greetings and in many other LBOs. We can also participate after the fact, which is often easier for the private equity shop because they have time to figure out what the critical assets are going forward and what they want to commit to in a long-term lease. If it’s a very real estate-intensive company, a sale-leaseback is often the best source of financing and consequently, it’s typically done in conjunction with the initial acquisition. In fact, some PE firms may be able to get their lenders to carve the value of the sale-leaseback out of their credit agreement and have it preapproved so we’re ready to go. Korsten: I read an interesting bid letter recently. It was for a consumer services company and they owned all the buildings. Included with the bid letter it said “in your bid please consider that a potential sale-leaseback we expect would produce X millions of dollars in net proceeds”. It was a car wash company. Cummings: Half our deals are with family-owned businesses. We’re finding in certain cases that there’s a benefit to being able to come to them with a conversation around how they can spark a competitive auction by allowing the PE firm to get a little more benefit from a sale-leaseback. Or, we can have a conversation about whether it make sense to do a sale-leaseback on their terms, even if you then sell for a different price point because now you’ve got a rent expense lowering your EBITDA. Sabatini: A sale-leaseback makes the most sense in situations where the asset is critical to the company or the life of the company. A car wash is a perfect example. Korsten: It’s not going anywhere. You can’t operate a car wash business without the car wash building. Sabatini: Manufacturing companies are another good example. If the private equity firm is purchasing a company that has a critical manufacturing facility with unique characteristics, a long-term lease makes sense. Same with companies that have a distribution network that they don’t foresee changing in the near future. Marger: Let’s just hope so. With the pace of disrupters your diligence efforts are even more difficult for the long-term. There was a time when we thought that CDs were going to save the world, and now they barely exist. Uber is another example. We don’t know what it’s going to be in next five years, the world can be dramatically different. Fugazy: How does the pace of change affect you when you’re looking at deals? Sabatini: As part of our underwriting, we evaluate each company’s ability to pay us rent over the long term because we’re entering typically into a 15 or 20-year arrangement. To the extent that we don’t have real estate that’s very fungible and that can be repurposed into a different use, the company’s future business opportunities are extremely important to us. Fugazy: Some private equity firms are holding onto investments longer. How is that impacting the initial financing structure? Cummings: I’d argue there’s something of a bifurcation in the market. You’re certainly seeing both funds exit earlier than they used to, as well as later. Given the strong market you’re seeing folks exit after three to four years or two to three years, simply because the market’s strong. The business has perhaps executed on seven of its 10 strategic goals, and they think waiting two more years to complete the rest of that performance plan is not worth the market risk. In those cases, how do you avoid prepayment penalties and how do you think about building that option into the structure? There are other companies that people are buying and saying ‘I’m going to be able to invest in a slightly lower entry multiple, because I know this will take longer, and the market does too.’ We’re seeing both sides impact structure. Korsten: There’s an unfortunate tendency with some in the private equity investment world to sometimes sell your good companies too soon and hold on to your bad ones. Managers want to feel like they can get themselves paid and by selling a bit early they can do that but that doesn’t mean that it’s the right decision. Funds do have an artificial life span. When somebody makes a commitment to us, eventually they want their money back; that’s natural. For us, if we achieve something really big, we’ll let the next buyer do the next big thing. However, there isn’t always something big to do, in which case you may hold it for longer. But if we buy a company and we are then able to buy our biggest competitor a year or two later, we have created something with more scale and substance. What’s next? We’ll often let somebody else figure that out. Fugazy: How does the sale-leaseback differ from other capital structures including ABL financing? Sabatini: The biggest difference is it’s very long-term. A sale-leaseback is a 15 or 20-year obligation. We don’t have a refinancing risk in a few years. The second biggest difference—and the most important difference—is the amount of proceeds a seller can garner. An ABL deal will give you 50 to 55 percent loan-to-value. With a sale-leaseback the seller gets 100 percent of the fair market value of the asset. The hope is that the money is put to a higher and better use. Private equity investors are looking for 15 to 20 percent annual returns, which real estate by its very nature doesn’t generate. So what makes the most sense is if there’s real estate on the books, pull that money out and redeploy it into what your company does best. Korsten: ABL