Commercial Insights - Sale and leasebacks: an investment bright spot
Amidst a general slowdown in real estate investment activity this year, sale and leaseback transactions have been one notable outlier. Antonia Haralambous, an analyst in Knight Frank's research team, speaks to Tom Vaughan-Fowler, a Partner in Knight Frank's Capital Markets team, about the appeal for investors and occupiers alike.
7 minutes to read
Antonia Haralambous (AH): Sale and leasebacks aren’t a new concept, or unique to real estate. What do they involve?
Tom Vaughan-Fowler (TVF): Simply put, an owner-occupier sells their property to a purchaser and then immediately takes a lease on the same property. They move from owner to tenant with minimal disruption to their operations.
AH: Would you say they’re a feature of the current pandemic, or was there an increased interest in sale and leasebacks beforehand?
TVF: The recent rise in activity is definitely linked to the pandemic, with £867 million or 83% of total sale and leaseback investment in the UK occurring between March and July this year, according to Real Capital Analytics. However, this is not a new phenomenon: sale and leasebacks accounted for 9% of total commercial investment in 2009 during the GFC, above the long-term average of 5%. This trend will likely continue in 2020, as corporate debt is not currently readily available and was even less accessible at the beginning of lockdown, meaning some businesses will have to resort to other means to raise capital.
AH: So now is a good time for sale and leasebacks?
TVF: Definitely. You are effectively creating new investment product in a market that is still starved of stock. Cyclically, yields are very low, pricing has remained relatively robust over the last quarter and the demand for long, indexlinked income has become stronger as a result of the pandemic. By way of returns, you don’t currently get much for your money elsewhere, so real estate is still a very busy asset class. One thing vendors should consider is the scrutiny that their business will come under as part of a sale and leaseback obligation. The due diligence completed by a buyer will be forensic, both in terms of historic performance and future forecasts. Buyers will need to understand the tenant’s business and their motivation for the sale and leaseback, but these are considerations that would be undertaken during any part of the cycle.
AH: Why have they become so popular? What are the main advantages of these types of transactions?
TVF: Many of the recent sale and leasebacks have been driven by occupiers seeking to inject cash into their business at a critical time. There are a lot of attractions to sale and leasebacks for owner-occupiers, not least that they can unlock equity that would have effectively been sitting dormant as an owned property. This equity can be used 1 1 for investment, expansion or simply to bolster balance sheets. It’s also worth remembering that through a sale and leaseback the vendor can unlock 100% of the value of the asset, as opposed to, say, the 60% they might get through a commercial mortgage. And unlike a bank loan, the capital generated doesn’t have to be repaid. It’s also tax efficient. Normally the rental costs are offset as an operating expense and can be deducted in full. This is another difference to a normal loan where only the interest payments are tax-deductible.
AH: What types of properties lend themselves to sale and leasebacks?
TVF: Realistically any property can lend itself to a sale and leaseback. The variance in investment appetite will come from the asking price, the tenant covenant and the lease structure. Of the sale and leasebacks completed thus far in 2020, 64% were in Industrial assets, 23% in Offices and 14% in Retail, according to Real Capital Analytics.
AH: Is there a sweet spot in terms of deal size or asset type?
TVF: A good way to look at it is to consider three main variables: the value of the tenant’s credit, the vacant possession (VP) value of the building and the difference between the two. If the tenant’s covenant is considered high risk, then a buyer is going to expect the overall pricing of the deal to be linked to the VP value of the asset, because there is a high risk of the tenant not being there in the future. With stronger covenants, you will see the delta between asking price and VP value expand significantly, particularly if there is a long, indexlinked lease attached, which is often the case. Some investors will put very little standing on the VP value of the building because they are comfortable with the credit position and they consider the building to be “mission-critical” to the tenant’s operations. In this scenario, if the building does end up becoming vacant, then something has gone very wrong during the underwriting process. Consequently, you get a range of values and a range of product types, but there is a home for all of them if they’re sensibly priced. In the last few weeks, we have seen a couple of short-term sale and leasebacks trade successfully as well as the more traditional +20-year leases with indexation, the appetite for which remains strong amongst investors. These are still the most common type of sale and leaseback, partly because a long lease and fixed uplift mean a higher asking price and more receipts for the vendor, providing they have the covenant to support the obligations.
AH: What types of buyers are interested in sale and leasebacks? Where are you seeing demand emanating from?
TVF: Predominantly it is buyers with their own coupon obligations, often in the form of listed vehicles. The typical sale and leaseback (i.e long lease and either index-linked review or fixed uplift) suits those with their own outgoings. From a REIT’s point of view, for example, who typically raise money from a variety of investors by promising them a minimum dividend, being able to secure a product with guaranteed income increases and long term lease obligations makes your life as an investment manager much easier. Sale and leasebacks do not typically suit the valueadd investor for exactly that reason. Sale and leasebacks with weaker covenants and more downside risk are the ones most likely to suit an opportunistic investor, as long as they can purchase the asset at a price where they can still make money if the tenant defaults and they get the property back.
AH: What about the occupiers? How do you ensure that they receive a fair deal?
TVF: As a selling agent, it’s an important balance to strike. You have to help create an investment opportunity that will be well received by the market, but you also have to remember that your client is about to become the tenant. While it may be tempting to ensure that the lease is drawn up in the most landlord-friendly manner, with the rent reviewed upwards by 5% every year, you wouldn’t really be doing your client much service. The sale and leasebacks we have found to be most straightforward are the ones where both the vendor and the purchaser are completely clear of the tenant’s future obligations before bidding begins. You can do sale and leasebacks by negotiation, where the lease is effectively written at the same time as the SPA (sale and purchase agreement ). However, these tend to become incredibly protracted because the value proposition is essentially changing during the legal process and you quickly end up with a different deal to the one that was originally agreed.
"Sale and leasebacks effectively create new investment product in a market that is still starved of stock."
AH: Are there any accountancy considerations that need to be factored in?
TVF: Accounting practises and obligations change depending on the type of vendor. Public companies may need shareholder approval to sell their assets, for example, depending on the transaction size. New accounting rules also mean that leases normally have to be declared in the accounts as a liability, whereas previously it could be an offbalance sheet source of fundraising. One of the key points is that most sale and leasebacks can’t be treated as a TOGC (transfer of business as a going concern) so VAT is payable on both the purchase price and the SDLT (stamp duty land tax). This can be dealt with by careful timing of the cashflow but it’s a very important consideration. Ultimately, the accounting position will be different on each deal and we make sure any vendors we are acting for take the requisite specialist advice.
Antonia Haralambous
Analyst, Commercial Research