SALE and LEASEBACK Opportunity in a Nascent Market

REAL ESTATE DEBT SALE AND LEASEBACK Opportunity in a nascent market

With a potential size of €1.1trn, investors have good reason to examine sale and leaseback deals for strong risk-adjusted returns. By Max Mitchell and Chris Nichols of ICG

What is a sale and leaseback transaction?

QMax Mitchell: In the simplest Property title transfer terms, if a company undertakes a sale and leaseback (SLB) transaction, it sells some ICG (Investor) Corporate Obligor Lease payments or all of its real estate assets to a third party Buyer/ Owner Seller/Tenant and remains in the premises as a tenant, most often via a long-term lease. Leases are Cash purchase triple-net in nature, meaning that the lessee is responsible for repair, maintenance, insurance and property taxes. corporates when thinking about financing a trend which we believe will continue solutions. The European Union’s BEPS throughout the rest of Europe. Why would a business be motivated to action plan includes an Anti-Tax Avoidance Q undertake an SLB transaction on its real Directive which came into force at the MM: There is a huge market opportunity estate assets? start of 2019 and essentially reduces the for SLB in Europe. In numerical terms Chris Nichols: SLB is an alternative form level of financial interest expense that can (excluding the UK) we estimate the value of financing available to corporates. In our be deducted for the purposes of calculating of the owner-occupied corporate real estate experience, a corporate is typically using corporate tax from 100 percent of market to be €5.5 trillion. When considering the capital raised to positive effect within EBITDA to 30 percent of EBITDA. Lease average annual SLB volume in Europe is the business by reinvesting proceeds into payments, by contrast, are operating approximately €7.5 billion, it would take growing it. expenses and are fully deductible. the equivalent of 147 years just to normalise When comparing potential sources the European market to current US levels. of financing, there are a number of What market opportunity do you see good reasons for management teams Q for SLB in Europe? Why is the European SLB market rela- and shareholders to consider an SLB CN: The SLB market in Europe is set Q tively under-penetrated in comparison transaction. Perhaps the most obvious is to grow significantly, as traditional with the US market? the fact the full value of the assets can be corporate lenders continue to operate CN: There is not a definitive answer to realised, whereas capital raised by taking in an increasingly challenging regulatory this question. What’s clear is that we can’t out a commercial mortgage would only environment and businesses look to find any structural reason for the differ- unlock a portion of that value (typically alternative funding sources such as SLB ence. Largely we think it relates to a cul- 50-60 percent of its value versus 100 in order to drive growth. tural difference in as much as European percent with SLB). A fundamental part of the market The other major consideration that opportunity relates to owner occupation “IN NUMERICAL TERMS we hear a lot from shareholders and of corporate premises. In Europe it is (EXCLUDING THE UK) WE management teams is that they see SLB high at over 69 percent whereas in the ESTIMATE THE VALUE OF as a “long-term” financing solution as there US, where there is a long-established SLB THE OWNER-OCCUPIED is no refinancing horizon and therefore no market, that figure stands at 50 percent. refinance risk associated with traditional There is no good reason for this structural CORPORATE REAL ESTATE bank financing. disconnect and in parts of Europe (eg, MARKET TO BE €5.5 Additionally, recent regulatory changes Scandinavia), we have recently seen a TRILLION” have created further benefit for certain significant reduction in owner occupation, Max Mitchell

30 Private Debt Investor | May 2019 SALE AND LEASEBACK

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ICG-London-2-042019.indd 6 11/04/2019 13:03 REAL ESTATE DEBT SALE AND LEASEBACK

companies are used to owning their assets financial track record and corporate Max Mitchell and because of this, tend to have more of strategy. It is also important to consider an attachment to them. Whereas in the downside scenarios and evaluate what US, people are much more comfortable alternate use a property might have should with the idea of taking a commercial view it be vacated by the incumbent lessee. and monetising their business premises in order to optimise the efficiency of their What are the attractions of such an balance sheet. Q investment strategy from a returns perspective? MM: Of course, Europe is also fragmented CN: SLB is a high-cash-yielding invest- on a regional basis, requiring a much Chris Nichols ment. Typically, over 70 percent of returns greater breadth of expertise in order to are generated from highly predictable cash successfully navigate the individual markets dividends arising from a diversified portfo- and legal jurisdictions. To be successful in lio of long-term leases. Unlike traditional SLB in Europe, investors really require the real estate investment, the long-term leases necessary local presence for origination minimise leasing risk and rental voids. as well as local expertise in order to SLB also produces inflation-protected maximise their returns. This fundamental returns because the underlying rents requirement has proved (and we believe it benefit from annual contractual uplifts will remain) a significant barrier to entry either through CPI or pre-set increases. for SLB investors. SLB transactions to businesses that might The rental uplifts can enhance value not otherwise have considered it, thereby leading to a capital appreciation of the Do you anticipate the SLB space becom- expanding the universe of potential deals. underlying asset and increased returns. Q ing more competitive in Europe? What We are confident that as a first mover in would the implications of this be for ICG? the space in Europe, we will benefit the What are the exit options for an SLB MM: In our view, yes, it is unlikely that most from the market growth. Q fund? the market will remain as under-pene- MM: If a manager is careful to negotiate trated as it is now. As mentioned above, What attributes are you particularly long-term, triple-net rental agreements, however, barriers to entry are higher Q looking for when sourcing an SLB deal? or ensure that there are terms that oblige in Europe than in the US, so we do not MM: A number of things, but one crucial the extension of those agreements, then foresee a transformation overnight. While factor is the importance of the property there should still be a long-term lease in increased competition is never at the top to the ongoing operations of the business. place at exit. of my wish list, we believe that having We want access to and occupation of the A well run SLB fund will benefit more professional asset managers active property to be essential to the lessee from a diversified portfolio of long-term in the space would benefit everyone; the company for the ongoing success of their inflation protected income secured against opportunity is so massive that having more business. This results in a true partnership co