availability also varies over time. With the sale-leaseback, we have a single transaction and we know the price; it’s done. With ABL, our collateral is constantly moving and so availability is constantly moving. One has a higher degree of certainty, the other can change significantly as the business’s performance changes. ABL is a riskier form of financing in that regard. Fugazy: Does having a 15-year lease impair the seller’s ability to sell? Korsten: We often consider, would a strategic buyer be less interested in the business because there’s a very long-term lease attached to it? For example, perhaps they wouldn’t be able to combine that facility with their existing facility. It may ultimately reduce our exit options. So, we really have to think, what’s the likely universe of buyers, before we enter into a long-term agreement. Fugazy: How is the sale-leaseback generally structured? Sabatini: Typically we create a new lease when the sale-leaseback is initiated. The company gets the full fair market value of the asset at that time, and they sign a lease committing to the payment of rent for the 15 or 20-year period. As we just mentioned, in particular situations there may be certain things which are important to the company which then get negotiated into the lease. The lease is then put on a shelf and the tenant maintains full operational control of the facilities, while gaining a long-term financial partner and landlord with the capital and expertise to support any future growth needs. Korsten: How often do you see any restrictions on the rest of the capital structure or who you can sell the business to? Sabatini: Some of our best deals are those in which the tenant is sold to a larger entity. As a long-term partner to our tenants, we try our best not to restrict them in this regard. Ultimately, as long as the new tenant can assure us that they’ll continue to pay rent for the duration of the lease, we’re happy to accommodate their changing needs. Marger: It also depends on how far up the chain of the corporate structure that the transfers are taking place. If you’ve done your underwriting under the entire company, and that entire company is being bought by somebody even bigger that could be a positive, not a negative. You’d be very happy to take a look at that. If someone just wants to chop out your company and move to someone with questionable management skills, you’re not going to be as inclined to go along. Korsten: There are a lot of oil and gas companies that have been hitting the market recently. Some of these companies had some pretty rough times, such as in 2016, when their EBITDA may have gone to zero. How would you look at a company like that who owns their real estate if we want to do a long-term sale-leaseback? Sabatini: With a situation like that we would really look more at the asset and try to understand what our alternative would be in a downside scenario. Is it a nice industrial building in Houston that we can repurpose if necessary, or is it an oil service field out in Midland that will have no alternative use? Fugazy: It’s been such a busy time in the market. Are you seeing an uptick in sale-leasebacks today? Cummings: We’re seeing more opportunities to think about, and work with private owners, on things like sale-leasebacks. It’s a more common part of the market today. It’s evolved in its maturity even in the past four or five years, and frankly, our sellers are becoming more sophisticated. They hear things from their friends at the country club and they say, I’ve heard about this sale-leaseback - and they want to know their options. Sabatini: We often get calls from private equity shops that want to buy the former owner out. Likewise, many sellers think they are the only ones who can run the portfolio company, and they don’t want to take a risk that their rent won’t get paid going forward, so they want out. From both sides sometimes having a third-party real estate owner makes sense. Marger: There may be more deals happening, but they’re more diversified across more bidders. The higher you go, obviously you’re going to get less bidders at certain price points. But in the lower-end market I think we’re seeing a lot of activity from family offices who have these long-term triple net portfolios. Fugazy: When you’re acquiring a company and you’re assessing the quality of the business, the company’s longevity, and the purchase price—all the ways you can add value—how important is the capital structure? Cummings: It makes a big difference because ultimately there are a lot of sales to the private equity community and they look very hard at what kind of leverage makes sense. There is no one-size-fits-all in the middle market. As such, finding the right partner, or partners, who can put the pieces together is really important to us. Korsten: We once won an auction for a company that had somewhat lower growth prospects but we saw two great things. One, they owned their own plants and those plants definitely had value in a sale-leaseback. So even though the business was not going to grow really quickly, we could hopefully help achieve our equity returns through a sale-leaseback transaction. Sabatini: Financing is obviously a critical piece of any deal, both at acquisition and almost more importantly going forward. It’s imperative that the owners set up a capital structure which makes sense for that company so it can handle the inevitable ups and downs.