White Papers

WHY EXECUTE A LONG-TERM NET LEASE IN TODAY'S MARKET?

U.S. companies own commercial real estate assets generally estimated to be worth over $3 trillion. Significant additional corporate real estate assets will be developed or acquired over the coming years. In addition, Federal, state and local governments, as well as many not-for-profit organizations own and occupy significant amounts of general-purpose real estate.

From financial and economic points of view, the question increasingly being asked is whether a corporation or other entity really needs to own its core real estate assets. Or, as an alternative, is it better off simply occupying those core assets under long-term leases, reinvesting the capital in expanding its business or buying back stock and leaving the risk of real estate to others, whose business is efficiently owning and financing real estate?

Historically, many companies insisted on owning all of their core real estate assets. The reasons ranged from fear of losing the control and/or upside in the assets, to concern about the perceived cost of leasing versus owning.

Yet it is interesting to note that retailers - who always have been the heaviest users, and most dependent on continued control, of real estate - have understood for decades that tying up corporate capital in real estate assets would prevent them from being cost-efficient and growing their businesses. Net leases provide companies with operating flexibility, long-term control and extraordinarily low cost of capital.

More recently, pressures on overall corporate profitability, low stock market prices, scrutiny of corporate accounting practices, and historically low long-term interest rates, have led many corporations - including industrial and service companies - to conclude that long-term net leases are the optimal way to finance their core real estate assets. This article will explore the reasons for entering into a net lease in today's market. While it focuses primarily on corporate users, much of the discussion also applies to governmental and not-for-profit entities, who are similarly concerned with making the most efficient use of the capital available to them.

A. Why enter into a long-term net lease at all?

By executing a long-term net lease, a corporation or other entity can accomplish the following objectives:

Convert a non-earning asset to 100% cash, for unrestricted redeployment in its core business or for other purposes. Real estate is a non-earning asset. In fact, it's actually a drag on earnings, due to the annual depreciation charge and the foregone use of debt and equity capital implicitly tied up in the real estate. By entering into a sale-leaseback or other net lease transaction, a company receives cash equal to 100% of the fair market value of its real estate. (By comparison, a conventional mortgage financing would yield it only 65-75% of fair market value, and the depreciation charge would remain in place.)

A sale-leaseback or other long-term net lease effectively frees up both debt and equity capacity for a company (in proportion to its debt-to-equity ratio). These funds can be redeployed directly into its business to produce yields at or greater than its Weighted Average Cost of Capital (WACC), - often meaning double-digit rates of return. By contrast, commercial real estate in the United States has on average appreciated less than 1% per year for the last 20 years.

Some companies will say they have no use for the additional cash, because they are not currently expanding their businesses (through acquisitions or otherwise). But this ignores the potential for stock buy-back plans or incremental cash dividends to the shareholders, either of which produces substantial financial benefits.
Achieve occupancy costs below its long-term cost of debt, below its WACC and below real estate market rents. For most investment grade companies, the Cost of Money in a long-term net lease transaction (the Internal Rate of Return produced by the rent, as a function of the up-front proceeds received) can be over 200 basis points below that associated with issuing a 20-year, unsecured corporate bond. (Although the Cost of Money calculation itself does not factor in that the company no longer owns the real estate at the end of the lease - as it would had it just issued a bond - the appropriate discount rate to apply to the foregone residual is so high (i.e., in the high teens) that the effective Cost of Money from the transaction, even take the residual value into account, would still be below the company's unsecured borrowing rate.)

Moreover, no company has unlimited borrowing capacity. For this reason, it is not just the company's cost of debt allocable to the real estate, but also its even higher cost of equity (as reflected by the company's overall debt-to-equity ratio) that must be used to compare the cost of owning the real estate to the cost of leasing. Therefore, the company's WACC (not its corporate debt rate) is the appropriate yardstick with which to make this measurement. The bottom line is that executing a long-term net lease, and reinvesting the proceeds over the term of the lease, even if only at the company's WACC, typically will produce dramatic net economic and GAAP benefits to the company.

