In this installment of Farm to Frozen, we will explore a creative way for owner/occupiers of existing cold storage to unlock equity in their real estate. This method, called a sale-leaseback (SLB), offers several advantages to owners seeking to retain occupancy of their facility, unlock cash, deleverage their balance sheet and lock in occupancy costs.
Why a Sale-Leaseback?
A sale-leaseback is a strategic arrangement where an owner sells a property to a buyer and subsequently leases the property back from the same (new) owner. In real estate, it is common to arrange a short-term leaseback when the occupying company is transitioning between locations. For example, a manufacturer selling an existing location after the delivery of their newly constructed facility may require a transition period of double occupancy in order to facilitate the move of equipment and starting up operations. Another reason for a short-term sale-leaseback would be a company that plans to build a new facility but does not have the capital for a new facility without first selling their existing facility. They would sell their old facility, while remaining an occupant during the construction of the new facility.
Long-term sale-leasebacks are usually done for different reasons, however, with rising industrial values, companies may be in a position with much more equity in their building than anticipated. If the interest rate environment is not conducive to a more typical refinance strategy, the company can deleverage by pulling equity out for company growth via a SLB with a long-term lease period. This is also a valuable strategy for rearranging partnerships and ownership structures. For example, there may be legacy or original founding member heirs who have ownership stakes but wish to exit the company and a sale-leaseback would create a capital infusion event, without requiring other partners to come out of pocket for the purchase of the departing shareholders.
How to Structure a Sale-Leaseback
To understand the relationship between sales price and post-sale rental rate, it is important to familiarize yourself with the concept of capitalization rates, or “cap rates.” A cap rate is simply the measure of net operating income (in this case base yearly rent, assuming a triple net lease for a single occupant building), divided by the sales price. A rent of $10,000 a month, with a sale price of $1 million would be a cap rate of 12%. The math: ($10,000 x 12 Months) / $1,000,000.
Depending on many factors, like market conditions, property condition, interest rates and creditworthiness of the occupier (the current owner/future tenant), cap rates can reasonably range between 5.5% and 9%, currently. Again, these ranges are illustrative only in nature, and can depend wildly on the specific situation.
As an owner, you may have a target sales price, in which case you would apply an appropriate cap rate to determine the rent a willing buyer would accept a lease. For example, if $50 million is the target sales price for a 150,000-square-foot building, using an 8% cap rate, would be a sales price of $50 million with approximately $26.66 per square foot for base rent.
[8% cap rate x $50 million sales price = $4 million annual rent; $4 million annual rent/150,000 square feet = $26.66/PSF]
If, on the other hand, a manufacturer wants to lock in occupancy costs at $20 per square foot for the same building, with the same cap-rate, they would be looking at a sales price of $37.5 million. [$20/PSF x 150,000 square feet = $3 million annual rent; $3 million annual rent/8% = $37.5 million sales price]
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Finding a Broker to Market your Sale-Leaseback
The Farm to Frozen series has discussed s the importance of specific knowledge experts and unlocking the greatest amount of equity through the purchase price is no exception. Finding a great broker to market the property for a SLB is hypercritical. The nuance here is that the broker is actually marketing and representing the owner in two distinct transactions. That is, the investment sale of a leased property, as well as the leasing transaction between the purchaser and previous owner-occupier. Taken holistically, the broker needs to understand the levers between the two transactions in order to achieve the best outcome overall. For example, is maximizing the sales price, at the risk of manufacturing an inflated above market rental rate worth it? Or, consider the flipside: Is giving yourself a sweetheart deal on the rent worth sandbagging the sales price?
Make sure when searching for a broker, they understand both your business needs (operating and occupancy costs) as well as the dynamics of your local real estate market.
“Unlike a traditional property sale, SLBs aren’t’ apples to apples’ and don’t have perfect comparable. Therefore, the underwriting process and the knowledge that the chosen broker must possess to properly do so is very important,” said James Watkins, net lease advisor at CBRE. “When looking at a sale leaseback candidate, I use the operating companies P&Ls and generated EBITDA as the basis for backing into the value of the real estate. For our clients, we underwrite the future annual rent in the range of two to three-and-a-half times EBITDA coverage to ensure the rent can be supported by the operating company long term. If a client’s company does $3 million in EBITDA; we want to target an annualized rent of not much more than $1.5 million.”
If you feel you have identified a group of brokers that understand these nuances, then select the one broker with the broadest reach and bias towards activity level. Typically, the most active broker is the one with the most current understanding of the market dynamics.
Selecting a Buyer and Future Landlord
If you are in the lucky position to have more than one offer on the table for a future property owner, consider this group's current portfolio. Do they have buildings similar to yours? Are they well connected to various cold storage vendors that can help you on an ongoing basis? Also, consider their funding sources: Is this an institutional money manager with deep pockets? Alternatively, is this more of a nimble high-net-worth family office? There are pros and cons to each. An institutional group can transact quickly and can offer more certainty to close, however ongoing ownership can feel disconnected and bureaucratic. Family or locally owned type of shops might not have as deep of pockets but can make the process more flexible and empathetic to your needs as a business.
Remember, you are actually solving for two transactions here. If you negotiate too strongly on the sale, that might set a negative tone for lease negotiation and your ongoing relationship with the future property owner. All things being equal, you want a friendly and professional relationship with your property owner. You never know when you might need to call upon a favor.
In Conclusion
Before wrapping up, it is important to touch briefly on two other methodologies that can help F&B manufacturers unlock existing equity. One, which many owners have already had experience with, is refinancing. In today's environment, refinancing might not be an option worth considering, however even with high interest rates, there are still certain situations where it is worth pulling out equity through the form of a new loan. Finally, consider partial sales of equity to new or existing partners. Though far more complicated and sometimes impractical, selling equity to other shareholders can allow an owner/occupier to unlock some existing equity, while retaining the balance of ownership and can be least disruptive to ongoing operations.
A sale-leaseback is, in my opinion, an underutilized strategy for owner/occupiers to shift the balance sheet focus back toward the business. It is not uncommon that as business owners spend their time and energy focusing on growing their business, they unknowingly realize tremendous appreciation in their real estate holdings. Each circumstance is unique, however many owners find that the rate of appreciation of their real estate is lower than the return on invested capital in their business. This leads to the determination that funds are better allocated towards business growth and research and development, rather than retaining and maintaining real estate. If this sounds like your business, consider a sale-leaseback to find those funds and better organize your occupancy costs.
