HotSeat: Sovereign Investment's Peter Mavoides

March 26, 2007

By Ian Ritter,

Sale-leaseback transactions have been picking up steam in the past few years. Last year's total number of those deals in the industry were valued at $9.6 billion, up from $5.3 billion only two years before, according to a study by Princeton, NJ-based Sovereign Investments, a private-equity investment firm that specializes in those deals. Sovereign itself has been busy. Earlier this month the company, and partner Atlas Investments, finalized a deal to acquire seven West Coast-located ShopKo stores for $75.5 million. Sovereign did $250 million in such deals last year, with tenants including Circle K, Rite Aid and Wendy's. Executives are forecasting $500 million in acquisitions more than the current year. Peter Mavoides, Sovereign's president and chief executive officer, recently spoke with GSR about the ShopKo transaction and trends in his sector of the industry.

GSR: What was your firm's attraction to the ShopKo portfolio?

Mavoides: As in any real estate investment, we had good credit in ShopKo and fairly-priced, well-located real estate. We did a $75-million transaction with ShopKo, and the more noteworthy story was Spirit's $800-million transaction with ShopKo. These assets were not part of that transaction. They were in West Coast markets, and ShopKo and the equity partners felt there was a little more value in these assets than Spirit was offering and carved those out. We recognized that value and did the transaction with our partner.

GSR: Do you prefer that assets you're acquiring are stores in shopping centers or do you like them more as stand-alone units?

Mavoides: I think whether or not it's part of a shopping center or standalone, we're indifferent to that. For the lease terms we're structuring, more than anything we're looking at the corporate credit and structuring a quasi bond-type of investment.

GSR: What is causing the increase in retailers' interest in sale-leaseback transactions?

A: Everyone's also looked at the leaseback sector and said that there is going to be an avalanche of corporations unloading their real estate assets. For the first time in a long time, you have this condition in the capital markets where real-estate capital is cheaper than corporate capital. This inversion in cost to capital is making a lot of companies wake up and realize that this is an efficient form of financing, and relative to the cost of debt, that hasn't always been the case, until recently. That's one macro factor, the efficiencies in the real-estate capital markets driving the cost of capital down.

The other is private equity and public-to-private transactions like ShopKo, Mervyns and Marsh [supermarkets]. In those cases, public retailers are going in the hands of private-equity investors who seek to maximize leverage and recognize the cheaper cost of capital that they can access through a sale-leaseback.

GSR: How do you decide on the time of a store's lease in a transaction?

Mavoides: The lease term is really dictated by the retailer, and the general rule is the longer the better for investors like myself, and the longer the cheaper for retailers. A retailer matches occupancy and the tenure of its tenancy to the desired cost of capital. In a sale-leaseback investment, in a 20-year deal, the returns are most likely 80% from cashflow and 20% from real estate. As you go down to a 10-year deal, that balance becomes 50-50. For credit-focused investors like myself, I want the 80-20 mix and not necessarily the 50-50 mix.

GSR: What kind of risk is there for your firm if the retailer files for bankruptcy or has operational problems?

Mavoides: If the tenant files for bankruptcy, it has the right to affirm or disaffirm the lease. That could potentially leave you without a tenant. One of the benefits of a sale-leaseback transaction is that you can go in and underwrite the individual unit's performance and the cash flow generated from that unit and base an assessment as to the likelihood of affirmation or rejection in bankruptcy. So the second line of defense beyond our corporate credit is the unit-level cash flow. Beyond that, you have releasing risk and your ability to replace the contract rent that you had. One of the hardest things in a sale leaseback is sizing the rent relative to the risk and to ensure that as a real estate investor you're assuming real-estate risk and not business risk. If the rents are sized inappropriately, you're inherently taking business risks, and you're not able to replace those rents in a bankruptcy situation.

GSR: Are you in a good situation, though, if a tenant vacates for those reasons because it might be easier to fill the space with a better-performing retailer with so much store expansion taking place?

Mavoides: If the previous tenant has disaffirmed the lease and was unable to make a go of the location, it's likely that competitors will have the same challenge. It's difficult to divorce the performance of the stores from the inherent real estate value. That said, if you structure the rent levels appropriately, someone can come in and replace your rent and make a go of it. If you put too much of a rent burden on that asset, you're going to have problems.

GSR: Is there a difference in the sale-leaseback arena between restaurants and traditional retail portfolios?

Mavoides: The restaurant sector is dominated by franchisees. By definition, you have a lot of smaller, regional credits. In the absence of a strong corporate credit, the unit economics become more important. Particularly, a restaurant has a more specialized box for that use than a generic big box like ShopKo. The balance of risks between corporate credit, unit-level economics and real estate is just shifted in restaurants relative to retail.

GSR: How do you see this sector of the industry changing in years to come?

Mavoides: I would anticipate the current trends to continue, public to private, and the use of sale-leaseback transactions to monetize investments. You also see shareholder activism pushing retailer to monetize real estate, like at McDonald's and Wendy's, I would anticipate those trends to continue. Over time, the pressure on some of these retailers will abate. It seems to be at an all-time high, and I would think that there is certainly a lot of good rationale for a retailer to own their real estate. But everyone in the world today is saying they shouldn't. I would expect the pendulum to swing back more toward the middle.

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