Significant growth opportunities in SLB and BTS expected in both countries as market sentiment changes

Dubai, UAE, October 8, 2016:   The United Arab Emirates (UAE) and the Kingdom of Saudi Arabia (KSA) are seeing a surge in demand for real estate Sale and Leaseback (SLB) and Build to Suit (BTS) transactions amidst changing economic conditions, says JLL, the world's leading real estate investment and advisory firm.

Gaurav Shivpuri, Head of Real Estate Transaction Services in MENA, JLL believes the decrease in oil prices and weakening market sentiment has softened the appetite for traditional funding sources - largely banks - to continue providing new capital for corporates to support their growth strategies.

He says corporations with significant real estate assets are either selling their existing assets with a leaseback (SLB) or are seeking real estate developer/ financiers to custom build their assets (BTS). 

“This helps in preserving capital for either retiring expensive debt, reinvesting in the business or acquiring competitors when valuations are lower,” said Mr. Shivpuri. 

“In Saudi Arabia in particular, I expect to see a significant growth in the SLB and BTS transactions, as a number of private family groups holding undeveloped land, falling under the white land tax, are keen to use such strategies,” 

“Overall, the lower liquidity in the market, the benefits of reducing exposure to real estate for the corporate entity and increase in investment appetite for such assets, is likely to create more transactions in the SLB and BTS space in the short to medium term in the region.”

In recent years, the UAE and KSA have seen a number of real estate SLB transactions undertaken by entities such as school operator GEMS, grocer Azzizah Panda & Lulu, dairy company Safi Danone and retailer Jarir. Although data on all concluded transactions are not transparently known in the market, JLL estimates the size of the market to be around circa US$ 200m per annum, which is expected to grow in the years to come, as the success of these transactions and ones currently underway become known.

While BTS is a less prevalent for now, Dubai’s Jebel Ali Primary School recently concluded a transaction of US$ 56m, in which the school’s structure was custom built by a financier, on the back of a long term lease.

“JLL is advising a number of corporations on these types of transactions, which gives us an indication that the market will see more of these structures in the future across real estate asset classes, including education, healthcare, offices, retail and workforce accommodation,” said Mr. Shivpuri.

However, Mr. Shivpuri added that he feels these transactions are often structured incorrectly, which creates a sustainability risk for the tenant and the purchaser. 

“We need to tackle the issue by assisting in establishing a structure that’s fair to both parties and is in accordance with the market and its fluctuating macroeconomic elements,” he said.

In particular, Mr. Shivpuri says a focus on the following aspects is critical to ensure that the transaction is well structured;

• Starting Rent; it’s important to ensure that the asset is rented ‘at market’. This ensures that the purchaser does not charge rent that becomes unsustainable over time and increase the risk of tenant default. This is done by assessing the market environment and incorporating any elements of the property that would make it unique, to justify a higher or lower rent than the market. This rent is then juxtaposed to the revenue and EBITDA of the business that uses the facility, to ensure that the business can support the proposed rent. As a rule of thumb, the rent shouldn’t exceed over 15% of the gross revenue and should be no more than 50% of the underlying EBITDA.
• Rent Escalations; Real estate investors always seek escalations in rent to match the inflation in the market. Establishing the appropriate increase or matching the increases to revenue growth is critical to avoid bottom line shocks over time when the rent inflates.
• Duration of Lease and Break Options; establishing the suitable duration of leaseback is critical to ensure that the value of the asset is maximized, yet does not pose more risk than necessary to the seller/tenant. Generally, a longer lease achieves the lowest cap rate, however, the appropriate balance of business risk and upfront value creation is important to be assessed.
• Buy Back Call/Put Options; some tenants seek the possibility of re-acquiring the asset when their funding lines open up and establishing the structure of the buy-back terms is important to manage risk on either sides. A call option provides the holder, an option to acquire, while a put option creates an obligation. Understanding the risk and reward on either is important for both parties.
• Evaluate the current market pricing; The pricing on a SLB is dependent on many factors including the historical operating performance of the business, the strength of the parent company guarantee and the lease back terms as discussed earlier. Subject to the above, we see interest amongst real estate investors at and around cap rates of 7.5-8.5% for leases around 15 years. For a BTS, typically a development margin of 20% on development cost is considered necessary to justify the risk of development. This results in a cap rate of 9-10% on Estimated Market Rental (ERV) for the property.
• Estimate the cost Benefit vs. Debt; One of the common question that is often posed to JLL is the cost benefit to the seller vis-à-vis debt funding. What is clear is that unless there is identified use of the released equity, to grow the business as discussed earlier, it makes less sense to undertake a SLB or BTS funding. Having said that, whilst debt is cheaper, the gap between cost of debt and acquisition cap rates has reduced over the past 12 months as Emirates & Saudi Interbank offer rates have climbed, making a SLB or BTS more viable for the corporates. 
• Market Demand; Besides the supply, another reason for a growth in such transactions is the increase in demand for it. This predominantly comes from real estate asset managers, institutions and sovereign entities, who are seeking opportunities to invest in real estate, but do not have any interest in its management. A SLB or BTS transaction, where the management of the asset remains the responsibility of the tenant and the lease is triple net (including maintenance, insurance and property related taxes) is ideally suited for such investors. 

Mr. Shivpuri added that due to most regional entities being privately held, owning a premise has historically been considered “psychological demonstration of financial strength”. However, as the real estate laws become more defined and transparent in the region and lending institutions become more cautious on balance sheet lending, the SLB and BTS trend is expected to grow.