Should We Fuss About FASB?

Recently, there has been some gnashing of teeth about the possible impact on sale-leasebacks by a proposed change in the manner in which leases are accounted for under GAAP. FASB has put forward some changes which, if enacted, will effectively eliminate the distinction between operating and capital leases. For companies such as Walgreens and CVS, who heavily utilize sale-leasebacks, and typically structure the resulting leases as operating leases, this would means billions of dollars of lease liabilities would move from the footnotes to the balance sheet.

While it's true that this change will be a headache for the accounting departments of both lessors and lesses (not the least of which due to its retroactive nature) it's impact onoverall sale-leaseback activity should be zero.

Here's why:

Sale-Leaseback Economics Don't Change Because of How You Account for Them.

The underlying economics of a sale leaseback need to work independent of how the transaction is accounted for. If the cost of doing the sale lease back isn't exceeded by the return obtained on the proceeds of the transaction than it makes no sense. How we record the debits and credits of such a thing is largely irrelevant.

It’s also not like operating leases are a secret on Wall Street. Analysts and those who follow these companies closely have already baked the operating leases into the debt loads of the companies. It’s common practice to take as much as 2/3 of the operating leases listed in the footnotes into consideration when conducting ratio analysis and comparing companies.

That being said, moving the obligations from the footnotes to the balance sheet is essentially a smoke and mirrors exercise although one would have to admit it does enhance transparency. Particularly so for companies who use the practice as a matter of course. It’s amazing how often you hear that Walgreens has no debt. Apparently, those who think so don’t read the footnotes.

While rationally, this change should be a non-issue to the investors in and conductors of sale-leasebacks, no one ever said people were required to act rationally....

2010 Cap Rate Report

“Are we there yet? Are we there yet? Are we there yet?”

- Bart Simpson

Are we there yet? No, but the steady rise of cap rates in 2009, born of the recession, bail-outs, defaults, and fall in consumer confidence has given way to a modest stabilization as financial indicators have subtly improved in the first quarter of 2010. Across the country, decreased transaction volume brought on by a still conservative lending environment and the impact of the recession in all but a few standout markets has prevented a true return to normalcy. Those factors have also turned investors towards key primary markets where real estate fundamentals remain strong, the impact of the recession is less severe and debt placement more readily available. Cap rates in these select primary markets have stabilized and even dropped to an extent as the influx of investors from across the country has led to a scarcity of quality inventory. The net result of the transaction volume in these primary markets is a modest downward compression of cap rates across all sectors.

Net lease investments continue to represent a large portion of the transactions taking place, proving that there is a significant flight to quality as buyers seek out properties with strong credit tenants. Single-tenant net lease retail properties, priced between $1M and $10M, have become the sweet spot for many investors and 1031 buyers. A quick analysis of these types of transactions points to the possibility of 2010 being a plateau year with potential cap rate compression coming in 2011. Today, most net lease properties have been trading at cap rates between 6.50% – 8.75%.

For more, check out our full report.

Zero Hour for Net Leases

It is not a secret that many commercial real estate loans stand on shaky foundations. In-fact it has been recently estimated that a “sizable amount of the additional $700 billion in commercial real estate loans coming due during that time frame are loans that could not get refinanced at existing levels in the current lending environment”. This of course will lead to many foreclosures and create an investment opportunity for CRE buyers. However, for the unfortunate holder of the original asset there may be a potentially huge tax consequence. There may also be a glimmer of hope in the form of a Zero-transaction.

Simply speaking a zero transaction is the acquisition of a property using a highly leveraged loan (loan to value usually 88% plus) with all rental income dedicated towards debt service, thus producing “zero income” for the property owner. One of the vehicle’s applications is to defer tax liabilities incurred in a commercial foreclosure.

The Problem

Though it is not widely known, the foreclosure of a commercial property is often a taxable event. How the IRS computes the tax depends on whether the property was financed with a recourse or non-recourse loan. In the case of a recourse loan, tax liability is calculated by taking the difference between a property’s fair market value and its adjusted basis. The tax liability of a non-recourse loan (which the remainder of this piece will be dealing with) is calculated by taking the difference between a property’s outstanding mortgage balance and the property’s adjusted tax basis.

