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06/26/08

More Banks Discovering Gold in Sale-Leaseback Deals

Several community and regional banks, already squeezed by the subprime mortgage crisis, tightened consumer lending and falling share prices, are following the lead of some banking giants and pursuing sale-leasebacks as a hedge against current economic volatility. The strategy allows banks to raise cash while pruning unneeded brick-and-mortar assets from their balance sheets.

In addition to large deals by the likes of Citi, Wachovia and SunTrust to monetize a portion of the real estate they owned and occupied, smaller and middle-market banks such as Harleysville National Bank, Independent Bank Corp. and Old National Bank Corp. have unveiled sale-leaseback transactions of their own in recent months.

Nicholas S. Schorsch, a real estate executive noted for pioneering the concept, has made buying and leasing back middle-market bank branches a cornerstone of his business strategy. Last month, New York-based American Realty Capital, headed by Schorsch and former Morgan Stanley exec William M. Kahane, announced an agreement with New York-based investment bank Sandler O’Neill and Partners, L.P. to partner on long-term net lease sale-leasebacks with financial institutions holding between $500 million and $50 billion in assets.

Editor's note: Can sellers in sale-leasebacks still get top dollar, or should they wait until the market recovers? E-mail me at rdrummer@costar.com and responses may be included with this article.

Increasingly, banks are realizing they can operate without owned real estate, opting to sell the assets and sign triple-net leases that allow them to control the property for up to 40 years. In one fell swoop, banks can raise cash through a sale-leaseback while slicing property operating and depreciation costs from their bottom line. The ball is now rolling and more deals are in the pipeline, net lease experts say.

Banks Ride Herd On SLB Trend

"It’s a growing trend in the industry. We are actively working on three or four portfolios of bank branches with institutional clients of ours," said Jeff Hughes, senior director with the Tulsa, OK-based Stan Johnson Co., which handled the Old National Bank sale leaseback transaction for a client, selling the bank’s corporate headquarters facilities in downtown Evansville, IN for $78 million. Subsequently, it facilitated the sale of a $110 million portfolio of Old National suburban bank branches.

"The banking industry is not unlike others; there’s a bit of herd instinct. When you see your peers structuring large, high-profile transactions, it attracts a lot of attention. When they start realizing the benefits, it creates a bit of a trend, which we’re certainly seeing today," Hughes said.

Selling branches in bulk allows banks to quickly shed redundant assets, Nick Schorsch told CoStar Advisor. Banks can achieve higher returns on investment by lending to borrowers rather then spending capital on fixed real estate operating costs. Sale-leasebacks provide operational flexibility for financial institutions while at the same time giving banks downside protection against a fickle, cyclical real estate market.

"Financial institutions can increase liquidity by monetizing their non-earning assets, moving them off their balance sheets while improving efficiency ratios and eliminating underutilized properties," Schorsch said. "For the banks, this ultimately translates into creating shareholder value and improved earnings."

Long-term leases with minimal rollover give American Realty Capital "a predictable and stable cash flow," which translates into stable risk-adjusted returns for investors, Schorsch said.

As reported previously in Advisor, retail banking is but one of a growing assortment of corporate users, private companies and institutional owners seeking to unlock the value of their assets. The current anguish in credit markets -- and its especially severe impact on financial institutions -- has fueled the urgency for banks in particular to restructure their balance sheets.

Bank-owned real estate can be an important source of liquidity, earnings and capital for an institution, said Tom Killian, a principal and manager of the sale-leaseback effort at Sandler O’Neill.

"The rationale for banks to consider sale-leaseback transactions of bank-owned property is straightforward," according to Killian. "Such a transaction could enable the bank to raise cash to meet strategic and funding needs, convert non-earning, 100%-risk-weighted assets into potentially lower risk-weighted, interest-earning assets, mitigate potential risk of decline in market value of owned real estate, monetize off-balance-sheet value into earnings over the life of the lease, and potentially bolster GAAP (Generally Accepted Accounting Principles) earnings," Killian said.

The deals have their limitations. Sale prices can and probably will increase when the market rebounds. Banks must recognize the sale as a deferred rather than an immediate gain, and must amortize the income over the life of the lengthy lease. But the income helps, as does the removal of asset operating costs and depreciation, replaced in the expense column by market-rate rents. By ridding themselves of fixed assets, smaller institutions can sometimes even lower the burdensome capital reserve levels required by regulators.

