The Future of Sale and Leasebacks

IFRS 16, has stimulated increasing sector and press speculation regarding the future of Sale and Leaseback (“S&LB”) activity. With almost all leases now destined for the balance sheet, a S&LB will usually no longer be considered a form of pure off-balance sheet financing. Several commentators have considered this sufficient to pronounce the early death of the S&LB.

Yet we’ve seen major commitments to S&LB transactions by the likes of KPMG, Lloyds Banking Group and DHL. The reasons behind these organisations committing to leasebacks are diverse and not simply a final ‘push’ before the introduction of the regulations in 2019.

The introduction of IFRS 16 will not kill the S&LB market, in fact for some companies it may stimulate increased demand to monetise owned assets. Here’s my top three reasons why:

Firstly The benefits of a S&LB as a means of off balance sheet financing is, after all, only one of a range of considerations. Other factors are of greater importance to many companies.  This can include lowing weighted average cost of capital, releasing capital for reinvestment, matching funding duration to expected occupancy, transferring unwanted liabilities and reducing exposure to real estate markets at a beneficial point in the cycle.

S&LBs will also, in effect, continue to offer a partial off-balance sheet solution as only the PV of the rent will be capitalised on the balance sheet (and that amount usually discounted at a much higher cost of capital than the implicit property yield). This means that as little as 50% of the cash raised will be capitalised on balance sheet.  This still compares favourably with bank or bond finance, which require the entire principal amount to be recorded.

Additionally, unlike with the corporate bond or bank debt market, the total cost of financing typically reduces with longer lease terms as shown below, and does not require a principal balloon payment at the end of the term.

Secondly IFRS16 could actually enhance the potential value creation from S&LBs and ‘Opco/Propco Structures (where property  is separated from underlying businesses to access a lower cost of capital).   Such deals take advantage of market inefficiencies and arbitrages different pricing approaches in the real estate and corporate markets.

The reason for this lies in the Enterprise Value/ EBITDA multiple valuation methodology that is now widely adopted, together with the impact on EBITDA caused by the new accounting standards. IFRS 16 will shift most lease payments from an operating cost that would be deducted in an EBITDA calculation to a combination of interest and depreciation that is not accounted for in EBITDA.

Therefore, under IFRS 16 most companies with operating lease liabilities will actually see EBITDA rise, albeit any equity valuation will now need to take account of the additional indebtedness created by the future rental liability as a deduction from the Enterprise Value.  However, as the rise in indebtedness will not usually offset the rise in Enterprise value allowing for value creation.

The chart below demonstrates an example of a hypothetical equity valuation based on an showing the theoretical impact on equity valuation of a sale and leaseback (pre, and post IFRS 16) at a constant EBITDA Multiplier.

Thirdly, IFRS 16 will have limited practical impact on Loan covenants for most companies. The inclusion of leased assets on balance sheet will result in an increase in both the lessee’s reported assets (ROUA: Right of Use Assets) and liabilities (the Present Value (PV) of the lease commitment will appear on balance sheet).

IFRS16 will have some impact on companies that are sensitive to gearing ratios including those with banking covenants that are linked to balance sheet indebtedness.

In our view this will be a relatively limited impact.  Due to the long lead in period to the new regulations, many banking covenants now have ‘carve outs’ protecting against changes in accounting regulations and more recent deals have often explicitly excluded the impact of IFRS 16 entirely.  Indeed, The Loan Market Association has since June 2016 provided optional wording to freeze the impact of any new leases on financial covenants as at before the introduction of the new standard in 2019.

So, in conclusion, I do not consider the S&LB dead.  Indeed, with around 50% of the Commercial real estate market held by corporate owner occupiers, it is likely to be heavily tapped to assist with any new wave of M&A and investment activity over the coming years.

By Paul Lewis, Head of Corporate Capital Markets, EMEA, CBRE.