How do you justify a sale and leaseback?
First of all it is important to understand the rationale for undertaking a sale and leaseback. In simple terms it is about efficient and productive use of equity. Simply put owning a property outright means your capital is tied up in an illiquid asset. It also means that not only are you running an operational business but you are also exposed to the property investment market with the value of your property fluctuating with property values generally. When the building comes to the end of its useful life (which modern buildings appear to do in a very short space of time) you then have to go to the expense of redeveloping it or selling the land for development.
Extratracting value by borrowing and securing the loan against the property might deal with the immediate issue of cash being trapped in an illiquid asset but it does not deal with the other issues highlighted above. Further owning the property outright and mortgaging has a very negative effect on a company's balance sheet something which, under current accounting principles, a lease does not.
In fact, failing to use sale and leasebacks to some extent might have hampered Southern Cross' expansion. Whilst one might argue this would have been a good thing one has to consider how, with an increasingly ageing population, having less care beds available is necessarily in the public interest.
I have been involved in a number of sale and leaseback transactions and also acquired and sold properties which have been investments created by them including some Southern Cross properties. Sale and leasebacks come in all shapes and sizes but I can confidently say that it is not the sale and leaseback model that is the problem but rather the way it is structured and its misuse.
A lease is a very flexible instrument and property valuation more of an art than a science. Accordingly, by varying the lease inputs in relatively small ways the capital value of a property can be increased or decreased significantly. But sometimes you can change the same variable without getting the same results. For example, altering the initial rent on a sale and leaseback transaction will have a greater appreciable effect on capital receipts where rent reviews are index-linked than if they are open market.
Let's consider the Southern Cross approach. Anecdotal evidence suggests that most of their leases were relatively long term (30+ years) on a full repairing basis with index-linked rents subject to a cap and collar. Analysing these inputs and whether they were sensible choices for Southern Cross to make I would conclude:
- Term - on the basis that you are not going to move residents around homes you need a long term. Further the large scale capital expenditure needs a long enough period to be amortised over the life of the lease
- Full repairing - SX would need to maintain the homes in order to comply with CQC and Care Standards so this covenant is not imposing a more onerous obligation on them. Leasing a commercial property is not about being relieved of the financial implications of repairing it it is about best use of available cash
- Index-linked rents - SX's business model was based on local authority spending. Historically this has always risen in line with a pricing index. Therefore linking rents to such an index is more logical than relying on either fixed uplifts or open market reviews where true comparables are very difficult to find
- Cap and Collar - These are important for certainty. From SX's point of view a cap limited its exposure to higher levels of inflation (and bearing in mind the concerns on inflation in 2007-2009 this was a good call). The quid pro quo to a cap is a collar to provide the landlord with some comfort that there will always be a rise. Frankly bearing in mind actual inflation you cannot blame the collar for the failure.
The sale and leaseback structure is not blameless but the issue is more likely that SX agreed rents that were too high in the first place. The incentive for this is clear. Within reason the higher the initial rent the higher a price a buyer will pay. SX extracted maximum value for each property by agreeing to pay the maximum rent which it was felt the business operated at that care home could bear; it left no room for drops in income. Had their assumptions borne out no one would have questioned their actions and everyone would be marvelling at what a fantastic job the board had done.
However, before singling out the board of SX for criticism regarding their assumptions let's not forget the following:
- landlords had their own advisors who were as well placed as SX to study the demographics, macro- and micro-economics behind the business and lease structure and highlight concerns - did they?
- we had a Labour government which had continued to increase year-on-year its public sector spending in key areas including elderly care and shown no interest in reducing it (even after the credit crunch hit)
- we had Gordon Brown as chancellor telling us he had "abolished boom and bust" and many were happy to believe him
- we had banks with apparantly endless resources able to lend at high leverage
Jamie Buchan, SX's soon to be ex-Chief Executive, said in an interview with Adam Shaw on BBC Radio 4 Today this morning, that he expects changes in the sale and leaseback model in the future after their troubled experience. Paul Pressland who responded to @AdamShawBiz's tweet said "it is simple, agree a rent you can sustain not one that gives you the greatest capital sum!". Whilst it may not be that simple it certainly would be a good start.