Site Lines: Lease To Grow
Unlocking the capital in real estate to finance growth and remain competitive
by Benjamin P. Harris
The pharmaceutical industry is a dynamic, ever-evolving business in the midst of a transformation. Competition and regulatory pressures are increasing, and the capital investments required in all phases of the business have increased. For companies to stay competitive they must remain acutely focused on their core business and have access to capital in a variety of forms. A growing way that many biotech and pharmaceutical companies have accessed capital is by unlocking the value of their real estate assets through sale-leaseback transactions.
The sale-leaseback has become an increasingly popular way for companies to convert the full market value of their real estate assets into cash. In a sale-leaseback deal, a real estate investment firm acquires a company's real estate assets. Typical transactions involve corporate headquarters, manufacturing facilities or other types of real estate assets. The facilities are typically acquired for their full fair-market value and then are leased back to the company on a long-term lease, allowing the company to retain operational control for the foreseeable future. Often, sale-leasebacks are done in conjunction with an acquisition or a private equity deal, where the proceeds of the sale-leaseback are used to fund an acquisition, a recapitalization, or to recapitalize the company's balance sheet.
At the end of a lease term, leases are typically structured with renewal options, allowing a company to retain operational control, but also to walk away from the property if it is no longer needed. By "off-loading" the residual risk of the real estate to a real estate investor better able to reposition or remarket the asset, the company can focus on its core business, and not on the real estate business. This can be an enormous benefit for drug manufacturers, drug research firms or others that use highly specialized real estate assets with limited alternative uses, and therefore often with illiquid secondary markets for the space. There are several real estate investment firms with extensive experience in owning and leasing biotech space and they can be better positioned to maximize the value of an asset that is no longer needed at the end of the lease term.
There are definitely benefits to ownership, including increased flexibility. Consequently a company must make sure before entering into a sale-leaseback that it understands its long-term requirements for the facility and the flexibility that needs to be structured into the lease document. In many cases, the cost savings of leasing when combined with the necessary flexibility structured into the lease can significantly outweigh the benefits of ownership.
Let's first use a hypothetical example to illustrate:
Contract drug manufacturer XYZ is looking to acquire a competitor to solidify its competitive market position. XYZ evaluates its options and realizes that it has four properties – three manufacturing facilities and one office building – that it can sell and leaseback to raise the funds necessary to fund this acquisition.
XYZ sells its three manufacturing facilities and one office building to a real estate investment firm for a total of $100 million and uses the proceeds of the sale to fund the acquisition of its competitor without significantly increasing the amount of leverage on its balance sheet. By selling and leasing back its facilities, XYZ was able to use the liquidity of its real estate assets to grow its business.
Here are two actual examples:
A private pharmaceutical company with interests in developing countries manufactures and markets a range of pharmaceutical products used in a number of medical disciplines including oncology, urology, gynecology, and pain management. As part of its global strategy, the company wanted to explore growth opportunities in the U.S. The group created a U.S. subsidiary, Tolmar Inc., to penetrate the marketplace by purchasing the assets and operations of a Canadian biopharmaceutical company, QLT, Inc's, U.S. subsidiary, QLT USA. To raise the necessary funds, Tolmar structured a sale-leaseback deal with a real estate investment firm.
Through the deal, the investment firm acquired a 65,000-sq.-ft. manufacturing facility in Fort Collins, CO. Fully equipped to produce dermatological products and injectables, the facility was leased back to Tolmar on a triple-net basis and Tolmar maintained full operational control of the facility. Tolmar was able to use QLT USA's FDA-approved building, assets, management, technology, and knowledge of the highly regulatory industry to its advantage when building its U.S. business. The $13.6 million sale-leaseback provided financing for a substantial portion of the purchase price of QLT USA.
This transaction was the perfect example of a strategic corporate buyer using a sale-leaseback to fund acquisitions at an attractive long term cost of capital.
Cetero Research is a large provider of early clinical and bioanalytical research services to the pharmaceutical and biotechnology industries, with a 1,646 study participant capacity. The company provides an integrated scope of services addressing the entire preclinical and Phase I trial testing process from study design through finalized reports required for regulatory filings. A platform company of Denver-based private equity firm, KRG Capital Partners, Cetero is the product of several separate acquisitions of CROs. To fund a portion of its fourth acquisition, Cetero/KRG engaged in a sale-leaseback transaction. The $21.6 million sale-leaseback of a medical office facility in St. Charles, MO, provided a low-cost and efficient source of capital to fund KRG's newest acquisition.
