Private Debt Investor May 2019 Sale and Leaseback: Opportunity in a nascent market

Transcript

1 REAL ESTATE DEBT SALE AND LEASEBACK Opportunity in a nascent market With a potential size of €1.1trn, investors have good reason to examine sale and leaseback deals for strong risk-adjusted returns. By of ICG Chris Nichols Max Mitchell and What is a sale and leaseback transaction? Q In the simplest Max Mitchell: Property title transfer terms, if a company undertakes a sale and leaseback (SLB) transaction, it sells some Corporate Obligor ICG (Investor) Lease payments or all of its real estate assets to a third party Seller/Tenant Buyer/ Owner and remains in the premises as a tenant, most often via a long-term lease. Leases are Cash purchase triple-net in nature, meaning that the lessee is responsible for repair, maintenance, insurance and property taxes. a trend which we believe will continue corporates when thinking about financing throughout the rest of Europe. solutions. The European Union’s BEPS action plan includes an Anti-Tax Avoidance Why would a business be motivated to There is a huge market opportunity MM: Q Directive which came into force at the undertake an SLB transaction on its real for SLB in Europe. In numerical terms start of 2019 and essentially reduces the estate assets? (excluding the UK) we estimate the value level of financial interest expense that can Chris Nichols: SLB is an alternative form of financing available to corporates. In our be deducted for the purposes of calculating of the owner-occupied corporate real estate market to be €5.5 trillion. When considering corporate tax from 100 percent of experience, a corporate is typically using the capital raised to positive effect within EBITDA to 30 percent of EBITDA. Lease average annual SLB volume in Europe is the business by reinvesting proceeds into approximately €7.5 billion, it would take payments, by contrast, are operating growing it. expenses and are fully deductible. the equivalent of 147 years just to normalise When comparing potential sources the European market to current US levels. of financing, there are a number of What market opportunity do you see good reasons for management teams Why is the European SLB market rela- Q for SLB in Europe? and shareholders to consider an SLB The SLB market in Europe is set CN: Q tively under-penetrated in comparison transaction. Perhaps the most obvious is to grow significantly, as traditional with the US market? the fact the full value of the assets can be corporate lenders continue to operate There is not a definitive answer to CN: realised, whereas capital raised by taking in an increasingly challenging regulatory this question. What’s clear is that we can’t out a commercial mortgage would only environment and businesses look to find any structural reason for the differ- unlock a portion of that value (typically alternative funding sources such as SLB ence. Largely we think it relates to a cul- 50-60 percent of its value versus 100 in order to drive growth. tural difference in as much as European percent with SLB). A fundamental part of the market The other major consideration that opportunity relates to owner occupation “IN NUMERICAL TERMS we hear a lot from shareholders and of corporate premises. In Europe it is (EXCLUDING THE UK) WE management teams is that they see SLB high at over 69 percent whereas in the ESTIMATE THE VALUE OF US, where there is a long-established SLB as a “long-term” financing solution as there THE OWNER-OCCUPIED market, that figure stands at 50 percent. is no refinancing horizon and therefore no CORPORATE REAL ESTATE There is no good reason for this structural refinance risk associated with traditional MARKET TO BE €5.5 bank financing. disconnect and in parts of Europe (eg, TRILLION” Scandinavia), we have recently seen a Additionally, recent regulatory changes Max Mitchell significant reduction in owner occupation, have created further benefit for certain P D I | M  30

2 SALE AND LEASEBACK Diversified , long dated and inflation income protected  Pan-European focus  Responsible investing  downside Emphasis on protection Tokyo | Sydney | San Francisco | New York London | Amsterdam | Frankfurt | Luxembourg | Madrid | Paris | Stockholm | Warsaw | Hong Kong | Singapore | @icgplc company/intermediate-capital-group [email protected] icgam.com ICG-London-2-042019.indd 6 11/04/2019 13:03

3 REAL ESTATE DEBT SALE AND LEASEBACK financial track record and corporate companies are used to owning their assets Max Mitchell strategy. It is also important to consider and because of this, tend to have more of downside scenarios and evaluate what an attachment to them. Whereas in the alternate use a property might have should US, people are much more comfortable it be vacated by the incumbent lessee. with the idea of taking a commercial view and monetising their business premises in order to optimise the efficiency of their What are the attractions of such an balance sheet. Q investment strategy from a returns perspective? MM: Of course, Europe is also fragmented SLB is a high-cash-yielding invest- CN: ment. Typically, over 70 percent of returns on a regional basis, requiring a much Chris Nichols are generated from highly predictable cash greater breadth of expertise in order to dividends arising from a diversified portfo successfully navigate the individual markets - and legal jurisdictions. To be successful in lio of long-term leases. Unlike traditional SLB in Europe, investors really require the real estate investment, the long-term leases necessary local presence for origination minimise leasing risk and rental voids. SLB also produces inflation-protected as well as local expertise in order to returns because the underlying rents maximise their returns. This fundamental benefit from annual contractual uplifts requirement has proved (and we believe it either through CPI or pre-set increases. will remain) a significant barrier to entry The rental uplifts can enhance value for SLB investors. SLB transactions to businesses that might leading to a capital appreciation of the not otherwise have considered it, thereby underlying asset and increased returns. expanding the universe of potential deals. Do you anticipate the SLB space becom- We are confident that as a first mover in Q ing more competitive in Europe? What the space in Europe, we will benefit the What are the exit options for an SLB would the implications of this be for ICG? most from the market growth. MM: In our view, yes, it is unlikely that Q fund? the market will remain as under-pene- MM: If a manager is careful to negotiate trated as it is now. As mentioned above, long-term, triple-net rental agreements, What attributes are you particularly however, barriers to entry are higher or ensure that there are terms that oblige looking for when sourcing an SLB deal? Q in Europe than in the US, so we do not the extension of those agreements, then MM: A number of things, but one crucial there should still be a long-term lease in factor is the importance of the property foresee a transformation overnight. While place at exit. to the ongoing operations of the business. increased competition is never at the top A well run SLB fund will benefit of my wish list, we believe that having We want access to and occupation of the from a diversified portfolio of long-term more professional asset managers active property to be essential to the lessee in the space would benefit everyone; the company for the ongoing success of their inflation protected income secured against business. This results in a true partnership opportunity is so massive that having more corporates’ mission-critical real estate, which should also have the potential to and alignment of interest between lessor people actively developing the market should help to endorse the benefits of and lessee. benefit from a credit enhancement during the initial holding period. In terms of other considerations, ideally With the bulk of returns taking the the business would be engaged in activity “EUROPEAN COMPANIES form of a cash coupon, such a portfolio that has limited cyclicality and operates in ARE USED TO OWNING would present an attractive opportunity a market with high barriers to entry. We THEIR ASSETS AND for an institutional investor looking for a are inclined to focus on sectors such as BECAUSE OF THIS, TEND package of long-dated cashflows. storage and logistics, healthcare, education n TO HAVE MORE OF AN and manufacturing. We look for a low ATTACHMENT TO THEM” concentration of customers and suppliers ICG Sponsored by Chris Nichols and pay close attention to a company’s P D I | M  32

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