It should be noted that within the context of leasing itself, some strategies are less efficient than others. For example, executing a short-term lease (less than 15 years) with a developer or other conventional real estate operator is substantially more costly to a company than executing a long-term net lease for a core asset with an institutional net lease investor. The reason is that the long-term nature of the net lease reduces much of the investor's risk in the transaction, other than that of the corporate credit. A developer's or conventional operator's debt and equity, on the other hand, must be compensated for the increased operational and residual real estate risk associated with owner obligations and a shorter lease term.
Keep the asset off-balance sheet. A long-term net lease can be reported for accounting purposes as an operating lease, in which neither the asset nor any liabilities are shown directly on the balance sheet. A footnote to the balance sheet shows net rent payment obligations. This off-balance sheet treatment reflects that there has been an actual transfer of economic ownership. At the end of the lease, the company can either vacate the property (with no guaranteed residual or termination payment) or exercise one or more lease renewal options. Effectively, the company has eliminated the downside risk of property ownership, while retaining the right to continue to use the property in its business at rents that may be fixed today.
Match long-term assets with long-term, fixed-rate liabilities. Real estate is a long-term asset. To finance such an asset with short- or medium-term funds (e.g., commercial paper, bank borrowings, or even 5- or 10-year corporate bonds) exposes a company to interest rate and refinancing risk during the life of the asset. Conversely, a long-term net lease insulates the company from these risks, by providing it with fixed-rate financing for the entire 15- to 25-year primary term, as well as potential fixed-rate renewal options for an additional 20 years or more, without CPI or other unknown rental increases.

With long-term interest rates at historically-low levels, this is an ideal time to lock-in a fixed rate net lease.

Enjoy ownership-type flexibility and control over the real estate, typically for up to 40 years. A long-term net lease typically provides the corporate tenant with close to the same operational flexibility as if it owned the property outright. This is because, unlike most developers or other conventional real estate owners (who tend to get involved in the day-to-day management of the property), the net lease investor is essentially a passive player. Its primary interest is to collect the net rent and to be comfortable with the long-term residual value of its investment.

In addition to the right to use and alter the property as reasonably needed for its business (provided long-term value or character is not destroyed), the company typically has broad rights of sublet and assignment (without an obligation to share resulting profits with the landlord), and in some cases the right to substitute another property or terminate the lease early if the property becomes uneconomic. As mentioned above, the company can typically enjoy this control over the property for 40 years or more.
Retain certain repurchase rights. For off-balance sheet net lease transactions in which the company has never owned the real estate, the company is permitted under GAAP to have an option under the lease to purchase the property for fair market value at lease expiration. In contrast, for sale-leaseback transactions (i.e., where the company has previously owned the real estate) a purchase option would preclude off-balance sheet operating lease treatment. However, the company can have a continuing right of first offer to purchase the property, as well as the renewal options described above.
Off-load real estate downside. As indicated above, the tenant in a net lease has no obligation to buy the property or to make any other payment at termination. It can either renew the lease or vacate the property. Because real estate values vary with constant shifts in markets, technologies, logistics and work environments, the value of a given asset can decline significantly over time. Even professional real estate investors have lost substantial amounts when their timing or strategy has been flawed.

For companies whose core competency is not investing in real estate, the assumption of this downside risk is not an optimal use of corporate capital, nor one its shareholders are paying it to take. Institutional investors are willing to assume this downside risk because they are in the business of timing markets, and also hold large portfolios of net lease assets, thereby diversifying against the risk of any particular property. Net lease investors have the further protection of the long-term net lease to ride out periods of market volatility.

B. Why enter into a long-term net lease now?

Entering into a long-term net lease can be beneficial in almost any market. Several current market conditions make this execution particularly compelling at this point in time:

Long-term Treasury rates are at historical lows. Rental rates for long-term net lease transactions are priced in close reference to long-term Treasury rates, particularly the 10-year Treasury. With the 10-year Treasury below 5% and the 30-year Treasury below 6%, the net lease market provides a unique opportunity for companies to lock in long-term, fixed rate rentals at low rates, with no CPI or other hidden increases and no continuing interest rate exposure.
Many real estate markets are descending from their cyclical peaks, making this a prudent time to divest. As the effects of the economic down-cycle work their way through the U.S. real estate markets, rental rates and real estate asset values have generally declined or are declining. However, net lease buyers are less concerned with potential short-term declines than other investors, due to the long-term nature of the lease obligation. Because the amount of sale proceeds from a net lease transaction bears a direct relation to current rents and values, companies will benefit by acting now to monetize their real estate, so as not to risk further declines in these markets.

U.S. Realty Advisors, LLC (USRA) is one of the leading owners of single-tenant, net leased properties in the United States with both investment grade and sub-investment grade tenants. With more than $2.7 billion of assets currently under management, and acquisition volume that has exceeded $500 million per year, USRA offers a broad range of executions, often with the deepest and most competitive sources of capital available. The track record of USRA's professionals in structuring creative solutions for corporate clientele, based on over 150 years of combined experience in real estate, investment and commercial banking, law, tax and public accounting, is known throughout the industry.