Editor's note: Can sellers in sale-leasebacks still get top dollar, or should they wait until the market recovers? E-mail me at rdrummer@costar.com and responses may be included with this article.

In some of the larger sale-leaseback deals of recent months:

  • SunTrust Bank in April closed the final portion of the $736 million sale and leaseback of property to Oak Brook, IL-based Inland Real Estate Acquisitions in nine southern states. The deal involves 433 triple-net lease properties encompassing more than 2.2 million square feet, which SunTrust will lease back for 10 years with an option for multiple renewals.

    "Not only will these sale leaseback transactions remove non-earning assets from the balance sheet, but we will lower occupancy costs by compressing space utilization by 25% to 35% in our moderate to large office buildings," SunTrust President/CEO James M. Wells III told investors earlier this year. "This will obviously drive ongoing occupancy expense benefits. Given the difficult operating environment, I can assure you that we will remain vigilant on costs and continue to explore additional ways to improve efficiency."
  • Transactions such as the $99.7 million sale-leaseback of 25 bank branches to SunTrust Equity Funding provided Old National with about $226 million in cash for redeployment and reduced non-earning assets and deferred liabilities in the third and fourth quarter of 2007, Old National CFO Chris Wolking noted in a conference call.

    "Our net interest margin and net interest income both benefited from our disciplined deposit pricing, the sale-leaseback of our real estate and the first-quarter balance sheet restructuring we executed," Wolking said. "Cash generated from our sale-leaseback transactions allowed us to reduce certain high-cost deposits and borrowings."
  • In December, Citigroup sold its iconic midtown Manhattan office property in Tribeca to SL Green Realty (NYSE: SLG) in a deal valued at $1.58 billion. Last month, Citi sold 47 retail branches in Manhattan, Queens, Brooklyn, and Westchester/Suffolk counties to an Irish investment group called Markland Holdings Ltd. for $100 million.

Mark T. Fitzgibbon, a principal and director of equity research at Sandler O’Neill, noted that equity investors generally don’t assign much credit to the off-balance sheet worth of bank-owned real estate when they value a company. He cited the major transactions by Citi and SunTrust as evidence that banks are beginning to unlock the value of their brick-and-mortar holdings.

"During the difficult financial environment facing many banks, it is important for bank management to turn over all the rocks to find sources of earnings, capital and liquidity," Fitzgibbon said.

Early Believers

Schorsch and Kahane anticipated the trend in 2003, long before many others in the commercial real estate industry. Before founding American Realty Capital last year, Schorsch and Kahane steered the growth of American Financial Realty Trust (AFRT), where they acquired more than 1,500 properties valued at more than $5 billion. Over the last five years, American Realty’s executive team has negotiated and closed a total of more than $7 billion in bank branch and net lease real estate transactions.

Schorsch and Kahane left AFRT in 2006. For the next year, Schorsch, bound by a non-compete agreement with his former employer, steered away from bank-operated real estate and focused on sale-leaseback deals for grocery store, pharmacy and chain store retail properties.

In November of last year, Gramercy Capital Corp. acquired AFRT in a $3.3 billion deal that closed in March. Freed from the noncompete agreement, Schorsch immediately went back to doing bank deals, announcing plans for American Realty Capital LLC to buy and lease back 14 branches and two offices from Pennsylvania-based Harleysville National Bank for nearly $39 million.

American Realty Capital isn’t limiting itself to the middle market, however. In March, an affiliate of ARC announced an agreement with Wachovia Bank, N.A. to exclusively acquire surplus branches nationwide. American Realty Capital II entered into an agreement with Wachovia to acquire up to 100 branches this year, many at major intersections and shopping center pads, with a total value of more than $100 million.

A subsidiary of American Realty Capital serves as the external manager of American Realty Capital Trust, a non-traded public real estate investment trust (or REIT). ARCT, launched early this year, has registered to sell up to $1.5 billion of common stock, with a focus on acquisition of fully occupied, net-leased, single-tenant retail properties with long-term leases to high-credit or investment grade tenants.

"Even in today’s historic dislocation in the capital markets, there’s still an abundance of equity capital ready, willing and able to invest in well-located properties with long-term net leases with good, solid credit tenants -- and that’s what these bank branch and headquarters transactions offer," concluded Stan Johnson Co.’s Jeff Hughes. "Even with the current difficulties, it’s a good place to put your investment. With long-term passive leases in place, there’s still a great appetite for that product type, so it’s going to continue to grow in importance in the commercial real estate investment world."