With inflation at a four-decade high, some investors are doubting real estate’s ability to defend against higher prices. That would seem to go against conventional wisdom as commercial real estate has long been viewed as a reliable inflation hedge. That’s because many property types can raise rents to stay ahead of rising costs. With skyrocketing labor costs and supply-chain shortages limiting new real estate development, you’d think such conditions would bode well for existing property owners.

This time it’s different?

But as The Wall Street Journal reported recently, investors are shifting money out of real estate as they focus less on CRE’s value as an inflation hedge and more on the potential damage to the property sector if persistent consumer price increases drive up long-term interest rates. “Rising rates lead to higher financing costs, making it more expensive for owners to refinance a building and eroding the value of property,” noted The Journal. Embedded in that quote is the direct correlation between raising rates and cap rates. As rates rise, so does the investor’s expected rate of return on the asset. Commercial property’s appeal as an inflation hedge could fade further if investors obsess about interest rates, which the Journal said look poised to “keep moving higher as the Federal Reserve winds down its bond-buying program and begins a new cycle of short-term rate increases.”

Enter the sale leaseback as a secure Net Lease investment

During uncertain times like these, with no clear direction on interest rates, inflation, labor shortages and supply chain disruptions, companies need to look closely at their assets and find ways to free up capital on their balance sheets. One asset frequently overlooked is on-balance sheet real estate holdings.

Through a strategy called a sale-leaseback (SLB), companies sell their real estate while simultaneously entering into a long-term NNN lease with the new real estate investor. That way they can enjoy continued use and control of the property without the responsibility of managing it. The result is a win-win for both seller (the company) and buyer (outside real estate investor).

Companies can quickly realize 100% of the value of an otherwise illiquid real estate assets and immediately inject capital back into their core business. This allows them to fuel growth, invest in operational efficiencies, fund internal initiatives, and expand their footprint. Let’s not forget family or founder-owned businesses that just may want to take a few chips off the table for personal and estate planning purposes.

In today’s high inflation environment, real estate SLB proceeds can be used to offset fast-rising rising wholesale prices and labor costs. Or they can be used for plain vanilla balance sheet optimization -- paying down debt and bolstering cash reserves while retaining full operational control of the asset with no disruption to the day-to-day business.

SLBs are great for companies but how do they stack up for real estate investors?

If you like the surety of bond payments with no landlord obligations, you’ve come to the right ice cream parlor. Asset appreciation is the cherry on top. As with any NNN investment, however, it’s worth doing a little digging into the lease guarantor’s financial health. Schedule a call with the CFO if possible.

Eisner Amper (EA) reported last month that it expects true sale-leaseback (SLB) activity to gain in popularity over the next six to eighteen months. According to Amper, “investor demand for downside protection” increases at times of uncertainty as the war in the Ukraine, rapidly rising interest rates and return of inflation have increased volatility in more traditional economic markets.

In response, EA said the SLB provides contractual income, capital preservation, and inflation protection. Further, an increased corporate understanding of the SLB “will drive primary market transactions as companies increasingly recognize that investment in their core business is rewarded more than tying up their capital in real estate,” added EA.

In common speak, SLB investing is highly regarded as an annuity-plus vehicle for a wide buying pool composed of REIT’s, family offices, high-net-worth individuals, PE real estate funds, and of course the 1031 exchange investor. From my vantage point, the appetite for this asset class is growing and SLBs will continue to hit the market as companies look to raise cash in these turbulent times.

As the Fed continues raising interest rates, “we naturally expect cap rates to begin trending higher across the board,” said Eisner “as both the ability to finance acquisitions becomes more expensive and investors begin to compare yields to other structured products.”

GlobeSt predicted last month that SLB transaction volume would continue to accelerate as “owners rush to lighten balance sheets and hedge against risk from a rising cost of debt before cap rates expand and spreads widen later this year.” The expert panel at GlobeSt’s Net Lease Spring conference determined that the “avalanche of capital and dry powder” from sponsors flowing into the market will continue to compress cap rates for another six months.

The GlobeSt panel also agreed that owners facing “credit deterioration” on companies valued at less than $10M EBITDA are under the greatest pressure to act now on SLBs. Meanwhile it said companies valued at more than $100M may decide to stand pat and see how much spreads widen.

“The sponsor world had its best year ever and there’s definitely more sponsor interest (in SLBs) as sponsor activity increased in the first quarter of this year,” noted Vincent Polce, CBRE’s national co-lead on corporate capital markets in the aforementioned report. While many parts of the economy may be cooling off, Polce believes SLB activity is just heating up.

SLB gaining traction

“The sale leaseback strategy continues to gain traction especially as business owners evaluate their financing alternatives,” observed my colleague, Chelsea Mandel, Ascension Co-Founder and Managing Partner. “Given recent interest rate activity, it’s significantly less accretive to place asset-level financing (mortgages) on owned real estate assets than it was even earlier this year,” she told me recently.

The sale leaseback market, however, has not seen cap rates adjust nearly as aggressively as interest rates have moved. “I’d say cap rates are up about 30 to 50 bps in the last few months, while the 10- year is up over 100 bps,” noted Mandel. “Despite what may be intuitive, empirically, interest rates and cap rates do not move one-for-one. This means there’s a widening spread between mortgage rates and cap rates, making the sale leaseback even more attractive to business owners on a relative basis,” added Mandel

SLB in action—Two real world examples

1. AUTOMOTIVE SUPPLIER USES SLB TO FINANCE BUSINESS ACQUISITION

SITUATION: Our team represents a private equity-owned automotive supplier. A middle-market private equity firm was under exclusivity to acquire the business unit through a corporate carve-out as an add-on to its existing automotive platform. The add-on acquisition included the unit’s two key manufacturing facilities in the Midwest. The investment thesis for the add-on relied heavily on the sponsor’s ability to turn around the plants as the business unit was neglected by the corporate parent. As a result, both facilities were operating at negative EBITDA levels.

SOLUTION: We raised the idea of financing the add-on 100% with proceeds from the sale leaseback transaction. The sponsor did not think it was possible given the complexity of the credit turnaround story and given it only had 30 days to close the transaction. However, we remained confident we could move quickly and find the right investor that would understand the investment thesis and be comfortable with the deal.

RESULT: We ran an off-market investor outreach process and closed the transaction at a purchase price of $25 million. This fully-funded the sponsor’s add-on of the operating business. The Team closed the transaction in 28 days.

2. SHORT-TERM INDUSTRIAL SLB TO PROVIDE LIQUIDITY

SITUATION: We represent a PE- owned industrial equipment and machinery supplier. The company was looking to shutter its western-U.S. operations as part of the company’s broader footprint consolidation plans. The properties were well-located in an infill industrial area of the market.

SOLUTION: Our Team recognized the value that could be achieved by monetizing the assets through a short-term sale leaseback, allowing an investor to capitalize on the redevelopment and upside potential of the sites. The Team structured a 9-month sale leaseback of the two manufacturing facilities.

RESULT: This provided the Company with enough time to close its local operations and vacate the properties. As a result, it generated substantial capital from the transaction that the business used to buy new equipment and fund the fit-out of its other manufacturing facilities.

Conclusion

The SLB trade is percolating as we enter into an uncertain economic climate. Rest assured, Ascension’s primary directive is to evaluate and advise companies through a successful sale and match them with equally qualified buyers.