UK: Leveraged Leasing - Property Assets Get A New Lease Of Life

Many UK corporates are looking for new ways of unlocking the financial value of their property assets. This is not a straightforward task at a time when the property recession is still adversely affecting values, and the banking sector's appetite for new property debt remains small. All businesses occupy property yet a very small proportion of them would consider that property was part of their core business. The result is that countless companies are sitting on substantial assets which are not being sweated and, in many cases, are untapped sources of funds which could be better utilised elsewhere in the business.

Traditionally, the corporate property owner looking to raise money against operational properties took the sale-and-leaseback route: selling the property to an investor while simultaneously taking a lease which guaranteed the purchaser income. It is a simple solution but one which can have drawbacks for both parties. The occupier has to forego future growth in the value of the property and invariably has to agree to take at least a 10 or 15 year lease with, typically, five-year upward-only rent reviews. This makes it difficult for the company to quantify future rental costs. Such deals also see management control of the buildings pass to the owner; a potentially frustrating experience for an occupier who wants tailor-made, flexible use of a building without having to defer to a second party.

Above all this, the greatest problem with the sale-and-leaseback route is that because it focuses so heavily on property values and future rental growth, capital values are heavily dependant on the state of the prevailing property market.

In the US, there has for some time been a mechanism which provides the benefits (and more) of sale-and-leaseback without yields directly reflecting the state of the property market: it is called leveraged leasing. This technique for unlocking capital tied up in physical assets raises about $7-8bn of corporate finance every year. It is a method of financing which is essentially a finance transaction and not a property transaction. Pricing is driven largely by the occupiers' covenant strength rather than property values. It is particularly efficient for US investors because companies can depreciate all their buildings and claim tax-relief on the depreciation charge. Accordingly, a US company with surplus cash and tax capacity can make its cash work by purchasing property and leasing it back to the occupier.

It might appear that, as the depreciation factor is particular to the US, the technique could not be put to work on property outside America. However, because of the tax treaties that exist between the USA and the UK, a structure can be developed which utilises American funds to purchase UK properties and whereby all parties enjoy the same advantages as if the deal had been conducted in America. The differences in structure between a leveraged leasing deal and a traditional sale-and-leaseback vividly illustrate the additional benefits available to both the US investor and the UK occupier.

A typical US-UK leveraged leasing deal would look something like this: the UK corporate occupier sells its operational property to a "special-purpose vehicle" which has been financed by equity from a US corporate and additional funding coming from, typically, a bank syndicate. The beauty of the system for the US corporate is that, although they only have to put up around 10-20% of the purchase price (the remainder being bank money) they receive tax depreciation allowance on the full value of the property being bought.

The are several attractions for the occupier. First, the lease granted in a typical leveraged leasing deal will be for 25 years, but not with the usual five-year upward-only rent reviews. Rental levels over the term - or the mechanism for how those levels will rise - are agreed at the outset; allowing the occupier to know what their rental liabilities will be for the next 25 years. The second benefit is that management control of the buildings remains with the occupier; the investor does not care how the buildings are managed as long as the rental income flows. This attitude is because leveraged leasing deals are about finance rather than property: in most deals the tenant can, after 25 years, exercise an option to buy-back the property for a pre-arranged sum. In short, the investor gets a highly tax-efficient, management-unintensive investment producing regular income (which services the purchase loan). The occupier gets an off-balance sheet agreement which secures rental costs over 25 years, retains full autonomy over the buildings and has the prospect of regaining the asset at a fixed cost at the end of the term.

Perhaps most importantly because leveraged leasing deals are "finance-driven" and not property-orientated they can be applied to a wide range of properties. In the past, institutional investors have attributed higher yields to "difficult" properties such as hotels, pubs, leisure centres, cinemas, large industrial premises etc. because of the uncertainties over rental growth and demand. But with a leveraged leasing deal, as long as the occupiers' covenant is strong, the US investor will have an appetite for any type of property - possibly even local authority assets.

Nabarro Nathanson, together with clients who are veterans of US leveraged leasing, are now pioneering this structure in Europe. So far, although UK corporates have been cautious to explore the system, $250m-worth of deals have already been concluded. Exhaustive preparation has gone into designing the legal and tax structures necessary to make these cross-border deals work. Now that the ground work has been completed there is no reason why the flow of deals should not quicken. Leveraged leasing offers an excellent way of bringing US funds into the UK property market while allowing corporate occupiers new financial resources to apply to their core business.

Detailed specific advice should be obtained before taking or refraining from any action as a result of the comments made in this article which are only intended as a brief introduction to the particular subject. Nabarro Nathanson is regulated in the conduct of investment business by the Law Society.

For further advice from Malcolm Finney on 0171 491 6788, Kevin Wheeler, Nabarro Nathanson, Tel 0171 491 6982.

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