Mr. Clark

Finance & Investment

Investment Overview: Sale-Lease-Back - Why more and more hoteliers are drooling over this alternativ

By Bryan J. Clark, President & CEO, Lion CFC Inc

Sale-leasebacks have long been used as funding and leverage tools by hotel owners and owners of commercial real estate in general. Although sale-leasebacks were once perceived to be a last resort for the acquisition or refinancing of commercial property, sale-leasebacks have grown in popularity as corporate attachment to property ownership has softened. Many benefits of a sale-leaseback are clear and easy to understand while others are not so transparent.

First it should be noted that cash is widely accepted as the strongest asset on the balance sheet. When utilizing a sale-leaseback on commercial property, the balance sheet is improved by exchanging fixed assets (real estate) that are often carried at a below market value, with cash thereby presenting the company in a stronger financial position. Additionally, the property value risk and management hassles are transferred to a third party (the buyer/investor). As property has moved up the hierarchy of corporate decision-making, off-balance sheet finance and capital sourcing including sale-leasebacks have become a hot topic among financial officers and treasury departments across the globe. Since most sale-lease backs are cash transactions, there are no lender conditions to deal with allowing transactions to close in a matter of weeks, not months.

As more and more residential mortgage companies, life insurance companies, and pension funds feel the effects of the so called "subprime mortgage meltdown," credit is getting tighter and traditional financing sources are drying up. More and more companies from large hotel operators to small private hoteliers are becoming more creative in their finance structures. Virtually all of the largest hotel companies and chains have begun seeking alternative capital sources, primarily sale-leasebacks. The process of converting real estate assets into cash is a technique that has been used for decades by hotel owners who own real estate that is not essential to their core business plan and day to day operations. Expanding hotel operations into new markets or adding additional hotel brands in current markets can be extremely difficult when credit is tightening and financing is not readily available. Many hotel owners see the sale-leaseback option as the best solution. When structured properly, a sale-leaseback provides access to "usable" cash immediately while improving the company's debt-to-equity ratio and reducing depreciation expenses, again, presenting the company in a stronger financial position.

A Sale-leaseback, by definition, can be understood by its very name. A sale-leaseback is accomplished by selling a real estate holding (in this case a hotel) to a 3rd party investor while simultaneously signing a lease to "lease the property back" and maintain usage and occupancy rights to the property. Since the property is being sold, and then immediately leased back from the new owner, a good portion of the tax liability can be deferred. In the case of tax write offs, only the interest portion of a mortgage payment can be written off. With a lease, the entire lease payment is a write off because it is technically a lease. In most scenarios, the company selling their real estate in a sale-leaseback transaction is guaranteed full market value for their property thereby reducing the risk of any money being lost in equity. Secondly, the lease term will typically be from 15 to 25 years therefore the property will no longer need to be refinanced every 5-10 years which eliminates the uncertainty of fluctuating market rates and property values. Some sale-lease back investors/buyers will require minimum up lifts and periodic lease payment increases. These increases can be set to increase based on an agreed upon number of years, certain market fluctuations, or even price indices such as the consumer price index. However, there are many sale-leaseback investors that will simply fix the lease payment rate for the entire lease term and give options to renew the lease at the end of the term subject to specified market conditions.

Payment rates for sale-leasebacks can be across the board. However, getting the figures right is critically important. Often hoteliers hear that they can secure a 100% "cash out" sale-leaseback at 9% and think to themselves that they currently have a loan at only 6.5% or maybe even 7.5%. Clearly their first thought is that their cost of funds would have to go up. However, this isn't always the case. In fact, a 20 year lease with a "rent rate" of 9% gives the client a payment that is equal to a mortgage of roughly 6.58%, yet the property would provide the owner with 100% of their equity in the form of "cash out." Typically there won't be any sort of limit on the amount of "cash out" a property owner can get, and usually the seller does not have to itemize what they intend to do with the cash because fter all, this is technically a sale, not a loan.

With the exception of McDonald's (the largest owner of commercial real estate), most companies' long term goals are much more heavily focused on revenue and profit produced by their core business and operations than by the appreciation realized on their real estate holdings. Therefore, most Chief financial officers at the world's top hotel companies agree that in times of tight credit, the use of corporate funds for core business activities and operations makes more sense than keeping these funds tied up in non-liquid assets such as real estate.

It should also be noted that sale-leasebacks can also be utilized to construct new properties as well with zero or little equity needed. Some sale-leaseback investors and capital providers will even finance 100% of the cost of acquisition, or 100% of the cost of construction for "build to suit." In addition, it is also possible to finance the additional cost of equipment (FF&E) that may be needed for the property as well.

