Articles

Friday, June 19, 2009

Sale-Leaseback is Not Dead

Starbucks decided it had too many stores in La Mirada, California and last year shut one there that was located at the end of a small strip mall. Like many of the locations the coffee chain vacated, this one didn't stay empty for long. But the ultimate occupant came as something of a surprise: Burger King.

But the way the franchisee structured the deal and financed the buildout is just as interesting. He bought the location, and then orchestrated a sale-leaseback that netted him enough proceeds to convert the location into a small, fast food restaurant. And he even had a little cash left over when it was done.

The death of the sale-leaseback has been greatly exaggerated. While the overall volume has declined precipitously in the last 18 months, those in the market say deals continue to get done, especially at the right price. "It's still a vibrant market," said John Glass of the Glass Group, part of Marcus & Millichap, the real estate investment firm. "There is a perception out there that it is so bad that everybody is staying on the sidelines. (But) assuming the sale-leaseback is properly structured, there is tremendous demand in the marketplace."

To be sure, the market is vastly different from what it was two years ago. Cap rates have risen. Buyers are fewer. And they're being more selective and demanding. They want better credit and debt coverage ratios that make more sense—which is adding up to a market that is not providing some of the value for real estate that it once did.

In simple terms: Just like the broader real estate market, and financing as a whole, the sale-leaseback market is returning to basic fundamentals after a period of investor excess. "Underwriting has changed dramatically," said Denny Ruben, of NRC Realty Advisors. "They're going back to real-estate fundamentals. The market is going to punish people that did not have good, conservative underwriting."

Between 1997 and 2007, the volume of sale-leaseback transactions in the restaurant industry boomed. Investors were eager to take advantage of 1031 exchanges and they were backed by debt from aggressive lenders. The cap rates they received from seller-tenants were often a few points higher than their borrowing rate which provided a substantial incentive to the market. As cap rates on sale-leaseback deals fell to historic lows, investors bid up properties as operators agreed to high rent-to-sales ratios.

Many 1031 buyers are now on the sidelines because tight credit means they can't borrow the money they need to purchase a property—Glass estimates that the percentage of buyers who are seeking to do exchanges has fallen from 70 percent to 40 percent. Those left in the market have cash, notably REITs and hedge funds.

"There are deals out there," Ruben said. "But it's harder to get deals done." He said that even those in the market don't have the stomach for the large deals they once did, and are more likely to favor smaller deals.

For both buyers and sellers, however, sale-leasebacks remain a good option, and that's keeping the market more robust than other financing avenues. For investors, passive investment deals still have the potential to bring in solid annual returns, certainly better than other options. "It's still an attractive investment as a whole," said David Sobelman, executive vice president of Calkain Companies, which works with both buyers and sellers on sale-leasebacks. "A lot of people are doing these types of investments and are paying all cash."

For restaurateurs, the market remains a financing option that simply isn't there in other areas. "It's not as easy as it used to be as far as valuing the properties," Sobelman said. "But it's still a source of financing for tenants/operators that is not there in other sources." Calkain, for instance, is working with a Denver-based Sonic franchisee that is using sale-leaseback financing to help build new units in Virginia.

Cracker Barrel, the chain of freeway-side family restaurants, said recently that it has a contract on the sale-leaseback of its retail distribution center and entered into a letter of intent for the sale of 15 of its stores. The company will net $53 million to $54 million to help pay down debt. And Lone Star Foods, the private equity group that owns Lone Star Steakhouse, in March reached a deal with Sovereign Investment Company on a $69 million sale-leaseback deal with a 15-year lease.

The key difference today is that investors are pickier about the properties they buy. "The deals that do get done are the pick of the litter," said Peter Mavoides, chief executive of Sovereign Investment Company, which specializes in sale-leasebacks and has done several deals with restaurant owners—including those involving Arby's, Wendy's and Golden Corral. "There is a flight to quality."

Small franchisees have a particularly difficult time getting deals done amid concerns over their track record and their long-term ability to make rent payments. "The ability to finance small franchisees comes around only in very flush and liquid markets," Mavoides said. "Clearly, we're not in that environment. It's gone in the other direction."

The market is also tough for casual-dining restaurants. Even though many chains have improved profits by cutting costs, long-term sales trends remain a deep concern for the sector, and investors recognize this and scrutinize those units more carefully. "It's still square in the sights of the consumer-led recession," Mavoides said. "All restaurants are difficult. But if you want a deal done, you have a better chance of getting a QSR done."

Carrols Restaurant Group, a large publicly traded operator of Burger King restaurants as well as the owner of two Mexican concepts, is marketing properties in anticipation of saleleasebacks. Yet Paul Flanders, the company's CFO, said in a May earnings call that it expects to do $10 million to $12 million worth of sales, down from the initially planned $15 million.

Cap rates are now at more historic rates after having dropped to 7 and below during the market peak. And they now vary depending on a host of factors, but notably credit rating. "If someone is going to finance the purchase as a passive investor of a restaurant net-lease investment, the first question they ask is how are the tenant's financial statements," Sobelman said. "When the market was hot, it was less of a concern."

Investors are also more scrutinizing of real-estate fundamentals. During the height of the market, prices were often set based on the cash flow that a property could produce, rather than its resale value. The result, Ruben said, is that properties were sold at rates higher than their actual value.

When a restaurant ran into trouble and had to shut down—a common problem, especially as they often ended up making higher lease payments following the deal—the investor would be stuck with a property worth less than the amount for which it was purchased. "There was no way you could sell it or lease it for what the original tenant paid," Ruben said.

That's not happening anymore. Investors are taking a more "balanced approach," Ruben said. Sobelman said that the intrinsic value of the land and the building has become much more important in the current economy. A Walgreen's in Midtown Manhattan, he said, would have a better cap rate than one in Brady, Nebraska.

All this said, Sobelman refused to call it a seller's market. Buyers, on the other hand, didn't exactly sound thrilled with the market and one described it as "slow to non-existent." The key, Glass said, is ensuring that the deal is properly priced. A $5 million casual dining restaurant probably couldn't get done, he said, but one at $2 million to $2.5 million probably could. He recently helped structure a 7-unit KFC deal and received 30 offers.

Indeed, Sean Hickham, vice president of net lease investments for Servant Investments, said that one of the big problems in the market is the expectation of sellers that they're going to get the same cap rates they did two years ago. He noted that Walgreen's, which used to get cap rates in the mid-six range, is now getting cap rates over 7. "That shifts all programs," he said.

Lisa Sickinger, an associate with Marcus & Millichap, said that sellers also expect the market to be completely non-existent, which it isn't. "Their impression of the market is more dismal than reality," she said. "There are not as many properties on the market. But their dismal overview is inaccurate. The list of buyers that were players a year ago has changed, but they're plentiful. And those buyers are looking for transactions."

For more information, visit www.nrc.com.

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