Raising capital from real estate
Selling the family silver to fund the business is not for everyone
By Michael Evans | CFO UK | Published 18:47, 18 December 12
There are lots of corporates with billions of owned property who would never consider a sale and leaseback – they are usually financially strong, have access to corporate debt at rates around 2 to 3 percent and do not want to sell off their core property to raise capital at a higher cost.
Others have taken a different view; J Sainsbury’s and Tesco in particular. They have actively recycled capital from core properties in their portfolio to satisfy their appetite for funds to extend and develop new stores. They have used their property portfolio as an alternative source of capital to equity and debt, at a relatively low cost – in some cases at rates between 5 to 6 percent, with the additional benefit that in most cases it has been off balance sheet.
They have also been creative in how they have structured property transactions. Demand from investors has fuelled innovation and there are now a whole range of options available to corporates for raising capital from their property. Strip income, fixed income, commercial mortgage and property fund investment products mean corporates have more choices to consider other than just the plain vanilla sale and leaseback.
Whatever the choice; the lowest cost of capital is available to investment grade corporates (BBB- or better) who are prepared to sign long leases with RPI uplifts. There is an overwhelming demand for this type of product, especially from annuity funds seeking to match assets to their pension fund liabilities. The pricing is particularly keen for properties where the residual value risk is low, like large supermarket sites or prime office buildings in Central London; but of course, not all properties fit that bill.
One way corporates may remove the residual value risk for investors can be by selling “strip income” investments. In this case, the sale and leaseback is structured with the corporate selling a 20 year lease interest (typically the minimum term required) to the investor for a premium, in return for the corporate signing a 20 year occupational lease. This way the corporate retains the freehold interest and provided the lease is indexed, the investor has a bond style investment which they are able to price much more keenly. So it’s like a bond, but it’s not a bond.
A process called securitisation takes this a stage further by using the lease income stream to actually create a bond. In this case, a special purpose vehicle (SPV) is created which issues the bonds, the proceeds of which flow through to the corporate. The bonds are repaid from the income stream from the long indexed lease to the corporate, fully amortising over the lease term and are secured on the asset.
The bonds attract fixed income investors more interested in the quality of the income stream rather than the nature of the property. This can provide very competitive pricing which is usually at a small margin (say 75 to 100 basis points) over comparable length bonds for the same company: a cheaper cost of capital than a typical sale and leaseback plus it can work for property that has no conventional market.
Securitisation issues have typically been carried out for large property transactions, in excess of £100 million where the bonds are publicly traded instruments. But they don’t to need be large or publicly traded. A private placement market exists of "fixed-income" investors, especially US Pension Funds and Insurance Companies, who are just as willing to invest in £10 million transactions unlisted and unrated transactions.
These transactions do not come without their complications. To support the issuance of the bonds, the rent has to be paid "come hell or high water". It means taking on a bit more risk than is typical under a normal UK "Fully Repairing and Insuring" (FRI) lease – although this can be managed by taking out insurance.
By tapping into fixed income investor appetite, corporates are more likely to achieve the highest sales proceeds and the lowest possible cost of capital, making it a realistic alternative to corporate debt - especially if it is structured to be off balance sheet.
Off balance sheet treatment needs to be monitored carefully for every option; particularly in the light of future changes to lease accounting. With all leases coming on balance sheet, it has made some corporates rethink ownership. It’s still possible to secure commercial mortgage debt against owned property with loan to value ratios typically 50 to 60 percent. It can also provide flexibility with loan terms typically just for 5 years, the relevant swaps currently priced at just over 1 percent with a margin of 250 to 300 basis points - it can be a cost effective and flexible option whilst still retaining ownership of the asset.
To provide security for the loan, the property is transferred into a separate property company (Propco) with a lease in place from the operating company (Opco). This structure affords even more flexibility, should the corporate want to raise more capital, either by selling off the prop co. altogether (the Opco/Propco model) or by setting up the property company as a fund and selling down units in the fund.
Property funds are popular with retailers and banks across Europe where they are set up as tax transparent vehicles. It is a way of retaining some interest in the asset, since you can sell as few or as many units in the fund as you want and of targeting retail investors and since the small unit sizes give them a slice of an investment profile they couldn't otherwise access. However, for this to work, a property fund has to be in excess of £100 million and demand needs to be tested since not all investors will want a single credit and, in some cases, single property fund.
There is one final option to consider – the property pension fund partnership. With so many company pension funds in deficit a property partnership is a tax efficient way of helping to plug the deficit whilst retaining control of the property. The property is put into a partnership vehicle in which both the company and pension fund have an interest, a lease is set up between the company and the partnership and the pension fund’s share of the income is used to help reduce the deficit. There are some tricky valuation and structuring issues to overcome but it is an innovative way for the corporate to make the capital it has tied up in property work harder.
The solutions here focus only on core strategic property assets and for some corporates it is still a huge psychological barrier to sell them, as well as to make long term commitments in an uncertain world. The model of monetising core assets and recycling the capital elsewhere in the business, popularised by some supermarkets, is designed to enhance shareholder value. So if you’re going take capital out of your property, it’s worth looking at the options to make sure you get the highest value and the cheapest cost of capital – come Hell or high water.
Michael Evans is director of the corporate solutions team at Jones Lang LaSalle. He actively works with organisations on financial strategies for their real estate.
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