“The best time to buy real estate is now, and the best time to sell it is never.” Real estate moguls have been preaching and practicing this adage for many years. Recently, however, many companies have been bucking that belief through sale-leasebacks. Sale-leasebacks of single-tenant property assets, valued at $2.5 million or more, reportedly grew 32.5% in 2017, according to Real Capital Analytics, a New York City-based research firm. A sale-leaseback occurs when a property owner sells its real estate (land and buildings) and as part of the same transaction leases it back under a long-term lease with the buyer/new owner.
Why are SLs so popular?
SLs have been popular for many years, yet as companies compete more aggressively today, the need to productively use capital makes SLs more attractive. To fuel growth, companies traditionally procure capital from a bank, providing one or more underlying real estate assets as security for the lender. However, since the Great Recession of the last decade, credit has increasingly become more expensive and more conservatively structured in favor of banks. Regulations such as Dodd-Frank have also made traditional financing more difficult and less desirable to source through traditional bank financing.
In light of these challenges, SLs provide a ready means for property owners to monetize their real estate assets and capture valuable equity. Owners can then obtain higher returns by redeploying their capital to modernize facilities, reduce debt or expand, or for other core business purposes.
For many sellers, it is an opportune time to monetize real estate because the strong real estate market fundamentals, coupled with the still historically low interest rates, have driven up property values. Consequently, SLs have become an important strategy to unlock the long-term value of real estate and better position a business for growth.
Some notable recent SLs include SuperValu’s portfolio of eight distribution centers ($483 million), Meek’s Lumber and Hardware’s portfolio of 41 assets (representing nearly the entirety of Meek’s operational real estate portfolio), and Albertsons’ portfolio of 71 properties ($720 million).
From the seller’s perspective, other primary advantages of SLs include:
- Maintaining control of an asset: An SL typically enables the property owner to not only continue to occupy its current space, but to also retain nearly full operational control over it. While conventional mortgage financing generally requires lender approval rights and restrictions with respect to the borrower’s operation of the mortgaged property, the seller/new tenant in an SL generally has free rein. Restrictions typically are limited to acts or omissions that would have a material adverse effect on the value of the property, result in the violation of applicable laws or create property liens.
- Tax benefits: The recent tax reform legislation encourages SL activity because there are new limits on the deductibility of business interest, but still no limits on the deductibility of rental expense (other than that the amount be reasonable). Previously, owner-user companies could deduct all their business interest expense, but new provisions, when applicable, limit deductibility of business interest expense to a specified percentage of income. The new business interest expense limitation applies to all taxpayers with annual gross receipts of $25 million or more.
- Removing management headaches: For non-real estate businesses that currently manage their owned facilities, the ability to shift certain responsibilities for managing the property to a professional real estate owner can be appealing. By having an experienced real estate owner worry about the real estate, the tenant can focus on core operations and potentially realize significant savings in operating costs.
What’s in it for the buyer?
With real estate selling at high prices, many buyers of properties in SLs are primarily interested in deferring their capital gains taxes from recently sold real estate. When an owner has held property for investment purposes and sells it at a price higher than its basis, capital gains taxes would be due unless the owner completes a “like-kind exchange” by using proceeds from the sold property (the “downleg”) to purchase new like-kind investment property (the “upleg”) per Internal Revenue Code §1031. Many buyers desire to enter into SLs to acquire their uplegs because there are long-term tenants in place, which helps guarantee stable, long-term cash flow.
SLs may also appeal to buyers because of limited ongoing responsibilities if they involve “net lease” or “triple net lease” transactions with the tenant maintaining responsibility for ongoing expenses of the property, including property taxes, building insurance and maintenance.
Another boon to the buyer is that SLs customarily provide higher returns than bonds for similarly rated tenants, with the additional security of real estate ownership.
SLs are the darling of the healthcare space
While SLs are industry-agnostic, they are gaining much attention in the healthcare space. For example, recent SLs include:
- Steward Health Care System: One of the largest fully integrated healthcare services organizations and community hospitals in New England entered into a $1.2 billion SL with Medical Properties Trust (NYSE: MPW), a real estate investment trust that invests in healthcare facilities subject to triple net leases.
- Signature Healthcare Services: One of the largest privately held psychiatric hospital communities in the U.S. entered into a $400 million SL with Care Capital Properties, a healthcare REIT, for six behavioral health hospitals.
- The LaSalle Group: The memory care assisted living community provider sold six memory care facilities to National Health Investors (NYSE: NHI) in a $61.8 million SL. The buyer is a REIT that specializes, in part, in SLs of medical properties.
Many REITs, insurance companies and other investors today are more interested in investing in medical facilities and medical office buildings, so SLs provide an attractive entry point into this space. Representing 18% of gross domestic product, healthcare is already America’s largest industry. And despite the uncertainty over federal healthcare legislation, demand for care is only expected to increase as aging baby boomers require additional services and will make up one out of every five U.S. citizens by 2050. Finally, healthcare real estate has simply become a more widely recognized asset class by both domestic and international investors, so demand for SLs has grown in this space.
Intersection of events in the healthcare industry
Beyond the standard justifications for SLs, a unique convergence of forces is driving medical providers to deploy SLs for their medical facilities:
- Cost pressures: Medical providers today generally receive lower reimbursements from insurance companies; thus, monetizing their real estate provides necessary liquidity.
- Need to grow: With the demand for quality healthcare rising, coupled with the need for more efficient medical facilities, healthcare providers view SLs as a way to turn assets into capital, which can be used to update facilities and fuel expansion.
- Consolidation pressures: Consolidation in the healthcare space continues. If the transition to an outcome-based payment model continues, it will require capital investment and sophisticated management expertise, which is likely to drive M&A activity. SLs provide funds for healthcare providers to acquire more hospital assets and enter new markets.
- Outpatient migration: A continued shift in the delivery of healthcare services to outpatient facilities will increase the need for smaller, more specialized and cost-effective medical facilities. If medical providers can tap into real estate for capital, they can invest in these new facilities and better adapt to the changing dynamics of the industry. Moreover, an SL gives hospital chains more flexibility for space contraction or relocation once a lease expires. That freedom is useful as the industry rapidly evolves and healthcare providers rethink the way they use space.
The art of an SL deal
An SL deal should be structured so that it successfully delivers both current and long-term value to both parties, who will likely have some of the following objectives in mind:
- Maximize price of asset sale
- Lock in acceptable fixed rental payments for leaseback
- Retain control over clinical operations
- Offload certain risk and managerial responsibility
- Utilize resources more efficiently
- Acquire asset at reasonable price
- Obtain favorable, long-term stream of rental income
- Invest in asset in a desirable location, in good physical condition without any material environmental issues and that is of mission-critical importance to the new tenant
- Avoid properties with significant capital expenditure requirements
- Ensure new tenant is creditworthy
Besides checking the proverbial boxes, it is critical that the buyer of an SL asset in the healthcare industry understands the particular business of its prospective new tenant and its stature in the industry. Without the right advisors, this can be a daunting task, as the healthcare industry is undergoing extensive change with new policies, innovative approaches to the delivery of and payment for care, and disruptive technologies.
Analysts in the real estate industry predict that 2018 or 2019 may be considered the peak of the current real estate cycle. If this is the case, healthcare real estate owners may be uniquely positioned to take advantage of the SL strategy to obtain optimal value and necessary liquidity.