Why sale-leasebacks are an attractive source of capital for QSR owners and operators
The cost of debt has more than doubled over the past two years due to interest rate increases resulting from the Federal Reserve’s open market operations. For many restaurants, this increase has hurt profitability and is an obstacle to supporting the recovery of the restaurant industry.
One attractive financing option that restaurants with their own real estate can consider is a sale-leaseback. These transactions are often viewed as a hybrid capital alternative, and with credit markets working well but still expensive, SLBs are now even more attractive by comparison.
Transactions in the hospitality industry
Several restaurant chains have engaged in sale-leaseback transactions in recent years to finance their growth initiatives. One of these is Red Robin, which sold and leased back 27 of its properties in a series of transactions over the past 12 months, raising a total of $84 million.
The company used the proceeds to pay down debt, finance capital investments and support share buybacks.
Two other examples include an $18 million portfolio of seven Taco Bells in Ohio and a portfolio of six Zaxby’s locations in the Southeast totaling $13.4 million (both in 2022).
In sale-leaseback transactions, real estate is sold and simultaneously leased back to the buyer under a long-term lease agreement. This frees up valuable capital tied up in real estate. This freed up capital can then be used to fund mergers and acquisitions, develop new units, pay down debt, and more.
What makes sale-leaseback transactions an easily accessible alternative is that: 1) real estate is a stable asset class with easily identifiable value and a relatively high degree of liquidity and 2) sale-leaseback investors are well capitalized and actively seeking properties to purchase.
Attractive capital costs
In exchange for an immediate injection of capital, the company assumes a long-term lease obligation with fixed payments. The dollar amount of these payments relative to the value of the property sold to the investor represents the implicit cost of the sale-leaseback financing. In real estate parlance, this initial return is called the “cap rate.”
While interest rates have increased by 300 to 400 basis points since the rate hikes began, cap rates have only increased by 150 to 200 basis points. Today’s sale-leaseback cap rates are not only within the blended cost of capital of most restaurant companies (a true apples-to-apples comparison), but are within the debt financing costs of most companiesDepending on the level of debt on a company’s balance sheet, the difference can have a significant positive impact on profitability and cash flow.
Arbitrage opportunity
Sale-leaseback is not only a cost-efficient financing mechanism, but in many cases it is also a tool to create value for the operator. Since companies typically transact based on EBITDA multiples, sale-leaseback valuations can be effectively translated into multiples to allow for easy comparison. Most QSR sale-leasebacks have multiples in the 13-15 range, with some even exceeding 16. Whenever a QSR company is valued within the SLB multiple, arbitrage can be achieved by executing a sale-leaseback.
Credit is the key
While owning real estate is a prerequisite for a sale-leaseback transaction, the key to releasing tied-up capital through this financing option is the creditworthiness of the company and the health of its underlying business. Investors look for a secure and steady income stream through the lease they enter into. They want a tenant that can meet the obligations of a long-term lease, meaning companies with growth potential and a healthy financial profile that allows them to handle fluctuations in revenue and profits.
Talk to the lobster in the room
If sale-leaseback schemes are so great, why do many people believe that Red Lobster went bankrupt after selling its properties?
Red Lobster’s bankruptcy is a failed search for the guilty party, which, as expected, fell to the chain’s former private equity owners. In particular, the sale of many of the chain’s locations as part of SLB transactions has come under criticism.
It’s easy to demonize private equity investors, and lately it’s fashionable to do so. In the case of Red Lobster, selling the real estate was a clever corporate financing strategy (and it was done nearly a decade ago!) to finance the acquisition of an iconic casual dining chain.
Criticisms of rental income through the SLB can be short-sighted and overlook the nuances of how these transactions work. The leases between the new and former owners of the property are transactions between arm’s length parties. The new landlord is looking for stable, long-term income and has an interest in promoting the financial health of the underlying business through a fair and viable long-term lease.
In this case, private equity investors did what they do best: efficiently capitalize on investments in companies they want to grow and improve. In the case of Red Lobster, the pandemic, food inflation, and competitive pressures ultimately led to the company’s unfortunate bankruptcy.
Overall, the sale-leaseback business offers many advantages, including a highly attractive source of capital that offers multiple arbitrage opportunities and efficient cost of capital. Unlike debt capital markets, the sale-leaseback market is open all the time and represents a reliable resource for restaurant operators who own their own real estate.
Matt Wrobleski is a partner at SLB Capital Advisorsadvises the company and private equity sponsors on a wide range of sale-leaseback transactions. Mr. Wrobleski has over 15 years of experience in sale-leaseback, real estate brokerage, capital markets and M&A. He can be reached at [email protected] or (646) 891-4862.
