A sale leaseback from a non-rated regional auto parts operator where the unit economics look better than the credit

For an investor whose usual path is land and long holds, a sale-leaseback offer from a regional operator is worth thinking through carefully precisely because it sits outside the usual comfort zone. Say a regional auto parts operator with 31 stores across two states approaches a broker about sale-leasebacks on four locations, and the offer on the table is a 7,400 square foot box on a commercial corridor in a county seat of about 22,000, 1.1 acres, hard corner, 14,000 vehicles a day per the state DOT count. Terms worth examining: 20 year primary, 1.5 percent annual bumps, true triple net including roof and structure, price $1.34m, rent $100,500, a 7.5 percent cap rate. A corporate guarantee from the parent operating company, no rating, private, family held, no public filings, three years of consolidated statements, and unusually, store level P&L for the specific unit. If that unit did $2.71m in sales last year with $341,000 of four-wall EBITDAR, rent coverage on the proposed rent comes to 3.4x. Consolidated debt to EBITDA around 3.1, with roughly 40 percent of that being existing equipment and floor plan debt, rounds out the credit picture. The tension every NNN investor faces here: standard guidance holds that the credit is the deal, and an unrated, unverifiable credit priced maybe 75 to 100 basis points inside where unrated regional operators typically trade cuts against that guidance. Rent set at what looks like a deliberately affordable number rather than maxed proceeds often signals an operator intending to stay long term. The real question is how much weight strong unit-level coverage should carry against the absence of any rating, and whether the better response is a lease structure built for protection rather than simply demanding a discount.

nicole_adeyemi SS3APRO 13

Answer

ehernandez74 PC3BPRO 12

Put the weight roughly where you already suspect it belongs, on the coverage, but make the lease carry the credit risk you cannot underwrite from the statements. Things to ask for, and they cost the seller nothing if they mean to stay. First, an ongoing financial reporting covenant, consolidated and unit level, annually with a deadline and a default remedy if they miss it. You got the numbers once during diligence and you will never see them again unless the lease says otherwise. Second, a rent coverage floor. If unit coverage drops below something like 1.75x for two consecutive years, you get additional security, an extra deposit or a letter of credit stepped up. Third, no assignment without consent to an entity of lesser net worth, with the parent guarantee surviving any assignment. The piece worth fighting hardest for is a right of first refusal on the other three locations, priced at the same coverage math. If they perform for four years and stay, you have built a small portfolio with an operator you now actually know, and that diversification is the only real answer to concentration risk on an unrated tenant. One unrated box is a bet. Four across two states with staggered expirations is a position. On the 75 to 100 basis points, do not chase it. Take the structure instead. A discount pays you once at closing and a reporting covenant pays you every year you hold, and on a 20 year primary term that is the whole investment. If they will not give reporting on a lease they wrote themselves, that refusal is the diligence answer.

ehernandez74 PC3BPRO 12

3 replies

kevin_lombardPassivePRO

Before I say anything useful I want to make sure I've got the basic tension straight, because this thread took me two passes.

A sale-leaseback means the company that operates out of the building sells you the building and then rents it back from you, so they get cash out of real estate they were sitting on and keep running the store. Is the reason people watch these carefully that the seller sets the rent themselves, and they have an incentive to set it high because higher rent means a higher sale price at any given cap rate?

If that's right, then parcel's operator setting rent low is the opposite of the worry, and the 3.4x coverage is them showing their work. What I don't understand is why the corporate guarantee matters so much if the individual store is that profitable. If the parent went under, wouldn't a store doing 2.7m in sales just get bought by someone?

kevin_lombardPassivePRO

Rena Expert

Juniper has the mechanism right. In a sale-leaseback the seller writes both sides of the trade, so above-market rent inflates the sale price and leaves the buyer holding a lease no replacement tenant would sign. That is the standard failure mode and it is why unit-level rent coverage is the number that matters more than the going-in cap rate.

On why the guarantee still matters when the store is profitable. In a bankruptcy the operator gets to decide which leases to assume and which to reject, subject to court approval, and that decision is made on the lease economics rather than on whether you were a reasonable landlord. A below-market lease on a profitable store is likely to be assumed or assigned to a buyer, which is the outcome you want. A rejected lease leaves you with a damages claim that is capped by statute and typically pays cents. How those rules apply to any particular filing depends on the chapter and the facts, so that is a bankruptcy counsel question before you sign.

For parcel, the two numbers to reconcile are the 3.4x coverage and the rent per foot. 100,500 on 7,400 feet is $13.58. Ask what second generation retail on that corridor actually leases for. If the answer is nine or ten, your coverage cushion is real and your re-lease downside is a 25 to 30 percent rent cut, survivable. If market is six, the coverage tells you the store is good and the lease is still mispriced.

Also ask why they are selling four rather than all 31, and what the proceeds fund. The use of proceeds tells you more about the credit than the consolidated statements will.

Rena Expert

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