Sale-Leaseback Due Diligence: What to Know

Given the state of the US economy and the cost of financing, it’s no surprise that sale-leaseback transactions are on the rise. Potentially advantageous to both buyer and seller, a sale-leaseback transaction involves a property owner selling real estate assets to a buyer and simultaneously leasing it back from the buyer. For the seller, sale-leasebacks can free up capital, allow greater focus on core operations, and improve financial ratios and creditworthiness. Buyers stand to benefit by acquiring long-term leased assets, demonstrating the occupier’s commitment to the real estate, with secure, long-term cash flow. I recently spoke with my client Maury Vanden Eykel, SVP of Corporate Capital Markets at CBRE about this trend, what is driving it, and his advice for ensuring smooth and advantageous processes for all parties.

“We expect to see sale leaseback volume increase, which is typical in more challenging economic environments and volatile markets,” he commented. “Corporate real estate owners are eager to unlock hidden capital and redeploy it elsewhere rather than take on additional corporate debt in a higher interest rate environment. Selling and leasing back core real estate can be a better strategy that is more accretive to an occupier’s business strategy.”

For the greatest benefit from a sale-leaseback transaction, Vanden Eykel recommends that the corporate occupiers perform appropriate due diligence ahead of a sale process. From Vanden Eykel’s perspective, “Minimizing surprises from third party due diligence alleviates the concerns of all parties involved and is of the utmost importance in today’s capital markets environment. It’s critical to do as much up front as possible to avoid issues later on and have greater piece of mind – for both buyer and seller.”

Due diligence for sale-leaseback transactions begins with the same basic reports as other commercial real estate transactions, namely:

• Environmental Site Assessment (ESA)
• Property Condition Assessment (PCA)
• ALTA Survey
• Zoning Report
• Seismic Risk Assessment (SRA)
• Appraisal

However, the nature of many sale-leaseback transactions present specific challenges. And, like all quality due diligence, the scope of sale-leaseback due diligence should be tailored to address the needs of the buyer or seller requesting the assessments.

A Proactive and Efficient Approach is Key

Sale-leaseback due diligence should be scoped to reflect the ordering entity’s objectives for the transaction. In other words, if a retailer is liquidating a portion of its portfolio to free up capital, then the scope of due diligence should be customized for cost-effectiveness—to save money on the cost of due diligence so more of the sale proceeds stay with the seller—and to identify deficiencies that may affect the sale price of the asset.

Vanden Eykel observed that “Buyers are much more willing to underwrite a transaction when they have existing, new due diligence because they know they’re not spinning their wheels, spending their own time and money to identify a problem no one knows about. Sellers can benefit from having greater surety of close and transaction success by doing due diligence up front to find and address potential issues before they actually become a problem.” Accordingly, Vanden Eykel advises a staged, rapid-paced approach to due diligence.

For example, a national retailer with thousands of locations across the US is selling portions of its real estate portfolio to meet quarterly capital goals and sell a portfolio of a certain value each quarter. Transactions are quick, so they proactively order environmental due diligence before each planned sale to uncover any conditions which might cause the buyer to cancel, delay the close, or request a price reduction. To reduce the expense associated with environmental due diligence at so many sites, they have worked with their consultant to develop a cost-effective approach.

Given the retail nature of the portfolios, the sites are typically located on hard corner lots at high-traffic intersections. Corner sites have a high incidence of gas stations in their use history, which means a greater likelihood of potential contamination – or at least reason for concern. Knowing this, the consultant routinely performs a desktop assessment of all sites to provide a basis for determining the next step. For sites where the desktop assessment reveals a significant likelihood of contamination, the consultant proceeds directly to a Phase II ESA to confirm whether contamination is present and get a measure of the severity – this could potentially allow the buyer to have enough of a comfort level to take on a site with a minor environmental challenge. The consultant may concurrently prepare a Phase I ESA report alongside the Phase II for a streamlined approach. Or, if enough information is known up front, the consultant may bypass further due diligence and proceed directly to remediation efforts. Because significant contamination would likely reduce the sale price, the owner may choose to pull this property out of the transaction until the site is remediated. In that case, the Phase I would be delayed until the property is ready for sale, as Phase I reports are only valid for 12 months.

