Key Takeaways
· Lenders can still lend, and deals can still get done even amid higher rates and tougher terms.
· SLBs remain a great financing tool in all economic climates.
· Expect a very active second half of 2023.
While many are predicting hard times ahead for commercial real estate – and those that finance it – sale leasebacks (SLBs) clocked in with record volume in 2022. As ConnectCRE reported: “Robust 2022 dealmaking was driven by multiple factors including the prior year’s record M&A activity, buyers’ strong appetite to deploy capital, and SLB’s attractive cost compared to other forms of capital.”
A similar trend seems to be playing out in Europe. As a recent Jones Lang Lasalle report stated, corporate disposals of real estate in EMEA in 2022 are well ahead of its historical 10-year average. “Our analysis shows that the sale and leaseback of owned properties remain an attractive and viable route to raising capital, providing both considerable operational flexibility as well as an exit route for surplus assets,” JLL stated.
From where I sit, volume was definitely up from an activity standpoint, even if the deals getting done were at a higher cost of capital. The volume trend is largely driven by SLBs remaining an attractive alternative to bank financing, especially when they’re used for financing M&A deals. We’re working on more SLBs in conjunction with M&A deals in which the sponsor’s traditional lenders are pulling back substantially on their terms, and lending more than a full turn (less leverage) for example, than where they were lending before. This leaves a gap in the cap stack.
SLBs have been able to fill that gap, at least for targets and businesses with company-owned real estate. In fact, GlobeSt reported that SLB transaction activity remains at or near its all-time high, driven by the strategy’s ability to provide “extra liquidity during tough times.”
SLB’s time to shine
I still see that many private equity (PE) investors and business owners remain skeptical about SLBs, especially when it comes to understanding the level of proceeds that we can generate through this strategy. This is especially important for business owners who tend to rely solely on appraisals to base the estimated value of their real estate. But when we put a long-term lease in place with a decent credit, especially if it’s soon to be backed by private equity, we’re instantly creating value above and beyond what the actual buildings and land are worth. When you evaluate a SLB valuation against some old appraisal that the seller is tied to - that’s the shock factor.
For example, a seller may think their property is worth $8 million based on what their appraisal says, but we can generate $12 million for the acquiring PE firm thanks to the long-term lease and the credit bump upon acquisition (even more dramatic if this is an add-on to a larger platform). This is the SLB spread that we’re talking about.
As GlobeSt opined about SLBs: “Does a ‘great tool in really uncertain times’ sound too good to be true? The increasing numbers of corporate real estate owners making the move don’t lie.”
In my experience, as long as the SLB rents aren’t above market and as long as the lease terms aren’t otherwise off-market or burdensome on the business, you’re not going to be penalized when you go to sell the company. Most private equity firms either don’t want to, or cannot own real estate, so they’d generally prefer to have real estate handled separately from their acquisition of the OpCo. And strategic acquirers typically will not allocate value anywhere close to the SLB valuation, if they must buy the real estate as part of their acquisition.
It’s really about looking at real estate ownership vs. long-term lease as being roughly equivalent for the operating business. Further, you can structure for this tradeoff with flexible lease terms in the negotiated lease agreement. This is effectively what you’re giving up as the properties have often been fully depreciated by the time we get involved. Given the nature of the assets we’re dealing with, most owners are not banking on any significant appreciation of the real estate.
Prediction: Expect very active second half of 2023
In the private equity world, we’ve been seeing much more on the M&A front in the past 45 days than we did late last year and earlier this year. In late 2022 and early 2023 pretty much everything we were involved in was a smaller add-on to a larger PE platform. Lately though, we’ve seen many more CIMs for larger businesses, generally platform deals. This is a good indicator that we’ll be seeing more M&A platform transactions close over the summer after accounting for the typical two to three-month lag. I suspect we’ll be doing a lot more SLBs in tandem with M&A deals that are funding larger platforms – alongside smaller add-on activity that dominated last year.
Last year, most of the smaller add-on activity could be attributed to family and founder owned businesses trading hands to private equity acquirers. In many cases, it was because aging owners of many family-owned companies saw the writing on the wall and wanted to exit before financial conditions tightened. That’s understandable, since at their stage of life, they wouldn’t want to withstand another full business cycle. Now, we’re seeing more sponsor-to-sponsor activity. While the PE firms may still not want to exit a big platform if they don’t have to, they also know they must do deals and return capital to their investors. They can’t sit patiently on the sidelines, especially for many of our clients who were pretty quiet in terms of activity in 2022. I expect to see these kinds+ of deals picking up later this year, based on the early indicators we’re seeing.
For instance, more of the big PE players are getting back into the market after taking a pause last year amid so much volatility. Six to twelve months ago, there were a great many unknowns. Today at least everyone knows where we are in terms of interest rates and inflation. Lenders can still lend, and deals can still get done even amid higher rates and tougher terms. The time when it’s hardest to get deals done is when there’s great uncertainty and lenders are just sitting on the sideline “waiting it out.”
Another reason I anticipate deal activity picking up in the second half of 2023 is that many of our clients are fundraising now. They wouldn’t be raising capital for new funds if they weren’t thinking about exiting their prior funds and returning that capital to their investors. So, this also means potential PE exits on the horizon.
S&P Global Market Intelligence found that despite a weak first quarter overall for North American M&A, March 2023 showed signs of resurgence with nearly $137 billion in M&A deals signed – twice the level of February and 10.8% higher than March of 2022. Meanwhile a Blackrock Alternative report indicated that investors are keen to increase their private market allocations.
Conclusion
SLBs remain a great tool in all economic climates, including uncertain times. If you’re interested in evaluating creative strategies to fill your financing needs, don’t hesitate to reach out.