Does the paucity of refinancing spell the end for OpCo-PropCos? Arjan van Bussel and Amir Khan look at the once popular structure's prospects

The objective of most sale-and-leaseback transactions is to release capital that is locked up in real estate assets so it can be redeployed in the core business. Traditional sale-and-leaseback transactions, where the property is sold to an independent real estate investor and the former owner becomes the occupying tenant under a lease agreement, are used when a complete disposal of the property is desired.

OpCo-PropCo transactions, a variant to the traditional form, do not dilute control at operational or property management level. The properties are transferred to an orphan subsidiary (the PropCo) and leased by an operating subsidiary (the OpCo) of the same holding company with the objective to raise long-term financing secured by the properties owned by PropCo. The financing is typically provided by banks and was in the pre-crisis days often repackaged into commercial mortgage-backed securities (CMBS), which were sold to institutional bond investors.

During the mid-2000s, rental yield compression resulted in values attributable to a corporate's properties becoming an increasingly large proportion of the value of the corporate as a whole. OpCo-PropCo structures offered those companies the opportunity to monetise this increased value without selling their real estate assets. To maximise the monetisation value, companies found it tempting to implement rigid lease terms between the OpCo and the PropCo, often containing increasing rental payment obligations, because both the property value and the borrowing capacity at PropCo level depended on the terms of the underlying lease agreement.

While this was value-enhancing at the time, the operating business was left exposed to the inflexibility of its future rental payments. The strength of the property and financing markets had created incentives for companies to extract value at the expense of protection in a downturn. The case of Southern Cross Healthcare in the UK is a clear example where this risk materialised with the business' status as going concern coming under threat due to increasing rental payments while the operating business struggled.

Southern Cross Healthcare should not serve as means to disqualify OpCo-PropCo structures; rather its lessons should prompt consideration of structural features that mitigate putting OpCo at undue risk without significantly reducing the value, or debt capacity, of PropCo. For example:

• Retention of sale proceeds in OpCo until there is evidence of sufficient growth in operating cash flows;
• Piecemeal transfer of those properties to PropCo whose underlying businesses are still in the process of ramping up. This will allow the OpCo to own tangible assets enabling it to finance independently;
• Direct alignment of real estate investors' returns with performance of the operating business, although this could compromise the value of the PropCo.

The repayment profile of European real estate loans has deteriorated consistently over the past three years. According to the UK Commercial Property Lending Market mid-2011 report by De Montfort University, around half of approximately £200bn debt held on balance sheet will struggle to refinance. CBRE highlights that the number of parties actively lending against UK real estate assets has decreased by almost 20% compared with a year ago. And although much has been written about insurance companies entering the lending business, their contribution, currently around 14% of the European property lending market, will not be adequate to plug the funding gap.

The availability of debt presents the biggest challenge for real estate investors refinancing. But the situation is exacerbated by the sheer size of the approaching refinancing wave and the widened property yields. Against this backdrop, it is imperative for OpCo-PropCo borrowers to consider alternative solutions. To refinance outstanding PropCo loans, borrowers will have to consider alternative investor sources with different risk profiles. For example:

• Outright sale of corporate real estate assets
Today's, property investors are predominately focused on high-quality, liquid assets such as prime retail properties and offices let to creditworthy tenants on long-term leases. Borrowers owning these types of assets might therefore consider selling them to repay the PropCo loan. Corporate real estate sales in Europe totalled €14bn (source: CBRE) in 2010. This is a material amount of liquidity compared to the refinancing requirement;
• Whole business securitisation
Some OpCo-PropCo structures could naturally migrate to a secured corporate bond framework under a whole business securitisation (WBS). WBS incorporates cash flows of the entire business and provides a more wholesome security package to lenders. In the UK, WBS has been tested in a variety of sectors including pubs, leisure, utilities and healthcare. Businesses demonstrating stable characteristics (such as healthcare) can be suitable candidates for WBS;
• Credit tenant lease transactions

Credit tenant lease (CTL) deals have been a source of long-term financing for investment-grade tenants, as demonstrated by four Tesco transactions between June 2009 and February 2011, and also by the Sceptre Funding transaction in July 2009 with the UK government as tenant. These structures contain full amortisation of the notes through rental payments and the real estate security is therefore only an add-on feature. This risk profile appeals to a different - and at the moment far wider - investor audience than CMBS transactions and therefore should be considered in investment grade refinancing situations.

The number of active real estate lenders is decreasing rapidly at the same time as a major wave of refinancing approaches. The resulting crunch in lender appetite will force borrowers to look at alternative funding sources to refinance maturing PropCo loans. PropCos owning less liquid, more operational assets, especially, will have to explore secured corporate-style financing structures such as WBS or CTL transactions with outright sale of crown jewels acting as natural back-stop.

The current market turmoil will cause pain for both borrowers and lenders. Current loans will be rolled over and maturities extended, or loans will only be partially redeemed with the balance converting into a quasi-equity position. The underlying prospects of the operating business and the borrower's ability to access financial markets at the time of refinancing will drive the outcome.

OpCo-PropCo financing is not dead but in hibernation. Revitalisation of the property market and improvement of liquidity in the real estate banking and CMBS markets in conjunction with the adoption of structural mitigants to protect OpCos in a downturn will, over time, help stage a revival of this financing tool.

Until then, alternative refinancing options need to be explored for upcoming refinancings.