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A tougher RE market

A price check on sale-leasebacks



Randy Blankstein, president of The Boulder Group, says the gap between A and B deals was narrowing, but is starting to widen recently.

Pricing on sale-leaseback transactions has slipped for many franchise deals in recent months. But that doesn't mean franchisees have missed the boat on this financing option.

Turmoil in capital markets and the resulting tightening of underwriting practices has hurt the sale-leaseback market. "You can still get a very good deal, but you are not going to get the deals you could a year ago," says Ethan Nessen, a principal at Boston-based CRIC Capital.

Overall, the capital constraints and downturn in the economy has prompted a flight to quality among both investors and lenders. A year ago, sale-leasebacks on lower tier deals—those properties in secondary or tertiary markets, or properties owned by smaller franchisees—were benefiting from the white hot investment market. The pricing gap between A, B and even C deals had narrowed considerably because of the intense investor demand for single-tenant properties with long-term, triple-net leases. "Pricing got really tight a year ago. So the gap between deals was very narrow," says Randy Blankstein, president of The Boulder Group in Northbrook, Illinois.

That gap has started to widen again in recent months due to a variety of factors such as the disruption in the capital markets, cooling investor interest and the downturn in the economy. Investors and lenders are more wary of investment risk, and they are now pricing those riskier properties accordingly.

So while operators with solid balance sheets and A properties in major cities have seen little change in pricing, weaker operators have seen cap rates dip by 50 to 100 basis points. (The capitalization rate is a measure of the ratio between cash flow and the purchase price. Investors typically use cap rates to calculate returns.)

Bricks and sticks

Sale-leasebacks are still viewed as an attractive financing option because it allows owners to unlock 100 percent of the capital from their real estate, unlike a traditional mortgage which might fund anywhere from 65 percent to 80 percent of the asset value. However, one of the big differences today is how those property values are calculated has changed.

The frenzied investment market that existed a year ago prompted investors—and lenders—to lose sight of core real estate values. Given the capital constraints in the market, both investors and lenders are now underwriting deals more cautiously and focusing more on real estate fundamentals such as location, market rents, and overall quality of the property.

For example, Restaurant XYZ generates $15 million per year in gross revenues. A year ago, the restaurant could have used its operational success to boost the value of the property in a sale-leaseback. Now an investor is more likely to underwrite the deal based on the average market rent for that particular area.

So even though Restaurant XYZ might be able to support rent of $60 per square foot based on its operations, the actual average market rent is only $20. In this case, the lower average market rent translates to a lower property value. "The bottom line is that owners have less of an ability to turn cash flow from operations and convert it into real estate value," Nessen says.

Pricing shift

Investors are still exhibiting a healthy demand for sale-leaseback properties, and there remains a good supply of deals from those operators that need capital. However, activity has slowed by about 15 to 20 percent in recent months as owners come to terms with the pricing shift that is occurring.

"What's happening is that there is a wide variety of cap rates at where deals are getting done," Nessen says. Pricing might range from as low as 6.5 percent to about 11 percent. Brands such as Walgreen's and Applebee's still represent the "gold standard" in the sale-leaseback world, and are commanding top pricing close to cap rates close to 6.5 percent.

Smaller franchisees that were able to secure cap rates of 8.5 percent to 8.75 percent a year ago have seen an increase in cap rates by about 100 basis points. In addition, deals that are perceived as too risky due to a weak concept or weak operator won't get done at all. "There is a real chance of default amid the current market conditions, and investors are shying away from that," Nessen says. "It is very hard to get any kind of debt for a concept or franchisee where there is a legitimate default risk."

 "Cap rates have definitely moved up since last year, but everything is still sellable," counters Keith Sturm, managing principal at Upland Real Estate Group in Minneapolis. For example, Upland is working on a sale-leaseback with an Arby's operator. "They have a situation where they need to sell quickly, so the deal is priced to attract investors and encourage a quick closing," Sturm says.

A strong mom-and-pop operator with five to 10 units can still do a deal in the current market, but they need to be realistic about pricing. The pricing is radically different than it was eight to 10 months ago.

The best way for owners to get a good idea of pricing is to look at deals that are trading now. In addition, a franchisee can maximize its value by structuring the transaction to meet investor demand. For example, a 15-year lease is more attractive to an investor than a 10-year lease, and annual rent increases are viewed more favorably compared to rent bumps every five years.

The upside is that while today's sale prices may be lower, owners who are planning to occupy the property may be able to negotiate a lower rent. "I don't think franchisees have missed the window of opportunity, although the pricing to get in the window has changed a bit," Blankstein says.

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