The following is a guest post from Malik Franklin, a partner at SLB Capital Advisors, who has over 15 years of investment banking experience covering the real estate, health care and technology industries.
Inflation, supply chains in disarray, drought and labor shortages are adding new challenges for food processors already in the throes of an intensely competitive business.
Global food prices have surged 65% since the start of the COVID-19 pandemic and by 12% this year alone since the start of the Russian invasion of Ukraine, according to data from the United Nations’ Food and Agriculture Organization. Inflation offers opportunities for food processors, but stresses as well.
In either case, food processors need fresh capital, either defensively, to meet new and ongoing challenges, or proactively, to fund opportunities for growth. Additionally, some may have a preference to pay down floating rate debt that has increased in the rising interest rate environment. The source of capital for these initiatives might literally be right under their feet, in the form of the real estate they own. By selling property and immediately leasing it back, food processors can realize a fresh layer of capital while maintaining long-term control of their facilities.
So-called sale leaseback transactions are on the rise in general, but particularly with industrial-oriented properties. Of the 236 sale leaseback deals in the second quarter representing $10.2 billion of value — a level close to pre-pandemic activity — fully 50% occurred with industrial properties.
The affinity between sale leasebacks and industrial properties is attributable to several factors. First, other sectors such as retail and office, have experienced COVID-related challenges. As institutional sale leaseback investors have significant capital allocated to the net lease sector, the industrial segment presents a relatively attractive opportunity on both a standalone basis as well as relative to other alternatives given many of the favorable market dynamics that continue in the industrial space.
Another, though less quantifiable, is the trend toward onshoring — in which manufacturers bring their manufacturing home to exert more control over their supply chains — is on the rise. This shift is driving even more of a premium on industrial real estate.
Textbook examples of sale leasebacks in the food processing industry were executed by Mercer Foods and Berner Food & Beverage. The former sold its headquarters and processing facility in Modesto, California, for $40 million to real estate investor LCN Capital Partners and then immediately leased it back. In the case of the latter, Berner sold its 316,300-square-foot food production facility in Illinois for $65 million to real estate investor W.P. Carey.
It is not uncommon for senior management teams at food processing companies to bristle at the thought of losing control of mission-critical manufacturing facilities.
However, ultimately the “long-term” feature of a sale leaseback provides owners with essentially the same control they have in an owned-facility scenario. Sale leaseback terms are generally 15 years (or longer in some cases), with renewals extending for an additional 20-plus years (at the tenant’s option), providing effective control for 35 to 40 years.
Unfortunately, simply owning real estate is not sufficient, in and of itself, to raise capital in a sale leaseback transaction. The underlying business needs to show not just stability, but growth too. The buyer wants a tenant that can easily satisfy the obligations of the lease over a prolonged period of time. Further, buyers are looking for companies with a balance sheet that can enable the company to weather any variance in its sales and earnings.
A stronger balance sheet may be something sale leaseback investors analyze on a pro forma basis. That is, once the value of the real estate is extracted from the business and reinvested to reduce other debts, the balance sheet might then be “right-sized,” and in this way, provide a pretext for getting the transaction done.
Similarly, the proceeds may be reinvested back into the company to fund growth initiatives, and in this way offer investors some confidence that the top line will continue to grow.
As a side note regarding candidates for sale leasebacks, location may not matter. Unlike retail, office or healthcare that are more dependent on strong locations, industrial properties do not. A sale leaseback relies heavily on the underlying credit of the company, and an industrial facility in a tertiary or even remote location remains attractive if the underlying business is healthy. This may be particularly important for food processors whose operations are situated in non-core markets.
Under the hood
Additionally, what can make a sale leaseback transaction especially attractive is the arbitrage opportunity it offers owners. In a nutshell, food processors can sell their real estate at a valuation multiple that is often greater than the business valuation multiple.
Remember, nearly all financial assets, including factories, plants, office buildings and, yes, businesses are valued at a multiple of the cash flow they generate. Under present conditions, real estate valuation multiples are higher than business valuation multiples, meaning that business owners can reinvest the proceeds from real estate assets into corporate assets that have the potential to grow more quickly and generate higher returns.
Many of the challenges facing food processors at the moment, particularly labor shortages, increasing costs and supply chain disruptions, may yet stretch on for years. Accordingly, the capital that a sale leaseback transaction provides may be important now, and well into the future.