Looking for a new source of fresh capital? You may find it at your feet—literally 
 
Regulators keep advising—and sometimes demanding—that banks raise more capital.
 
But finding capital is tough, right now. Pooled trust preferred offerings have been dead in the water for months. Selling more common shares is a difficult proposition when bank stocks are a Wall Street pariah. Retained earnings require starting with something to retain, a harder proposition for institutions hit with narrower spreads.
 
Bankers scanning the horizon for an answer might do better to put down their telescopes and look at their feet. If your institution owns its headquarters, branches, and operations center, you may literally be standing on the capital you’re seeking. Through the sale-leaseback of any or all of those facilities, the bank can turn them into capital.

Turning bricks into capital
Case in point is Harleysville National Corp., a $3 billion-asset holding company that turned 15 offices into more than $38 million of fresh capital in November 2007. George Rapp, CFO and executive vice-president of the southeastern Pennsylvania bank, had done such a deal years before at Philadelphia Savings Fund Society. The time looked ripe to try another.
 
“The economics of this kind of transaction are compelling,” says Rapp. “The only reason to own real estate is to have it appreciate.
 
This is not the business that banks are in, however, so owning real estate is, in Rapp’s mind, a waste of capital. Under current federal risk-based capital standards, bank premises, fixed assets, and other real estate owned all fall into the 100% risk-weighted category. Indeed, Thomas Killian, principal, investment banking, at Sandler O’Neill & Partners, L.P., in N.Y.C., notes that many banks have between 5%-10% of their risk-weighted assets tied up in real estate. (Sandler O’Neill arranged the sale-leaseback for Harleysville National.)
 
So, “turning nonproducing assets into income-producing assets is appealing,” Rapp continues. In the case of Harleysville National, the funds will be turned into loans. The sale-leaseback transaction, which Rapp is interested in trying again with additional properties, is part of a broader effort to rationalize the company’s use of buildings and real estate.
 
But new lending is not the only use that such capital can be put to. For another potential use, one need look no further than Willow Financial Bancorp., Inc., which Harleysville National agreed to acquire in May. Willow Financial had been going through some difficulties, prior to the merger, and in one effort to strengthen itself, did a sale-leaseback of eight branches in February 2007, garnering more than $11 million in new capital.

Growing trend among smaller banks
Very large banks have used sale-leasebacks for some time—some are even selling help to other institutions looking to follow their lead. But in recent months, more mid-size and smaller community banks have been looking very seriously at sale-leasebacks.
 
Thomas Capello, a former banker who is now a partner at Bank Realty L.P., York, Pa., a firm specializing in such arrangements, says his company has seen a 50% increase in volume thus far in 2008, and he expects the trend to continue.
 
“It’s driven by banks needing to shore up capital,” says Capello. He and others working in sale-leasebacks say that regulators have no issues with the transactions. Indeed, Capello notes regulators suggested the approach to one bank as one of several options.
 
American Realty Capital Trust, Inc., a relatively new private real estate investment trust that has a specialty in sale-leasebacks for banking institutions, has purchased nearly 100 bank branches in the last eight months, as well as other bank properties, according to Nicholas Schorsch, chairman and CEO.
 
“Banks don’t need to own their real estate—they need to control their real estate,” says Schorsch, who became known for these deals at an earlier firm, and continued the practice at his present trust, based in New York City. In his experience, most banks that have done sale-leasebacks to date have sold properties in order to build up war chests for acquisition.
 
“This is an opportunity to take some of the gain on real estate and turn it into capital,” says Mary Lynn Lenz, a former New England banker whose institution, since sold, looked seriously at sale-leasebacks before deciding to put itself on the block, instead.
 
Indeed, Bank Realty’s Capello notes that real estate is a depreciating asset. “If a bank is sitting there with depreciated branches, they are actually impairing shareholder value, to a degree,” he argues.

How it works
While there are variations, at a detail level beyond the scope of this article, the basic sale-leaseback transaction, in principle, is relatively straightforward.
 
The bank sells its property or properties to an investor, who then leases the building and land back to the same institution. Not one desk gets moved. Properties are appraised and change hands at fair-market value. The bank moves from being an owner to a tenant. (Some de novo banks have structured the building of their branches, effectively, as a sale-leaseback from their inception.)
 
While the property clearly has changed hands, in some ways the transaction is more of a financing arrangement than a real-estate deal, according to Jonathan Horn, CEO of Horn Capital Realty, Miami, Fla.:  “It’s like a bond in the form of a lease agreement encompassed by real estate.”
 
The bank, as tenant, engages in an operating lease. Generally these run for 10-20 years. Typically the operating lease is contracted as a “triple net lease” contract. In a triple net lease, most of the cost aspects of ownership—maintenance, insurance, and taxes, for instance, reside with the tenant. For the transaction to make sense for the bank, along the lines that follow, it must be structured as an operating lease, by accounting rules.
 
Statement of Financial Accounting Standards 13 (“Accounting for Leases”) and Statement 98 (“Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate…”) guide the structuring. (While the Financial Accounting Standards Board has a lease accounting project under way, it will not be exposed for public review until the last quarter, and would not likely be effective earlier than 2010.)
 
Pricing of the acquisition and determination of rents must be done carefully to avoid breaking accounting rules. Bank Realty’s Capello, for instance, points out that his firm usually avoids lease payment increases indexed to the Consumer Price Index. While CPI-based increases are an industry norm, he says they are unpredictable and can upset the parties’ original calculations. Thus, he recommends fixing rental increases by some other means. The deals set up by Sandler O’Neill and American Realty, in partnership, typically base annual rental increases on the lesser of the CPI or 2.5%.

