By Matt Geist & Riley Hillis
Something happened in July 2019 that warrants considerable attention. The U.S. economy pushed through 120 months to reach the nation’s longest ever economic expansion.
This phenomenal economic story demonstrates the resilience of American businesses and the consumer. Along the way, equity markets as measured by the Dow Jones and S&P 500 have more than quadrupled, while commercial real estate values have concurrently skyrocketed.
As compared to the peak of 2007, commercial real estate prices in 2019 are 30 percent higher as measured by Costar.
That is quite a remarkable run and represents a sizeable appreciation in value.
The question is…what comes next? Let’s look at this through the eyes of a business leader.
A property/business owner-user CEO with a flourishing operation in the Greater Seattle or San Francisco metro is no doubt pondering the numbers and considering her options.
As CEO, she has expansion plans, wants to commit more capital to the business, hire more employees and expand the company’s product offerings.
Borrowing is always an option however; she is concerned about adding debt to the balance sheet and siphoning away valuable cash flow.
While she has seen a tremendous boost in the company’s asset value from the property appreciation, the capital is tied-up and unable to be put to use in ways that could create robust long-term financial returns.
If only there was an alternative…
The Sale-Leaseback Option
A very common, yet not well understood commercial real estate transaction is the sale-leaseback.
The sale-leaseback transaction involves an owner-user selling their real estate asset to an institutional purchaser, and then leasing back the property as a tenant.
In this case, the CEO owns a manufacturing facility, which based on recent market sales is worth $10 million against a mortgage obligation of $3 million. The $7 million in potential equity could go a long way towards pursuing her expansion plans.
By conducting the sale-leaseback, the CEO unlocks this frozen capital, which in most cases is not generating the return it otherwise could.
In addition to turning illiquid equity into deployable capital, a sale-leaseback carries a number of additional benefits.
- In most cases business rent is fully deductible for tax purposes.
- There are no interest costs associated with borrowing against the property’s equity.
- A lease offers future cash flow visibility.
- There may be ways to minimize capital gains liabilities through a 1031 Exchange or Opportunity Zone investments.
Sale-leasebacks are not complicated in theory, but as with all commercial real estate transactions, the complexity is in the details.
A Little Math
The CEO is intrigued by the sale-leaseback idea but would like to understand the financial elements in more detail. Let’s work through an example:
In 2011, the CEO purchased the property for $5 million with a Capitalization Rate (Cap Rate) of 6 percent.
Cap Rate = Net Operating Income (NOI)/ Property Value
NOI= Gross Operating Income-Operating Expenses
From this one Cap Rate equation, the CEO can determine any figure, provided she has two data points.
In this case, the NOI of the property in 2011 was $300,000.
Fast forward to 2019…
NOI now stands at $600,000 and the Cap Rate is 6% percent. As such the value of the property is: $10,000,000.
These are simplistic examples of course, and there are multiple methods to valuing a commercial real estate asset including among others: gross rent multiplier, sales comparison and cost approach.
The numbers are one piece of the puzzle, but must be examined in the context of the economic environment, and the fundamentals of the market where the property is situated.
The economic expansion of the last decade may still have room to run, with months or perhaps a few years of growth still attainable. Unquestionably though the pace of expansion is weakening and the astronomical rise of property values in hot markets is also softening. Over the last years, cap rates have compressed–moved lower–substantially and this could be a point where that trajectory stalls or even reverses.
All of which leads to the CEO thinking that perhaps the time may be now to act and tap the equity value of the property.
Professionals examine the company’s numbers and believe the market price of $12 million based on comparable sales is far too low. Reaching out to a number of institutional investors who have been gobbling up well positioned and profitable properties, the team negotiates on behalf of the business owner to secure the best lease terms, rate and sale price for the property.
One year later, the CEO has expanded operations in a new metro with her unlocked capital, her lease is locked in for 10 years at a terrific rate and she took advantage of an Opportunity Zone investment to mitigate the capital gains impact.
If a sale-leaseback is something you’d like to consider, reach out to our team and we’ll be happy to explain this option in much greater detail!
Matt Geist is an associate vice president of Hughes Marino, an award-winning commercial real estate company specializing in tenant representation and building purchases with offices across the nation. Contact Matt at 1-844-662-6635 or firstname.lastname@example.org to learn more.
Riley Hillis is an associate with Hughes Marino, an award-winning commercial real estate company specializing in tenant representation and building purchases with offices across the nation. Contact Riley at 1-844-662-6635 or email@example.com to learn more.