A recent lease accounting rule change provides a new financing wrinkle for retailers.
By Mark Radosevich
Fifteen years ago, I worked as a deal originator for a Lehman Brothers entity focused on the sale-leaseback (SLB) as an alternative to traditional debt financing for retail petroleum acquisitions.
Some of the advantages of an SLB that we featured included reduced buyer equity (many times we could finance 100% of the cost of a deal), tax deductibility of rent payments and the off-balance sheet features of a lease, whereby the overall lease obligation is not reflected on the company’s balance sheet, making the company seem financially healthier than it may otherwise be.
The Financial Accounting Standards Board (FASB), a non-profit entity that sets accounting rules for U.S. companies, in the last few months has required companies to add various lease obligations to their balance sheets. Mandatory compliance of this rule begins in 2019.
The rationale for this rule change is aimed at better reflecting a company’s financial condition by including both lease and long-term debt obligations, thereby making some companies appear deeper in debt.
This may not pose a big problem for larger companies, as sophisticated investors already calculate lease obligations into their evaluations as to the true financial strength of a company. The rule will ultimately increase transparency and allow smaller investors to obtain a clearer picture of a company’s financial health. Of course, there are always pros and cons with SLBs.
LIMITED FLEXIBILITY
An SLB seems to be best suited to stores that are new-to-market, located in good locations and best equipped to handle trade area growth and potential competitive intrusion. Long-term leases of this nature typically include assign-ability clauses that limit a company’s flexibility to exit out of a property in the event of an unforeseen situation that negatively impacts a store’s financial performance.
To exit, the company can only assign the lease to an “equal or better credit rated” tenant. Thus, when entering into one of these leases, the tenant must be sure that the subject store has viability all the way through the lease. In some instances, the lease will allow the tenant to substitute the lease to another property, thus allowing an exit from the impacted store.
This clause is generally seen in master lease deals, where more than one property is encumbered by the lease.
TEST OF TIME
Great care must be taken when using an SLB to finance an acquisition of multi-unit store packages whereby the stores may currently have cash flowing at an acceptable level but because of their age, size, configuration and location, are vulnerable should a sophisticated store operator enter the market.
For all of the flexibility reasons outlined above, the key criteria when considering an SLB as the financing tool for an acquisition is insuring that the subject stores can stand the test of time. Sites in the package that fall below this threshold should be acquired using traditional debt financing.
INVESTING AND EQUITY
In today’s market, traditional marketers seem best suited to growing through debt. For small to mid-sized acquisitions, financially healthy companies can access financing at very good rates and terms. They generally don’t stretch for an acquisition and as such have, on hand, the required amount of equity to secure the loan.
Most importantly, they maintain the flexibility to dispose of a property with no long-term lease interference and gain increased equity as the loan is paid down.
Despite the new lease rule changes, sophisticated store operators will continue to utilize SLBs as an important financing tool for their new to market stores built to a modern standard of size, offerings and operational quality. Using SLBs to fund acquisitions will hold hidden challenges unless leases are adapted to provide greater flexibility to enable operators to exit out of stores through the life of the lease.
Although the lease obligations will now be reflected on company balance sheets, the risks associated with lease encumbered stores that do not stand the test of time will not be. For this reason, investors must continue to do their due diligence before investing in such companies.
Possessing more than 35 years of downstream petroleum experience, Mark Radosevich, president of PetroActive Real Estate Services LLC, offers confidential mergers & acquisition representation and financing services exclusively to petroleum wholesalers and convenience store marketers. He can be reached by email at [email protected] or at (423) 442-1327.
