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SELL THAT VALUABLE REAL ESTATE, LEASE IT BACK, CHAINS ADVISED

BY DONNA MITCHELL

The Home Depot is asking for a little respect.

As one of the company’s top executives said in June, Wall Street seems not to have taken Home Depot’s valuable real estate properly into account. And yet it’s not only what’s inside the chain’s stores that offers value, but also the physical stores themselves.

“It’s hard to believe that our stock price reflects the value associated with our real estate,” said Home Depot CFO Carol B. Tomé at a Chicago conference organized by William Blair & Co., a private investment banking firm. One statistic she cited, however, says a lot: Home Depot’s stores represent about 80 percent of the company’s book value.

Well, if the stock market won’t respect the value of a company’s owned real estate, the property market will. Maybe Home Depot should consider a sale-leaseback, says Wayne Hood, a senior analyst at Prudential Equity Group, a division of Newark, N.J.-based Prudential Financial. Sale-leaseback transactions, in which a company sells its real estate and then leases it back from the buyer, are one way to ensure your real estate is working for you, proponents say.

“We believe the logical structure to unlock the value of the real estate would be a sale-leaseback arrangement with a large insurance company or bank,” Hood wrote in a report on Home Depot published the day Tomé delivered her address. A sale-leaseback on, say, half of Home Depot’s 1,468 owned stores, could generate as much as $29.7 billion, the report says.

But Home Depot isn’t taking that road, at least not for now, says Jerry Shields, a company spokesman.

Too bad, say proponents of the device. For one thing, there couldn’t be a better time than now, given the current low interest rates. In anticipation of a rise in long-term rates, the sale-leaseback market is expected to pick up, says Lynn Gray, senior vice president of the global real estate group at Lehman Bros. Most purchasers in sale-leaseback transactions finance their deals with mortgages equal to as much as 90 percent of the value of the real estate, says Gray. In turn, the tenant’s rent is tied to the interest rate on that mortgage, which is why it’s probably a good idea to seriously consider the option before rates go up.

And there are plenty of retail chains who could benefit, say sale-leaseback advocates. Sale-leaseback transactions make sense for any company that owns its own real estate, but they are ideal for retail chains that operate mainly out of stand-alone stores, such as Costco. In-N-Out Burger, an Irvine, Calif.-based fast-food chain that tries to buy land for its restaurants whenever possible, might also be a candidate for sale-leasebacks, says Alan Clifton, director of leasing and dispositions at Irvine-based investment firm Passco Real Estate Enterprises.

Sale-leasebacks originated in the 1970s, as retailers looked for ways to finance store expansions. At the time, U.S. tax laws made leveraged real estate investments attractive for wealthy individuals, who used the property depreciation and interest payment deductions to offset income taxes. Securities firms sold hundreds of single-tenant properties to individuals as tax shelters.

Underwriters formed limited partnerships to buy real estate assets from retailers and financed the deals by borrowing from institutional investors such as TIAA-CREF and Massachusetts Mutual Life Insurance Co.

“Retailers provided the most product for the sale-leaseback business,” Gray said. “They are the ones with regular expansion needs.”

Albertsons, J.C. Penney, Kmart and Wal-Mart led the way, says Gray, and Clifton adds that drugstores, fast-food chains and other stand-alone retailers have joined them. In recent years rival drugstore giants Walgreen Co. and CVS Corp. have both completed the occasional sale-leaseback deal, says Mike Heneghan, senior vice president and general counsel of Capital Lease Funding, a New York City-based net lease REIT. In fact, Walgreen leases 80 percent of its 4,583 stores. CVS owns about four percent of the 4,179 retail and specialty pharmacy drug stores that it operates in 32 states, according to the company’s 2003 annual report.

Sale-leasebacks quickly caught on in other real estate sectors. In the early 1980s Mellon Bank used sale-leaseback financing to build its Pittsburgh headquarters. Hershey, Pa.-based chocolate maker Hershey Foods, too, financed a good portion of its headquarters using a sale-leaseback, says Gray. During the sector’s heyday in the early 1980s, just about every major investment bank had a sale-leaseback department, including Goldman Sachs and Lehman Bros. These days very few investment banks maintain departments for these transactions, but Lehman Bros. still employs a few experts.

Even municipalities, such as the city of Oakland, Calif., use them to get funds from their owned real estate, says Gray.

It is hard to measure the size of the sale-leaseback market today, because most deals are done privately. But most sale-leaseback deals end up resembling net leases, wherein the tenant bears various levels of responsibility for operating the property. That market is estimated to produce $20 billion in deals a year, says Jeff Rothbart, research director and general counsel at The Boulder Group, a Northbrook, Ill.-based investment real estate firm.

The sale-leaseback market took a hit in 1986 when the Tax Reform Act curbed the ability of individuals to use real estate as a tax shelter, says Gray. But despite that, sale-leasebacks continue to offer advantages to real estate owners these days, sources say. For one, the 1031 exchange market is spurring sale-leaseback transactions, according to Gray. In a 1031 exchange, a real estate seller can defer capital gains taxes by reinvesting in a similar property. The seller has 45 days to identify a suitable asset and 180 days to buy it. In some cases, 1031 exchange buyers prefer to swap their properties with credit-tenant sale-leaseback properties, because the latter do not require active management. Like sale-leaseback situations, a credit-tenant lease is long-term, typically between 18 and 25 years, with rental rates reflecting the tenant’s credit rating and long-term debt.

If a company is large enough, it can sell a property to a wholly or partially owned subsidiary and structure a lease agreement favorable to itself, says Clifton. Or the property seller can request first option to repurchase at the end of the lease.

Given these advantages, why aren’t Home Depot and other chains rushing to sale-leasebacks? Well, there is one unavoidable drawback, says Rothbart.

“If they are renting [the property], they are throwing money at it and they have no equity in the store,” says Rothbart. “That is a detriment.”

Further, sale-leaseback transactions would complicate a company’s financial reporting, says Joe Bonner, a securities analyst at New York City-based Argus Research Corp.

“In a post-Enron world, anything that makes things more difficult to understand would lead to a discount in [a company’s] share price,” Bonner said.

Sale-leaseback transactions also increase a company’s fixed costs by imposing monthly rent payments. If the transaction raises lease payments by much, it could become an issue for some companies, Bonner adds, though noting that a company the size of Home Depot is unlikely to have much trouble with such payments.

But ultimately, sale-leasebacks let retail chains mind their core businesses and give them the cash to expand.

“They are better off … improving technology, hiring and doing whatever they need to do to grow their business, rather than stay the same size and own all their real estate,” said Rothbart.

Not that the Home Depot is holding back on expansion. During the Blair conference, Tomé outlined the company’s plans to expand existing operation in Mexico and embark on a new venture in China. Home Depot operates some 1,806 stores in the United States, Canada and Mexico and has opened about 50 stores so far this year.