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November 15, 2017

By Bill Cavaganro, President, JLL Securities, LLC

In the midst of monumental changes like impending tax reform and clarity around new lease accounting standards from the U.S. Financial Accounting Standards Board and the International Accounting Standards Boards, many professional real estate investors are flocking to time-tested safeguards to mitigate this risk. What many are finding is that credit tenant lease (CTL) financing is a reliable and viable solution.

The truth about CTLs

Forget what you think you know about a CTL. It’s really just another type of attractive financing. And under the right circumstances, it has some real horsepower to offer borrowers.

Simply put, a CTL is a type of mortgage financing that is structured as non-recourse to the borrower. And here’s where it gets compelling – CTLs are delivered as a high-leverage debt product with a long-term fixed rate. While they typically apply to single properties with investment-grade tenants entering into long-term leases (think 15-20+ years), it’s possible to create a structure where companies without a public investment grade credit rating can use one. What’s more, in an interest rate environment that many are anticipating will likely go higher in the near future, CTLs can provide a stable source of long-term capital to lock in today’s low rates.

The beauty of a CTL comes at the end of the loan. As the borrower pays off the financing, it never relinquishes ownership of the asset; therefore retaining ownership of the property. Given its ability to potentially fund up to 100 percent of an asset’s value, a CTL is highly effective for acquisition financing as well as “cash-out” refinancing. In either case, given the ability to provide a source of high leverage with zero equity contribution, the CTL can both provide a highly effective means
of increasing assets under management as well as a reliable source of long-term capital to re-deploy into other investment opportunities. If structured properly, it’s a safe source of long-term financing.

While CTLs can be used on existing leases, financing economics can often be optimized if they are structured in tandem with lease formation under terms that are beneficial for CTL treatment. CTL economics are driven by tenant credit and lease quality. Done correctly, CTL financing enables borrowers to realize economics that are pegged to the corporate financial strength of the tenant, rather than their own cost of capital.

Market trends

In a search to continually drive shareholder value, corporations are looking for ways to optimize their capital stack and monetize capital locked into non-revenue producing property, plant and equipment-related assets. CTLs enable corporations to unlock this capital through a long-term fixed-rate real estate loan at a cost of capital that is akin to their corporate borrowing rate.

CTLs have become particularly popular with third-party investors seeking to retain asset ownership while paying off existing financing and recapturing owner’s equity. Today, we’re also seeing corporate and third-party owners using them as a source of high leverage construction-to-permanent financing for all asset types.

It’s all about the analytics

Take as an example, one private developer who was looking to procure construction-to-permanent financing for a 735,000-square foot headquarters facility to be built for Zurich in suburban Chicago. The borrower wanted a long-term source of fixed rate financing. Zurich, the tenant, wanted a state-of-the-art facility with low occupancy costs.

Sounds tricky, right? With no obvious solution in sight, the notion of a CTL came up. There was one problem though – Zurich wanted its North American entity, Zurich American Insurance Company, to be the lessee and it does not carry a public rating. Because CTLs are heavily dependent on credit, many people think the conversation has to end there. Not so.

After an intensive credit analysis based on the statutory financials Zurich posted, the answer became more apparent. From the analysis came a lease that maintained CTL eligibility for the developer, enabling it to achieve a low financing cost which, in turn, drove down Zurich’s overall occupancy cost.

The key is getting to the credit. You may have to go through several layers of corporate entities, but it can be done. You just need access to a provider of sophisticated real estate modeling and credit analysis capabilities. When you look at the Zurich example, the parent company is not on the hook. It was structured and funded as a $334 million construction-to-permanent financing at a relatively low fixed-rate for a 26-year term.

That’s just one example. Every deal is completely different. By their nature, CTLs offer the ability to customize a transaction structure for any given deal. Hartz Mountain Industries is a large, privately held real estate owner and developer that was looking to refinance the primary maintenance facility for the New Jersey Transit Corporation. The property was part of an industrial facility built in 1970 with three tenants, each holding an interest in the facility governed by a condominium regime.

Conventional lending sources weren’t bringing in the loan-to-value Hartz was hoping for. Digging deeper revealed an alternate, yet slightly unconventional path: restructure the condominium documents. Once that was done, it allowed for a full analysis of NJ Transit’s credit as a tenant. Using a CTL enabled allowed Hartz to make use of the financial benefits of a highly credit-worthy municipal tenant and monetize the complex NJ Transit lease.

Their CTL received strong interest from a number of global capital sources because of the strong credit rating, the modified condominium structure and the critical nature of the facility. That structure provided $48 million in proceeds at a low interest rate, which let Hartz finance tax-free nearly 96 percent of the market value of the real estate and re-deploy the capital elsewhere.

Do your homework

With an estimated $540 billion of capital sitting on the sidelines waiting to invest, get ready for an uptick in the number of companies asking questions about CTLs. On the investor side, there’s a strong appetite for this type of paper – and for good reason.

It’s relatively safe. CTLs provide professional investors a predictable long-term cash flow stream that provides yields slightly higher than corresponding corporate bonds. Investment managers are grabbing a $150-200 million piece of these deals as the stable fixed returns provide a means of asset-liability matching.

For many, CTLs are uncharted territory. But, they do offer a smart way to solve debt challenges and remain financially solvent in both strong and uncertain markets.

This article was also featured in NAREIM Dialogues Fall 2017

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Bill Cavaganro

President, JLL Securities, LLC

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