A few days ago, I wrote a bullish article on Iron Mountain (IRM). In it, I explained that the REIT "has around $2.5 billion of 'owned' real estate at its disposal." So, it could theoretically "sell all of its 'owned' real estate and lease it back."
I went on to explain that:
"As far as I'm concerned - given the global demand for data storage - Iron Mountain should take a much closer look at monetizing its owned real estate to drive shareholder value. But to be clear, I'm not an activist, merely a suggestivist!"
Today, I thought I'd take a closer look at the larger concept of a sale/leaseback. That way, you can get more color on the value creation potential in Iron Mountain's properties - not to mention the significance of the asset monetization tool.
It's an extremely interesting way of doing business.
For starters, a sale/leaseback is an arrangement between two parties:
According to the Journal of Accountancy, benefits for the seller-lessee include:
Benefits for the buyer-lessor include:
Then, there are the disadvantages. As Fountainhead Commercial explains, there are "potential tax liabilities associated with capital gains that you may be responsible for after the sale of your property."
In addition, you won't "be able to leverage any depreciation benefits" anymore. And you forfeit "any future appreciation." That's why it's important to work within a robust market and not the bottom of a cycle.
With that said, keep in mind that there are plenty of options when it comes to sale/leaseback structures, such as:
The primary benefit for the seller (and new lessee) is that it can convert an illiquid fixed asset into cash and increase its working capital. This not only provides the seller-lessee money to work with… It also enables the entity to increase its current ratio of current assets to fixed assets.
That then makes the seller-lessee appear more creditworthy to conventional short-term lenders. And, in this pandemic-marked cycle, that can be extremely beneficial, as the company can then enhance its liquidity position.
As you'll discover below, companies like Iron Mountain, Home Depot (HD), Lowe's (LOW), Tractor Supply (TSCO), Dollar General (DG), Cracker Barrel (CBRL) and hundreds of others are sitting on massive corporately-owned real estate. They could easily earn higher returns on their core business as compared to investing their capital in owned real estate.
The sale/leaseback alternative provides the occupier 100% of the value of the property. Traditional mortgage financing, however, usually offer around 65% loan-to-value.
In addition, the gain realized from a sale/leaseback transaction can be amortized on the corporation's income statement. This then increases reported earnings, which can potentially improve the firm's financial ratios and margins.
Empirical evidence shows that a sale/leaseback property sells for a premium of 13% relative to comparable non-sale/leaseback properties. In addition, rental payments are 100% deductible against the company's taxable income versus only the interest portion of a mortgage payment.
A few examples of companies in REIT-dom that have gone this way are:
Clearly, they all found it worthwhile.
Consider United Trust Fund, which has a 40-year track record of originating sale/leaseback transactions. The following quote comes from its website brochure:
"The sale-leaseback often begins with companies recognizing that assets frozen in concrete and steel are neither good for the balance sheet nor a productive utilization of capital.
"Old economy or new, boom times or downturn, the demands of adjusting to shifting economic realities are exacting. Managing balance sheets must be done at the speed of business today.
"This requires efficiency and creativity. Now more than ever, businesses have a need to convert existing real estate assets into cash and find cost-effective and efficient alternatives to traditional debt to fund the costs of expansion, acquisitions, special investment opportunities, and construction of new facilities."
That's not to say a sale/leaseback is right for every company. But when it works, it works.
As of Q1-20, Iron Mountain had $7.95 billion in property, plant, and equipment.
As of Dec. 31, 2019, IRM conducted operations through 1,150 leased facilities and 298 owned ones. The owned properties were broken down as follows:
Theoretically, Iron Mountain could sell its entire owned portfolio for around $2.5 billion and lease it back at a 6.5% cap rate. This could provide it with meaningful growth capital to accelerate the data center platform.
Why 6.5%? We consider that reasonable for an industrial property leased to a sub-investment-grade tenant (IRM is rated BB-). Also, it's much cheaper than IRM's current weighted average cost of capital, or WACC, that we estimate at 9.5% (year one).
As stated earlier though, there could be considerable tax leakage, which wouldn't make the deal efficient. IRM would have to either utilize a 1031 exchange or use OP units.
Arguably, it could make more sense for IRM to de-REIT altogether and then spin the real estate off. Either that or merge the real estate with an existing REIT.
The goal here is for IRM to use its owned real estate (mostly warehouses) to create liquidity and reinvest the proceeds (tax free) into its higher-growth datacenter business.
So, the most logical path to profit is to find a suitable buyer (transact at 6.5% cap rate), and then exchange into properties that generate double-digit returns.
Withstanding the tax implications (assuming a 1031 exchange), a large sale/leaseback could drive meaningful value for IRM, possibly sparking a credit upgrade from BB- to BB. It also could accelerate profit margins and improve its payout ratio.
We believe the pandemic also could generate a wave of corporate sale/leasebacks, especially for sub-investment-grade companies. For many companies (e.g. Home Depot, Tractor Supply, etc.), the fastest way to grow initially is to own real estate.
Later though, they're often sitting on a lot of real estate and could easily tap into the sale/leaseback business to generate liquidity. That's one of the reasons we're so bullish with REITs like Realty Income, Store Capital, and W.P. Carey.
And stay tuned for our next article on The Art of the WACC (hint: Whoever has the lowest cost of capital wins the game).
Author's note: Brad Thomas is a Wall Street writer, which means he's not always right with his predictions or recommendations. Since that also applies to his grammar, please excuse any typos you may find. Also, this article is free: Written and distributed only to assist in research while providing a forum for second-level thinking.
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This article was written by
Brad Thomas is the CEO of Wide Moat Research ("WMR"), a subscription-based publisher of financial information, serving over 15,000 investors around the world. WMR has a team of experienced multi-disciplined analysts covering all dividend categories, including REITs, MLPs, BDCs, and traditional C-Corps.
The WMR brands include: (1) iREIT on Alpha (Seeking Alpha), and (2) The Dividend Kings (Seeking Alpha), and (3) Wide Moat Research. He is also the editor of The Forbes Real Estate Investor.
Thomas has also been featured in Barron's, Forbes Magazine, Kiplinger’s, US News & World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox.
He is the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, 2019, 2020, 2021, and 2022 (based on page views) and has over 108,000 followers (on Seeking Alpha). Thomas is also the author of The Intelligent REIT Investor Guide (Wiley) and is writing a new book, REITs For Dummies.Thomas received a Bachelor of Science degree in Business/Economics from Presbyterian College and he is married with 5 wonderful kids. He has over 30 years of real estate investing experience and is one of the most prolific writers on Seeking Alpha. To learn more about Brad visit HERE.
Disclosure: I am/we are long O, STOR, WPC, IRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.