When CEOs, CFOs and others identify owned facilities for potential monetization, there are many questions and considerations that come into play. Why pursue a sale leaseback (“SLB”)? What are the motivations? What is the strategic and/or operational importance of the facilities, and how should that factor in? How does this impact my cost of capital?
In this Insight, we set out to identify and provide a balanced view on reasons why a sale leaseback may (or may not) be the right capital allocation tool for businesses.
How will an SLB impact financials, key credit metrics, debt covenants and credit ratings?
Sale leasebacks are typically credit-positive and earnings accretive events given their attractive cost of capital and the de-leveraging they generally enable.
- While each situation is different, many SLBs are often accretive to earnings. Levers include magnitude of the SLB, use of proceeds, and the company’s current financial condition, among others.
- Sale leasebacks are usually credit-positive in that proceeds from the sale can be used to de-lever, improving key credit metrics such as Debt / EBITDA.
- Unlike some debt instruments or facilities, SLBs typically contain no financial covenants, balloon payments or call provisions.
Is there a divergence between the business multiple and the cap rate (real estate multiple)?
Executing a sale leaseback at an implied real estate multiple above the company’s EBITDA multiple will drive immediate value creation.
- A value arbitrage often exists between the real estate valuation and company’s underlying EBITDA multiple.
- With many sale leaseback cap rates implying multiples of 12x – 16x, a single digit EBITDA multiple business will almost always capture a value arbitrage save for any unusual tax considerations.
- Real estate valuations continue to be highly attractive relative to other forms of capital, with cap rates close to all-time lows.
Cost of Capital
What is the cost of capital impact and how do alternatives compare from a cost of capital standpoint?
Cap rates on sale leasebacks are typically favorable compared to a company’s WACC and therefore represent an attractive financing source for the business.
- An SLB can be an attractive option among a menu of capital alternatives that include common equity, preferred equity, convertible securities and varying types of senior or mezzanine debt.
- To ‘make financial sense,’ an SLB should be attractively priced relative to a company’s weighted average cost of capital (WACC). In discussing this point with clients over the years, we have found that many people tend to think about the sale leaseback cost relative to a company’s debt cost of capital. However, an SLB is selling 100% of the capital stack of a specific asset, just as the WACC represents the blended cost of capital for the business as a whole — therefore the appropriate point of comparison is against the WACC.
- Given that WACC is the relevant benchmark, when the cap rate on a sale leaseback is lower than the WACC as well as the incremental cost of debt capital, an SLB is very appealing from a cost of capital standpoint.
Use Of Proceeds
How will proceeds be used?
Use of proceeds include funding M&A, growth capital, de-leveraging and stock buybacks, among others.
- Sale leasebacks often represent a compelling capital allocation tool, and can be utilized for a wide array of strategic and financial purposes.
- Redeployment of Capital to Higher ROI Business Segments – As owned real estate is a comparatively low return asset on the balance sheet, redeploying proceeds to grow the business will typically be forecast to produce a better return on investment. Common uses with a comparatively higher ROI include investment in equipment and machinery, human capital and other special projects.
- Deleveraging – Many businesses use sale leasebacks as a tool to manage the balance sheet, in particular to reduce leverage. While a rent expense is created by way of executing a sale leaseback, the reduction in leverage tends to reduce both debt / EBITDA and debt as a percentage of capitalization.
- External Growth – Businesses regularly pursue sale leasebacks to help fund M&A transactions, whether helping fund an add-on to an existing business (in the case of a private equity firm) or utilizing SLB proceeds in a concurrent transaction for a new platform business in which the SLB closes simultaneously with the M&A transaction.
- Stock Buybacks – For publicly traded companies, executing an SLB for a stock buyback will often be accretive to earnings and therefore economically attractive among a range of capital alternatives.
What is the strategic and operational importance of the real estate?
Long-term, strategically important assets make for optimal sale leaseback opportunities.
- Because sale leaseback buyers are looking for a long-term consistent income stream, a traditional sale leaseback should only be considered for long-term operationally important locations. Short-term and partial SLBs are alternatives as well, though both have separate considerations as compared to a typical long-term SLB.
- A typical base lease terms for sale leasebacks is 15-20 years; when coupled with 5-10 year built-in renewal options, the company will be able to continue operating out of the subject location(s) upwards of 40 years
- If a particular location is questionable as to its long-term operational importance, it likely would make sense to keep it out of the SLB discussion entirely or look to structure a short-term SLB potentially with a different buyer.
Risk of Obsolescence
What is the value and importance of the building at the end of the projected lease term?
Monetizing an asset captures today’s attractive valuation while transferring the long-term functional obsolescence risk to the new owner.
- At the end of the base lease term there is a strong possibility that the value of the asset may diminish – a sale leaseback provides the ability to capture an attractive valuation today driven by a long-term lease.
- In the vast majority of sale leasebacks, given today’s attractive real estate valuations, the value received is meaningfully higher than what the valuation would otherwise be for an empty building, due to the combination of tenant credit and long-term lease.
How will SLB impact shareholders, research analysts, activists?
Unlocking real estate value through multiple arbitrage is generally applauded by all stakeholders.
- For public companies, a sale leaseback can be a tool that shareholders and the investment community find quite compelling.
- Extracting real estate value from the business when there is a divergence in company versus real estate multiple can represent an astute capital allocation decision. By way of example, if a business trades at a single digit EBITDA multiple, a sale leaseback (with an effective multiple in the teens) will present a compelling value creation opportunity and is often accretive to earnings per share as well.
- Many public companies have significant levels of owned real estate, and evaluating some of that owned real estate with an eye toward monetization can create additional shareholder value.
There are many key questions to be asked when considering a sale leaseback as a capital alternative. Sale leasebacks can be a fantastic capital allocation tool, with many strategic and financial benefits for both publicly traded and private businesses.