A buyer in a sale-leaseback transaction may benefit from custom due diligence scopes as well. They may wish to expand the scope of the PCA beyond the ASTM E-2018 standard to include greater depth of analysis or add specialty reports such as roof, mechanical/electrical/plumbing (MEP), or elevator assessments. Lately, our equity clients are beginning to significantly increase the scope of their PCA, requesting asset data collection efforts to support the transition into asset management and the achievement of portfolio objectives, such as increasing cash flow or meeting ESG initiatives. If the buyer intends to seek financing on the portfolio, they may order an equity-level PCA then, with the cooperation of their lender, ask for a modified, debt-level version to meet the lender’s requirements as well—saving time and money versus ordering two separate assessments.

Portfolio Transactions, Quick Turnarounds

Many of the sale-leaseback transactions we support involve the sale of a real estate portfolio. In some instances, owners of small businesses such as daycares, veterinary offices, and dialysis centers sell their entire business, including real estate assets, to M&A (merger and acquisition) investors seeking recession-proof business investments. Should the M&A buyer be chiefly interested in the business, they may sell off the real estate as a single asset or as part of a larger portfolio. In many other cases, portfolio owner/operators such as retail chains will divest all or a portion of their portfolio.

Because sellers are usually divesting to free up capital, sale-leaseback transactions often follow an accelerated timeline, such as a 30- or 60-day escrow period, or have specific quarter or year-end closing requirements. The challenge, then, is to efficiently assess the entire portfolio within the desired transaction timeline. Meeting this challenge requires a combination of the right resources, efficient organization, and smart scoping. “Look for consultants that have the scale and expertise to deliver efficiently, think proactively, and solve problems throughout the process,” advised Vanden Eykel. Consider the following when selecting a due diligence provider for a portfolio acquisition (or disposition) with a compacted transaction timeline:

• Single source: selecting a consultant who can provide all the required assessments will save time and likely be more cost-effective than using multiple providers. Furthermore, using a single consultant will increase consistency of data between reports.
• Geographic reach: For geographically diverse portfolios, using a national consultant with staff located near each property saves time and money by reducing the amount of travel necessary for site assessments.
• Centralized staffing and coordination: The consultant’s ability to deploy staff in an efficient manner is also critical, both to schedule assessments concurrently and to ensure consistency in execution and reporting. Finally, centralized project management, i.e. a single point-of-contact who orchestrates assessments for all sites, saves time and frustration and ensures seamless communication between all parties involved.
• Diverse in-house expertise: During due diligence, issues may arise that require further investigation or expert opinions by specialists. In these situations, quick access to in-house experts saves time and expense, and likely results in more accurate reports. For example, recently a private equity firm was acquiring several sites owned by a discount retailer. During the PCA site visit, questions arose regarding the roof: had it been properly installed? Instead of completing the assessment and reporting the questionable condition of the roof to the buyer, who would then have to source and engage a roof specialist to get more detail, the consultant was able to tap an in-house roofing expert to provide a specialty evaluation in the context of the PCA.
• Known, reliable brand: “Because reliance on the third-party reports is typically granted between the buyer and seller, and possibly a lender as well, it is very important that the due diligence provider is known and trusted by all parties,” noted Vanden Eykel. “Having a reputable, respected consultant such as Partner Engineering and Science has ensured that our buyers have never questioned the integrity of the reports that they will be relying on.”

With proper due diligence, sale-leaseback transactions are strategic tools that can benefit both parties involved. To ensure the transaction aligns with financial goals and long-term strategies, both buyer and seller should engage an experienced consultant who is adept at executing on portfolios and savvy enough to provide customized scopes that support objectives.

About Vanden Eykel

Mr. Vanden Eykel is part of CBRE’s Corporate Capital Markets Group focused on single tenant occupied industrial, retail, and office assets across the country and globally. The group advises corporate occupiers through the sale leaseback process and also assists institutional net lease investors with asset disposition. CBRE’s Corporate Capital Markets Group provides qualitative and quantitative analysis and advice regarding alternative capital solutions and the team’s diverse real estate knowledge is combined with exceptional expertise in finance, accounting, economics and tax, as well as underwriting of both real estate-based and credit-based transaction structures.