The Art Of The Sale/Leaseback

Summary

• The primary benefit of a sale/leaseback for the seller is that it can convert an illiquid fixed asset into cash and increase its working capital.
• In this pandemic-marked cycle, this option can be extremely beneficial, giving the company enhanced liquidity.
• The sale/leaseback alternative provides the occupier 100% of the value of the property. Compare that to traditional mortgage financing, which is usually around 65% loan-to-value.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

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.

Explaining Sale/Leasebacks

For starters, a sale/leaseback is an arrangement between two parties:

1. One party (the seller/lessee) that owns an asset sells it to a second party (the buyer/lessor).
2. The seller/lessee leases the asset back from the buyer/lessor.

According to the Journal of Accountancy, benefits for the seller-lessee include:

• An immediate inflow of cash that can be deployed in some area of the entity's business.
• A cheaper form of financing.

Benefits for the buyer-lessor include:

• Reduced default risk from being able to directly investigate the seller-lessee's credit.
• The ability to more easily terminate the contract than would be the case under conventional financing.
• Important tax advantages.
• Guaranteed residual value at termination.

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:

• Gross Lease: New owners generally pay all additional costs, ranging from utilities to taxes, maintenance, and insurance.
• Net Lease: New tenants pay for most variable costs including maintenance, taxes, and insurance. A new owner often pays for roof and structure maintenance. Or sometimes, a cap is negotiated for certain expenses.
• Bondable Lease: Tenants pay full rent for the lease term, even if the building is uninhabitable following a casualty, becomes otherwise condemned property, or is resold by the buyer.

Source

More to Know About Sale/Leasebacks

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:

• Monmouth (MNR) acquired (and is acquiring) properties from FedEx (FDX).
• W. P. Carey (WPC) pioneered the sale/leaseback as a mainstream form of financing in the U.S. It's been a leader in introducing sale-leasebacks to corporations and governmental entities throughout Europe and now in Asia.
• Realty Income (O) expanded into international markets starting with a strategic sale/leaseback with Sainsbury's (OTCQX:JSNSF), a leading grocer (founded in 1869) that operates over 1,400 grocery and convenience stores across the U.K. and Ireland. The company also acquired 7-Elevens.
• STORE Capital (STOR) acquired stores via a sale/leaseback from Bass Pro, Camping World, and Stratford School (now Spring Education).
• National Retail Properties (NNN) acquired (and is acquiring) Bloomin' Brands (BLMN), restaurant properties.

Clearly, they all found it worthwhile.

A Leader in the Game

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."

Source

That's not to say a sale/leaseback is right for every company. But when it works, it works.

The Iron Mountain Example

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:

• U.S. - 179 facilities amounting to 20.68 million square feet
• Canada - 16 facilities amounting to 1.78 million square feet
• International - 103 facilities amounting to 5.84 million square feet.

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 Most Logical Path

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.

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.