In general, the longer the bank has owned the property, the more it has been depreciated and the lower the book basis of the property. And the lower the book basis relative to current market value, the bigger the potential book (GAAP) gain when the property changes hands, points out Sandler O’Neill’s Tom Killian.
 
Several changes and flows result once the deal has been done.
 
First, the net proceeds of the purchase go to the bank. This fresh capital can be used for a variety of purposes.
 
Second, there are multiple income streams. One comes from the reinvestment of the capital raised (if it is reinvested). Another comes from the gain recognized under GAAP from the sale; this is amortized over the life of the lease term. (By way of example, in the Harleysville National sale-leaseback, the company has received net proceeds from the sale of $38.2 million. The actual gain on the sale, versus the purchase prices of the properties, came to $18.9 million, of which $2.3 million was recorded in 2007. The remaining gain, according to the company’s 10-K, will be deferred and amortized through a reduction of occupancy expense over the 15-year term of the operating leases.)
 
Third, the expense of depreciation, if any, is eliminated. Thus this drag on earnings goes away.
 
On the expense side, depreciation is replaced, in that the bank now is making rental payments under the lease. There are other payments, as well, required under the triple net lease, but those are costs the bank would have been paying as an owner, too.
 
Assuming no hitches—regulatory approval is not normally required—a sale leaseback can go from signing of a letter of intent through to purchase and delivery of payment in 60-90 days, according to Tom Killian of Sandler O’Neill.
 
Jonathan Horn points out that sale-leasebacks are typically more beneficial to a bank than mortgaging the same property. For example, 100% of payments made under an operating lease can be written off, while only the interest portion of mortgage payments can be written off.
 
There are tax considerations, of course, which require a tax professional’s advice. Horn points out that any sale of property will involve capital gains tax. He says, however,  that a bank can marry a sale-leaseback transaction with a “1031 Exchange.” Named for Section 1031 of the Internal Revenue Code, the strategy involves an exchange of properties to produce a tax deferral. (While two parties swapping parcels is possible, transactions tend to be more complicated and involve additional players.) No tax on capital gains need be paid until the property acquired is sold for cash.

Risks in structuring sale-leasebacks
One stumbling block that some banks face when attempting a sale-leaseback strategy is close to home: the board. Ownership of bank premises remains dear to many directors’ hearts. Overcoming the notion that “real estate is king” can be a challenge. Bank Realty’s Tom Capello recalls one board that included several real estate brokers.
 
“They felt that the properties were worth more than we thought they were worth,” Capello explains. Until there is a meeting of minds in such cases, no transaction is likely to take place. Killian says that values put on the properties, and the rents and related charges to be paid, must be in alignment with the market before the buyer-investor and the seller-tenant will likely make a deal.
 
“Many of these deals crater before they reach due diligence,” says American Realty Capital’s Nicholas Schorsch. “So surety of closing is the biggest risk that financial institutions have in structuring these deals.”
 
Buyers may back out, depending on how negotiations proceed, says Schorsch, but equally possible is the seller’s decision to drop out of the talks.
 
“One thing that banks will not tolerate is somebody cherry-picking their properties,” Schorsch explains. “That’s why a lot of deals break.”
 
And while experts say there aren’t many completely unworkable properties, they do say that banks have some white elephants that don’t tempt buyers much.
 
“The most problematic property is one with little rentable area on a large piece of land,” says Sandler O’Neill’s Tom Killian. “Land generates no income,” as the rent can only be charged on space in the building.”
 
Simple things like parking can delay or kill a deal. In one bank transaction, notes real estate expert Colin Kane, principal at Peregrine Group LLP, Rumford, Mass., the town owned half the parking lot. Obtaining rights to the space for the buyer was going to require town hearings.
 
“Without the parking,” says Kane, “the property was worthless to the buyer.”
 
Accounting considerations can also be deal breakers, according to Capello. Under the FASB standards, the rules governing sale-leasebacks are fairly stringent, he explains. There are limits on how much of a property can be sub-leased by the seller-tenant, for instance. And a sale-leaseback done at a price that does not meet requirements to be considered a true sale is not treated as resulting in an operating lease.
 
Instead, the transaction would be treated as a capital lease. “A capital lease never leaves the bank’s books,” Capello explains, “and is treated instead as a debt financing, not as a true sale-leaseback.”

Fix things up first
In spite of the special nature of a sale-leaseback, property nonetheless is changing hands, and many issues that arise when that happens confronts these deals.
 
Former banker Mary Lynn Lenz says her former institution found that it had to do a great deal of catch-up before it could move to its anticipated sale-leaseback transaction.
 
“We didn’t have any of our due-diligence materials together,” says Lenz, “because we never thought we’d be selling any of our properties.” The bank found that many upfront steps were necessary to prepare properties for sale, ranging from appraisals to environmental checks at basic or advanced levels. Older properties may have title issues that need clearing up, that can stall or kill a deal. In one of her own branches, title research revealed an easement issue that had to be resolved before the property could change hands.
 
“Some older branches have the whole kit and caboodle of issues,” says real-estate expert Colin Kane. He advises sellers to identify and fix the problems themselves, long before going to a closing.
 
Kane says he is often surprised that banks don’t apply the same standards they would insist upon, as lenders on property, to their preparation for sale of their own facilities.
 
The back end of a sale-leaseback must be addressed, as well. Typical issues include options for renewal and rights-of-first-refusal should the investor decide to sell the property the bank has been leasing. In addition, banks with evolving branch networks and changing approaches to property use and branch design may want to explore “site substitution” arrangements with their buyers. BJ

The electronic version of this article available at: http://lb.ec2.nxtbook.com/nxtbooks/sb/ababj0808/index.php?startid=16

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