Rising interest rates fuel sale-leasebacks
Operators considering doing a sale-leaseback of property to raise capital may want to act quickly in order to capitalize on what could be peak pricing.
Investors continue to exhibit a healthy appetite to buy sale-leaseback properties, but it is not as much of a frenzy as was the case a couple of years ago, notes Gary Chou, first vice president & senior director at Matthews Real Estate Investment Services. Pricing has remained stable for the best quality properties, locations and top brands. However, sale prices have started to slip for lesser quality deals as buyers become more selective.
Investors are gravitating toward best-in-class brands and locations, as well as stores that have a proven track record of generating sales. “I think people are moving up on the quality scale of what they are willing to buy at this stage compared to where they were a few years ago,” agrees Randy Blankstein, president of The Boulder Group, a firm that specializes in single tenant, triple net lease property sales. It is becoming more difficult to do second-tier brands and locations with no proven sales, he says.
The expectation that interest rates will rise this year also will likely fuel more sale-leaseback transaction volume. Overall, the sale-leaseback market for franchisees is still strong. However, transaction volume in 2017 was down year-over-year by more than 20 percent, says Chou. Part of that slowdown is simply because a lot of franchisees who were thinking of selling have already done so.
In addition, owners did not feel an urgency to sell properties in what continued to be a stable interest rate environment. Many economists believe the strong economy, along with Federal Reserve rate hikes for the short-term lending rate, will result in a rise in the 10-year treasury rate. The low-interest rate environment has a direct correlation on property values as rising interest rates translate to higher capital costs and lower sale prices. More franchise operators are expected to pull the trigger on sale-leaseback financing deals this year in order to lock-in long-term financing at more favorable rates.
Buyer focus shifts to restaurants
Overall, there continues to be strong investor demand for all categories of sale-leaseback properties. Investors like the steady income and the low-maintenance that sale-leasebacks offer. Deals are typically structured where the single tenant of a building continues to occupy and maintain the property under a long-term triple net lease, meaning the tenant pays rent, taxes and all maintenance expenses.
Restaurants in particular are reaping the benefit of the broader disruption in the retail sector that has created more uncertainty due to a surge in store closings. Buyers are shifting away from some retail properties due to concerns about the negative effects of e-commerce.
Traditionally, investors have had a lot of choices when it comes to buying triple net lease properties with options such as Verizon Wireless, Dollar Tree and Walgreens.
“All of those retailers are being affected by Amazon,” says Doug Roland, an investment adviser on the restaurant team at Sands Investment Group in Charleston, South Carolina.
Banks have been another perennial favorite of net lease investors. However, the shift to online banking is creating a similar disruption in the banking sector that is resulting in more closings of bank branches across the country. As a result, investors are now gravitating toward internet-proof businesses including restaurants, entertainment and service businesses, such as spas and gyms.
Franchisees find attractive pricing
Restaurants have been out-performing retail over the past year, because of the shift to e-commerce-resistant tenants, notes Blankstein. That demand also is helping to shrink the pricing gap that normally exists between corporate and franchise-owned restaurants. Because investors like the restaurant category, it creates a lot of demand and a window of opportunity for franchisees to monetize assets, he adds.
Historically, restaurants have traded at higher cap rates as compared to retail properties. Fourth quarter sales data shows a thin margin between capitalization rates for corporate versus franchisee-leased QSR properties with averages of 5.35 percent and 5.75 percent respectively, according to The Boulder Group. (The cap rate measures the rate of return on a real estate investment property: cap rate = net operating income / current market value.)
The strong buyer appetite for restaurants is reflected in the pricing, agrees Roland. For example, Roland recently closed on the sale-leaseback for a franchisee operator of four Steak ‘n Shake restaurants that sold for a 6 percent capitalization rate, which is only about 50 basis points higher compared to a sale of corporate-guaranteed Steak ‘n Shake.
That reflects a lot of favorable momentum in the market from investors, notes Roland. “Some of my investors actually gravitate more towards a franchisee-run QSR or casual dining restaurant rather than a corporately run store,” says Roland. Investors like that franchisees have “skin in the game” and are emotionally and financially invested in making sure those stores continue to perform well, he adds.
The traditional “A” credits, such as McDonald’s, Chick-fil-A and Dunkin’ Donuts are still very popular and commanding top dollar. However, buyers also are very in tune with restaurant trends and there is strong demand to invest in healthier food options. “Some of the newer concepts do have a little bit of a sit and wait feel, but a lot of them are fetching very good prices and appealing to investors, especially investors from the West Coast,” says Roland.
Tax reform has minimal impact
The broader sale-leaseback market has been watching to see what, if any, impact the new tax reform bill might have on 1031 tax-deferred exchanges. The 1031 tax law allows an investor to defer capital gains on the sale of a real estate property by rolling proceeds into the purchase of another “like kind” property. This has been a key issue for sale-leasebacks as 1031 investors represent a dominant buyer group for sale-leaseback properties.
The good news is that the tax bill did not change 1031 tax law. “I think there is some ambiguity on the interpretation and how it plays out,” says Blankstein. However, any impact to the sale-leaseback market is likely to be minor, he says.
One new 1031 tax law change would allow 1031 investors to only use property value and not personal property value (such as FF&E for restaurants) when calculating the total amount of the capital gain that is eligible to be deferred. In theory, that could mean that a 1031 buyer might end up being taxed on a portion of the capital gain. However, it is not likely to be a big enough amount to serve as a disincentive for investors to do sale-leasebacks as a part of tax strategy.
The impact of that tax law change is further minimized by the fact that most franchisees do a carve-out on furniture, fixtures and equipment when doing a sale-leaseback and effectively retain ownership of that personal property. Second, the tax change would have no impact on sale-leasebacks that are sold as ground leases—the land underneath the building. Those ground lease sales are common for free-standing restaurant deals.