The “outstanding mortgage balance” is the key element which catches investors off guard.

For example:

Let’s say you bought a property for $5M (your cost basis) which subsequently has been depreciated to an adjusted tax basis of $3M. Let’s also say you refinanced this property during an upsurge in the market and pulled out $8M of equity. If this transaction was foreclosed upon (without any action to defer tax liabilities), you would face a taxable gain of $5M, i.e. the $8M in outstanding mortgage amount minus the $3M in adjusted tax basis.

Thus, investors who think returning the keys to the bank absolves them of all monetary concern involved in a commercial foreclosure are gravely mistaken. The IRS views any money previously pulled from a property via loan refinancing to be taxable gain, even though the property is foreclosed upon.

The Solution

With proper scheduling and use of the 1031 exchange, the situation above can be avoided through the purchase of a “zero income” property. The reason a zero income property can be so beneficial is due to its highly leveraged nature and its ability to defer a taxable gain through a 1031 transaction. A portion of the money an investor would have otherwise paid to the IRS can be used instead to acquire the zero income property through the 1031 exchange.

Here is how our previous example would be impacted by a zero transaction:

Assuming a tax rate of 25% (Federal capital gains rates, Federal recapture rates and state taxes), the $5M in gain would cost $1.25M in taxes. If instead, a zero transaction was pursued, the investor would need to replace the balance of the debt, $8M. By exchanging into a zero income property for approximately 10% of the $8M debt amount replaced ($800,000), there would be a $450,000 savings ($1.25M-$800,000) and the investor would own NNN property with a very high credit tenant.

In order for the transaction to flow smoothly, it will have to be properly organized and scheduled on an individual basis. It should be noted that a zero transaction is not possible without outside assistance of at least a Qualified Intermediary and qualified professional tax and accounting advice. If done properly, this strategy can be an invaluable tool for investors caught in a foreclosure situation.

Drug Store Wars

Recent developments concerning Walgreens and CVS point to changes in their stores and company interactions. These range from alterations in store layout and product offerings to new rules concerning prescriptions. Both of these tenants are huge players in the net lease market and these shifts could change the way investors view them.

CVS to Expand Grocery Aisles

CVS plans to expand grocery aisles in 3,000 of their stores during 2010. They will be doubled in size, giving the company more exposure to the trillion dollar U.S. food market. Many see this as continuation of “channel blurring”, a trend which has been embraced by many retailers. As reported by the Patriot Ledger “Just as supermarkets have expanded pharmacy and health and beauty sections in the past decade, drugstores are retaliating by putting food products in the forefront.” Cleary CVS is jumping in head first by modifying 43% of their 7,000 nationwide stores.

Walgreens to Sell Beer and Wine Again

Walgreens is breaking a nearly 15 year self-imposed ban on the sale of alcohol in their stores by reintroducing beer and wine. So far 3,100 (41.3%) of their stores have already been stocked, with plans to increase that number to 5,000 by years end. Previously the sale of alcohol and other spirits made up 10% of Walgreens total sales, indicating a likely increase in sales this year. Other drugstores such as CVS and Rite Aid have continually sold alcohol. It is available in 4,300 (61.4%) of CVS stores and 28 of the 31 states Rite Aid operates.

CVS to Exclude Walgreens from Retail Pharmacy Network

CVS Caremark has stated it will end their retail pharmacy partnership with Walgreens in roughly 30 days. This occurred in response to Walgreens announcement that it will no longer participate in new CVS managed prescription drug plans. Thus, the pharmacy networks of the two will become mutually exclusive forcing customers to one or the other. This certainly heightens the competition for customers between the two and could increase marketing to that effect.

Looking at the situation from an investor’s standpoint, the first two changes are certainly positive. CVS expanding their food section is in line with a nascent trend of frugality and “back to basics” purchase behavior. Walgreens on the other hand is opening itself up to the conclusively popular trade in alcohol which should only benefit their store revenues. The only trend which could be perceived as worrisome is the segregation of prescription customers. Forcing an exclusive choice could lead to higher costs to maintain and attract new customers. However, such fears maybe overblown. A little competition never hurt anyone.