Strategy & Operations » Real estate » Sale and leasebacks on the rise to fund alternative assets and improve ESG

Sale and leasebacks on the rise to fund alternative assets and improve ESG

UK corporates are looking for alternative methods of capital raising to improve real estate assets and meet proposed legislative energy targets, says Douglas Babington Smith, partner at Charles Irvine

The UK government has set new targets for commercial buildings, which will now require an EPC Grade B by 2030’where cost-effective’, as stated in its 2020 Energy white paper.

There is still plenty of uncertainty as to how the government plans to implement this target, but with only eight years until the 2030 deadline, occupier and corporate property owners need to start thinking now about how they are going to meet that challenge.

For many owner-occupiers, there is simply no evading this target as they have probably made a similar commitment to their shareholders; over 92% of S&P 500 companies publish sustainability reports. For UK listed firms and financial services firms, there is also an obligation from next year to disclose a climate transition plan.

However, for some, the capital commitment and expertise required to implement the required physical improvements may simply not be available. We know that traditional corporate banks have reduced their lending to real estate as a result of the Capital Requirements Directive.

Challenger banks and alternative lenders could step in but their rates are likely to be higher and long-term finance may not be on offer. Neither do they offer the expertise and capability to implement those changes. For many corporates, a relocation to more modern premises is simply not an option, as the costs involved and/or disruption to operations, employees and customers are too high.

An alternative solution

There is another financial solution, which is not new but has only recently become a lot more attractive to companies wanting to raise capital without going through traditional routes – sale and leasebacks.

S&P Global Market Intelligence estimates that in 2021, $92bn was invested globally in ‘net lease investment’, since it also includes income strips, where tenants can repurchase at lease expiry. Overall, that is an increase of 48% in one year and around 11% of all commercial property investment – this is at a time when yields across almost all sectors are at historic lows.

The CBRE Long-Income Index tracks the performance of the UK market for Sale and Leasebacks and Strips and their sample of these assets for the index (excluding ground rents) is alone valued around £14bn. For Europe as a whole, Savills reports that there were  €8.5bn of transactions in 2020, a fall over 2019 but an increase of 8.5% over the five year running average.

This increase is the result of available capital from investors who are looking for long-term stable income and not simply targeting the traditional favourite sectors like offices and retail.

Over the past few years, the real estate market has seen an increase in the number of investors diversifying their portfolios and actively seeking alternative sectors, such as research and development facilities, production space, healthcare, and nursing homes. In fact, there are specialised funds now for virtually any type of commercial property. Even the lot sizes are smaller, with some investors willing to commit as little at £10m per transaction.

There is ample scope for a sale and leaseback operation to incorporate a commitment from the buyer to upgrade the premises to an Energy Efficiency standard, so long as that target is readily measurable and can be quantified in terms of cost and risk. Many funds in any case will also have the same ESG obligations and will be limited to purchasing assets which meet, or will meet, high environmental standards.

So, a sale and leaseback can offer occupiers, even in sectors that in the past did not garner any interest from real estate investors, the benefits of not just releasing capital for reinvestment in the business whilst securing long term occupation, but also the expertise and capital necessary to implement energy improvements to their real estate.

There are still factors to be considered. A sale and leaseback can be an expensive process if not carried out correctly. It needs careful consideration of the accounting, fiscal and operational impacts. Investors will scrutinise a company’s financial statements, looking to ensure its credit worthiness is robust. The properties identified must meet the investor’s quality standards and the occupier will almost certainly be required to maintain the properties during the entire duration of the lease.

Occupier-owners across all sectors are having to re-evaluate how they can make their estates more energy efficient and upgrade them to today’s environmental standards. Sale and leasebacks present an opportunity to source both the capital and expertise to engineer those improvements and bring value to the asset and business long-term.

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