Typically an additional 20% (on top of the 100%) of the property's value or construction costs can be added into the transaction for FF&E, fees and other reasonable soft costs. Therefore it is possible to "strip" up to 120% of an existing building's value in the form of "cash out" or 120% of the cost to construct a new building.

When purchasing a building or property undervalue it is ideal to close on the property first through more traditional mortgage financing procedures, then immediately sell the property via a sale-leaseback. This allows the hotelier to purchase a property (sometimes at deep discount) and then immediately strip the "new found" equity via a sale-leaseback at full market value. Most sale-lease back products available have very little or zero seasoning requirements. Therefore it is possible to purchase the property at a price under market value and sell it the next day for market value via a sale-leaseback. Although sale-leasebacks are indeed a sale and then a lease, sale-leasebacks are typically handled by a financial institution or by a commercial lending expert that has working relationships with large hedge funds, equity partners, and other investment entities that have the immediate cash needed to successfully complete the transaction. Sale-leaseback transactions are underwritten similar to commercial mortgages, therefore it is best to choose a commercial finance consultant that has a firm understanding of all the working parts and parties involved in a sale-leaseback transaction.

Although underwriting criteria for sale-leasebacks vary from fund to fund or from investor to investor, the following is a guideline of what is needed and what to expect when setting out to find the right sale-lease back for your property. Acceptable property types typically include, although are not limited to, flagged and unflagged hotels, resorts, casinos, sports centers/arenas, shopping centers/strip malls, and restaurants. Investors usually prefer to stay away from high risk properties including adult themed properties. Fee simple properties are ideal, but properties on leasehold land are approved on a more limited basis. Of course a copy of the lease will always be required.

The net worth of the guarantor or the liquid assets of the borrowing company will typically need to be great enough to service at least one year of the annual debt service (annual lease payments). Additionally, the funds needed to satisfy this condition will need to be readily accessible and usually liquid. The investor wants to know that a company can service the debt portion for at least a year in the event the property has difficulty with cash flow. All guarantors or the elected management of the company or property will need to have a proven track record in the industry and will need to demonstrate sufficient experience to make the project successful. Debt service coverage ratios for the property will typically need to be between 1.2 and 1.5 although various specifics and nuances of the deal will almost always be taken into consideration. For example, a company or hotelier with a large amount of liquid assets may be granted a lower debt service coverage ratio whereas a project in a high risk area may be required to have a debt service ratio above 1.5. Other factors including management experience and property specifics are usually taken into consideration as well. The debt service coverage ratio is typically based upon actual leases already executed, or by a plausible pro-forma and feasibility study for a new/proposed project.

Applicable almost exclusively to hotel groups, many hotel owners have taken advantage of a sale-leaseback product that is available to virtually no other property type. Since the hotel business relies on turnover to produce revenue, it can be difficult to determine a suitable "rent rate." Therefore some investors/buyers that invest in sale-leasebacks offer to purchase the hotel without a guaranteed minimum rent set in the lease terms, effectively taking a risk on the success of the hotel. However, this typically requires some sort of equity sharing or joint venture agreement between the buyer and the hotel operator. This type of agreement would allow for hotel operators to pay less in slow months and more in months of high occupancy.

While sale-leasebacks provide so many benefits, it is important to consider all possible exit strategies before entering into a sale-leaseback transaction. Some investors will allow the property to be purchased back at specific dates; others won't provide such an option. Some investors give the option of purchasing the property back at fair market value on any of the anniversaries of the closing date, regardless of whether the property value has gone up or down. Clearly this is a point to include in your negotiations.

To recap, sale-leasebacks are an alternative capital source that "unlocks" equity that is currently tied up in real estate. A sale-leaseback allows the owner to sell the property and immediately lease it back thereby reaping the benefits of a sale while maintaining control of the property. Sale-leasebacks can be a lucrative solution for hotel companies who are looking to finance new growth, pay down debt, make an acquisition, or reallocate equity in a manner that provides a greater return than the real estate itself.

Bryan J. Clark is President and CEO of Lion Commercial Funding Consultants Inc. Lion CFC maintains relationships with real estate investment trusts, hedge funds, and a variety of private money pools. The firm is a leader in innovative alternative finance structures and solutions involving standby letters of credit, bank guarantees, medium term notes, bills of exchange, and "take or pay" contracts. Mr. Clark is a member of the Urban Land Institute and contributing writer to various monthly publications. Mr. Clark can be contacted at 858-602-8080 or info@lioncommercial.com Extended Bio...

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