Monday, June 29, 2015

Sale Leasebacks: Fact and Fiction

SALE LEASEBACKs (SLB) allow the separation of ownership from control in the use of real estate reflecting the comparative advantages of owners and operators. It has a long history in the hotel industry where the hotel groups manage the hotels which are owned by investors such as REIT. SLBs are undergoing renewed popularity in the challenged retail and restaurant industries by firms with substantial real estate assets including Macy’s, Sears and Darden. This is due, in part, to the recovery in real estate values since the bottom of the Great Recession in 2009. For example, Sears is using SLBs to fund continued operating losses to hopefully stabilize the firm. Darden transferred restaurants like Olive Garden to a REIT, and plans to use the proceeds to reduce its debt (probably not the wisest use of funds). Activists are pushing Macy’s to lever up by selling assets to a mall operator and leasing them back to fund a share repurchase.

There are many reasons, some real - others bogus, for using SLBs. Bottom line, SLBs are just another form of financing. Their value to the seller/lessee depends of the sale price, lease terms and ultimately on the use of the proceeds. Some bogus reasons include:

1)     Improve Balance Sheets by Reducing Assets:  need to distinguish accounting from real effects. In any event, accountants have gotten tougher about removing such assets from the balance sheet. Even if they do remove them they are disclosed in footnotes allowing analysts to adding them back.
2)     Improve Debt Ratios: again unlikely as the rent obligations disclosed in footnotes are easy to add back. Most analysts focus on EBITDAR (earnings before interest taxes depreciation amortization and rent) over funded debt plus lease debt.
3)     Monetize Equity: This may, however, trigger possible capital gains taxes. You can structure the transaction to avoid true sale treatment to avoid taxes. This usually complicates achieving off balance sheet treatment for accounting purposes. Finally any book gain realized will be given back in the new higher lease terms.
4)     Increased Debt Capacity: giving up residual ownership and flexibility.
5)     Improved Focus: this may have some merit if the buyer/lessor has a comparative advantage in managing/owning the real estate AND is willing to share some of that with the seller. There may be a benefit in expressly charging an explicit rent to better reflect true operating performance.

As long as the sale price and lease terms are fair, which you would expect in a large relatively efficient real estate financing market involving sophisticated parties, there is unlikely to be any value created. You need to compare SLB against alternative functionally equivalent secured real estate financing (e.g. mortgage) to determine if market conditions may favor a SLB over a mortgage.

The second step is to review the use of the proceeds raised by a SLB. These include:

1)     Capital Structure Change: use to reduce debt in a potentially over leveraged situation like Darden. This was not well received by shareholders (possibly reflecting a decrease in Darden’s tax shield and reduced debt discipline). Alternatively, increase leverage in an under leveraged situation by repurchasing shares as activists are suggesting for Macy’s.
2)     Fund Operating Losses as in Sears
3)     Finance an Acquisition/LBO using an Opco-Propco structure as reflected below:

Be careful of free lunch arguments when evaluating SLB pitches from investment bankers (e.g. Mesirow ). Focus on how the transaction impacts firm cash flows and risk to determine the value impact and not the accounting. Finally, no matter how good the SLB, the key is the use of the proceeds.


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