The cost of debt capital has more than doubled over the past two years thanks to the rate hikes prompted by Federal Reserve open market operations. For many restaurants, this increase has impacted profitability and presented a barrier to supporting the rebound of the food service industry.
An attractive financing option that restaurants with owned real estate can consider is a sale leaseback. These transactions are often considered a hybrid capital alternative, and with debt markets functioning well but still expensive, SLBs are now even more attractive on a comparative basis.
Transactions in the Restaurant Industry
A number of QSR chains have executed sale leasebacks to fund their growth initiatives in recent years. One is Red Robin, which has sold and leased back 27 of its properties in a series of transactions over the last 12 months, raising a total of $84 million. The company used the proceeds to reduce debt, fund capital investments, and support share repurchases.
Two other examples are 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.
Sale leaseback transactions involve the selling of owned properties and then simultaneously leasing them back from the buyer under a long-term lease, unlocking valuable capital that is tied up in real estate. This freed-up capital can then be used to fund M&A, new unit development, and to pay down debt, among other use cases.
What makes sale leasebacks a readily accessible alternative is this: 1) real estate is a stable asset class with a readily discovered value and a reasonably high degree of liquidity and 2) sale leaseback investors are well-capitalized and actively looking for properties to purchase.
Attractive Cost of Capital
In exchange for an immediate infusion of capital, the company takes on a long-term lease obligation with fixed payments. The dollar amount of these payments, relative to the value of the real estate it sold to the investor represents an implied cost of sale leaseback financing. In real estate parlance, this initial yield is called a “cap rate.”
Whereas interest rates are 300-400 basis points higher since rates started rising, cap rates have only expanded 150-200 bps. Not only are today’s sale leaseback cap rates inside most restaurant companies’ blended cost of capital (a true apples-to-apples comparison), they are inside most of businesses’ debt financing costs. Depending on the level of debt on a company’s balance sheet, the difference can have a materially accretive impact on profitability and cash flow.
Arbitrage Opportunity
Not only is the sale leaseback a cost-effective financing mechanism, it is in many cases a tool to create additional value for the operator. As businesses typically transact on the basis of EBITDA multiples, sale leaseback valuations can effectively be translated into multiples for a straight-forward comparison. Most QSR sale leasebacks see multiples in the 13 to 15x range, with some north of 16x. Any time a QSR business is valued inside the SLB multiple, there is an arbitrage to be captured simply by the exercise of executing a sale leaseback.
Credit is Key
Whie owning real estate is a pre-requisite to a sale leaseback transaction, the key to unlocking trapped capital through this financing option is the company’s credit strength and the health of its underlying business. Investors are looking for a safe and steady stream of income through the lease they enter into. They want a tenant that can fulfill the obligations of a long-term lease, i.e., companies that have growth potential and a healthy financial profile that enables them to endure fluctuations in sales and earnings.
Addressing the Lobster in the Room
If sale leasebacks are great, why do many think Red Lobster failed after selling its properties?
The Red Lobster bankruptcy is a failure looking for culprits that have predictably fallen to the former private equity owners of the chain. In particular, the sale of many of the chain’s locations in SLB transactions has come under fire.
It’s easy to demonize private equity investors, and lately fashionable. In the case of Red Lobster, the sale of the real estate was a smart corporate finance strategy (and almost ten years ago!) to help fund the acquisition of an iconic casual dining chain.
Criticism of the rents incurred via the SLB can be short-sighted and miss the nuances of how these transactions function. The lease agreements between the new and former owner of the property are arm’s length transactions. 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, the private equity investors did what they do best: efficiently capitalize investments in companies they intend to grow and improve. In the case of Red Lobster, the pandemic, food inflation and competitive pressure ultimately led to the firm’s unfortunate bankruptcy.
Overall, the sale leaseback provides many benefits, including a highly attractive source of capital that provides multiple arbitrage and an efficient cost of capital. Unlike the debt capital markets, the sale leaseback market has been consistently open and is a reliable resource for restaurant operators with owned real estate.
Matt Wrobleski is a Partner at SLB Capital Advisors, which advises corporates and private equity sponsors on a wide range of sale leaseback transactions. Mr. Wrobleski has over 15 years of sale leaseback, real estate brokerage, capital markets and M&A experience.
