Banco de México's Governing Board initiated a series of rate cuts, beginning with a 25 basis point reduction in the overnight interbank interest rate to 11.00%, effective March 22, 2024. This move marked the start of an anticipated trend, with Fitch Ratings as well as BBVA research both projecting further decreases to 9.25% by the end of 2024 and a target of 7.50%-7.25% respectively by the end of 2025.
The impact of the interest rate reductions is expected to be significant across various sectors, including the sale leaseback market. This article explores possible impacts that rate cuts will bring to private equity firms and private companies.
One of the primary effects of lowering interest rates is the decrease over time in capitalization (cap) rates across the commercial real estate sector. The full effect is typically not felt for at least a number of months as the market takes a while to adjust. This impact is similarly felt within the sale leaseback market. Capitalization rates, or cap rates, are used to estimate the return on investment properties. When interest rates drop, borrowing costs decrease, making real estate acquisitions cheaper to finance, thus generally leading to lower cap rates as buyers can afford to pay lower cap rates when their cost of debt is lower. This trend is beneficial for investors looking to acquire properties using at least some leverage (debt financing). The movement is also positive for sellers, as prices tend to go up during these times when more buyers enter the market and increase the competition for available inventory, while paying lower cap rates for the same assets, which raises property valuations.
For private equity sponsors, a decrease in cap rates can enhance the multiple arbitrage opportunities between a potential sale leaseback multiple and a company valuation multiple. Multiple arbitrage occurs when there is a positive difference between the company’s real estate or sale leaseback multiple and the EBITDA multiple of a company. The lower the cap rate, the higher the inverse multiple becomes for the sale leaseback. And therefore the greater the opportunity for arbitrage becomes.
The lower interest rate environment encourages both activity on the M&A side, as capital becomes cheaper, as well as in the sale leaseback market for private equity firms, allowing them to take advantage of the potential spread in multiples and maximize their returns through this type of financial engineering, making them more competitive during an M&A bidding process.
The anticipated reduction in interest rates and predicted subsequent decrease in cap rates create a favorable environment for portfolio companies and owner operators as well. This is due to the potential increase in sale leaseback proceeds derived from lower cap rates, which provides more capital for companies that can increase their financial flexibility, enabling them to invest into growth initiatives and optimize their balance sheets, amongst other benefits that the additional liquidity may provide.
Private equity firms and their portfolio companies have successfully utilized sale leasebacks in Mexico for some time already, as demonstrated by case studies from Ascension’s track record. For instance, a strategically structured industrial sale leaseback in Querétaro allowed a manufacturing company to unlock capital tied up in its real estate at an attractive cap rate multiple, and the proceeds were then used to pay down expensive debt and fuel operational initiatives at the company.
Similarly, another success story involved a manufacturing and assembly facility, where the sale leaseback strategy provided the owner with significant capital, facilitating expansion and technological upgrades. This approach not only strengthened the company’s market position but also improved its competitive edge in the industry.
As Banxico continues to lower interest rates throughout 2024 and beyond, the sale leaseback market in Mexico stands to benefit significantly. The expected decrease in cap rates will create more attractive investment opportunities, enhance multiple arbitrage for private equity firms that own corporate real estate assets in Mexico, and provide portfolio companies and owner operators with accretive capital. The examples from Ascension Advisory’s experience highlight the potential benefits and successful implementation of sale leasebacks in the region, signaling an even more promising outlook for this financial strategy in the lower interest rate environment to come.
Learn more about how private equity firms and their portfolio companies can utilize the sale leaseback strategy by reaching out to our team today.