Pharmaceutical and biotech companies can use sale-leaseback financing to penetrate new markets, expand their business, fund acquisitions, and pay off existing debt. Sale-leasebacks can also be used to construct new facilities -- an attractive option for companies looking to expand their existing facilities or open a new facility at a different location but that do not have the cash on hand to do so.
As more sophisticated financing techniques and structures continue to be developed, business owners, managers and financial officers need to be aware of alternatives for managing and financing their real estate assets. In the biotech and pharmaceutical industries, as well as other industries, companies need to evaluate their current and future real estate needs, financial structure, capital requirements, and performance history on a semi-regular basis in order to avail themselves of the most attractive real estate financing options.
For the firm that does choose to engage in a sale-leaseback transaction, there are different types of leases that accommodate varying financial and operating needs. The two general categories of leases today, as characterized by the Financial Accounting Standards Board (FASB) guidelines, are operating leases and capital leases. The most substantial difference between the two categories is that the former is an off-balance sheet obligation whereas the latter is not. Within this general classification are many variations of leases, some of which are described below:
An operating lease that is generally short term (five or seven years) in length. As part of the lease obligation, the tenant is required to guarantee the residual value of the property at the end of the term with a predetermined maximum termination payment. This obligation at termination mitigates the lessor's residual risk and the lessor can, therefore, offer relatively low rental rates. In addition, a synthetic lease can only be written when a tenant is a new occupant of the particular property.
A lease that meets several tests that allow it to be accounted for as an off-balance sheet obligation of the company. Some provisions that are reviewed to determine if the lease is an operating lease include:
- the lease does not contain purchase options;
- the term of the lease does not exceed 75% of the useful life of the property; and
- the present value of the minimum lease payments does not exceed 90% of the fair value of the property.
A lease where the tenant is responsible for paying all the property-related expenses throughout the term of the lease such as taxes, maintenance and insurance. Roof and structural expense is often also the expense of the tenant. The rationale for this type of lease is that the tenant can best manage its own property costs and the lessor, with reduced operating exposure, can offer lower rents accordingly. Residual risk is borne by the lessor in this transaction.
A lease that is signed before a property is constructed. The future lessor funds the construction and, during the construction period, rent is typically accrued into the overall project cost. The initial term of the lease begins at occupancy and works similarly to the transaction outlined in the above triple net operating lease description.
A lease that contains certain provisions that make it treated as an on-balance sheet obligation. Some provisions that may cause a lease to be treated as a capital lease include
- a bargain purchase option;
- transfer of ownership to lessee at the end of the lease term;
- a lease term that is more than 75% of the useful life of the property; or
- a present value of the minimum lease payments exceeds 90% of the fair value of the property.
A long-term lease (12 years or more) typically with an investment grade credit tenant. Most leveraged leases are "off balance sheet" but it depends on the situation. Leveraged leases are generally three-party transactions with a lessee, lessor and third party lender. As they look primarily to the rental income of an investment grade tenant, leveraged leases typically offer very competitive rental rates and are typically tax motivated with the lessor bearing very little residual risk.
Every company that engages in a sale-leaseback has the ability to choose the lease that best suits the firm's needs. The factors that a real estate investment firm takes into consideration when considering and negotiating a sale-leaseback deal include evaluation of the lessee-firm's residual risk, ownership and financial structures, external performance measurements, access to capital and capital requirements, and the firm's current and future real estate needs. An experienced real estate investment firm with a history in the sale-leaseback business will be able to structure a transaction that meets both the near term liquidity needs while addressing the longer term operating issues of the company.
Sale-leaseback financing offers companies the opportunity to retain many of the benefits of real estate ownership, while simultaneously freeing up cash for redeployment in the company's core business and improving its balance sheet and financial ratios. Given that significant real estate assets are an essential component of pharmaceutical companies' ongoing operations, the sale-leaseback offers these companies a financing alternative well suited to funding near-term growth initiatives as well as longer-term corporate strategies.