The Case for PE-Sponsored Sale Leasebacks

Last year saw strong commercial real estate activity as transaction volumes reached $481 billion, according to JLL’s U.S. Investment Outlook. Overall interest in net-lease assets remained robust: The sector recorded $44.1 billion in transactions, of which sale-leaseback transactions represented nearly 15 percent.

Companies continue to hedge against market uncertainties through sale-leaseback transactions, in which an owner/occupier sells real estate and then leases it back from the purchaser. Specifically, we’re seeing increased sale-leaseback liquidity for lower- and middle-market companies in secondary and tertiary markets, largely driven by attractive risk-adjusted returns and the support of strong private equity sponsorship.

Benefiting the seller

Sellers often use sale-leasebacks as a preferred way to recapitalize, especially for non-rated, smaller or middle-market companies that may have trouble accessing capital markets. Executing a sale-leaseback allows them to lighten their balance sheet and use proceeds to pay off other liabilities. Furthermore, it allows these companies to focus on their core competencies and business growth.

Industrial assets are particularly ripe for this type of transaction. They accounted for more than half of sale-leaseback transaction volumes in 2018, up from 35 percent in 2017, according to JLL’s research. Record or near-record pricing and strong investor demand are driving owners to evaluate selling rather than holding their assets.

PE Funds and Add-on Strategies

Private equity investors continue to target middle-market acquisitions—companies valued between $25 million and $1 billion— which accounted for $427.9 billion of private equity-backed deal volume in 2018, according to PitchBook. Many large platform companies have pursued middle-market companies due to the flexibility they offer for add-on acquisitions; they are large enough to be impactful and still small enough to deter competition. These add-on acquisitions—in which a private equity fund integrates the acquired companies into existing operations—can often be an effective and capital-efficient way to grow a portfolio business. Add-ons accounted for 66 percent of U.S. private equity-backed deals through 2018.

According to PitchBook, 2018 was another healthy fundraising year for the U.S. middle market, with about $110.8 billion total capital raised. Given the scale of the opportunity, nearly 70 percent of capital raised is targeting this deal profile. Increasing activity is taking place outside of primary markets, where companies often own mission-critical real estate, such as industrial production and manufacturing facilities.

Sale-leasebacks have become a sought-after mechanism for private equity firms to finance and enhance those businesses, while also creating a positive arbitrage opportunity for investors. By carving out real estate from a business alongside or after an acquisition, buyers can unlock substantially higher value for the real estate. This is achieved through the disconnect between the lower EBITDA multiple (often 6x to 8x) paid to acquire the business and the higher EBITDA multiple (typically 12x to 14x) achieved from the sale of the real estate.

Fundamentals remain strong in the real estate business, notwithstanding slowing economic growth. We expect sale-leasebacks, especially for middle-market companies, will remain prevalent and that an increased number of investors will target industrial assets.

This story originally appeared in the May/June print edition of Middle Market Growth magazine. Read the full issue in the archive.