With the onslaught of corporate downgrades, it is becoming more difficult for some firms to get traditional financing. In a last-ditch effort to obtain funding, some of these corporations have turned to sale/leaseback transactions.

After being approached by two particular companies who found themselves in this situation, Fitch Ratings has warned CMBS investors who are planning to invest in sale/leaseback transactions - specifically deals that represent a final attempt by companies to get money when access to traditional corporate funding has been cut off.

The rating agency is also particularly watchful of companies - which are on the brink of bankruptcy and may eventually close their doors -attempting to do these types of deals.

In a press release, Fitch defined a sale/leaseback deal as the instance "when a company sells its commercial real estate assets and then leases them back so that the new owner can securitize the resulting pool of mortgages."

"We just want to make sure that investors don't lose sight of the fact that just because they're secured by an asset, they're not necessarily in a better position," said Jenny Story, a managing director at Fitch.

Story explained that the underlying real estate may end up vacant. In this instance, the only way to recover losses is by spending time marketing the property while continuing to pay taxes and insurance.

"When you're looking at these transactions, you've got to look at it on a recovery basis," said Story. In the release, Fitch told investors to carefully review transactions where investment- grade proceeds are more than the highly stressed value of the property.

Typically, empty buildings are sold at a distressed price. Whoever buys that building is going to look at it more as a developmental opportunity. The buyer is going to want to make a higher profit because he is taking on more risk since there is no longer available cashflow to make payments with. The seller would then have to offer it for less than he would have if there had been a tenant occupying the property.

In this instance, if investors are looking at coming up with investment-grade proceeds they must estimate a recovery value that reflects the value of the distressed property.

The two transactions reviewed

The warning from Fitch was prompted by the inquiry of two companies that approached the rating agency with plans to do sale/leaseback transactions.

One of these companies was a large department store chain. Initially, the rating agency was looking at where and in what kind of mall the department stores were located and how easily fungible the retail space is. Subsequently, however, the department store ratings were downgraded.

"This made us feel that they were exploring this avenue because they had no other option," said Story.

Another deal that Fitch examined roughly three months ago involved a large technology company. Fitch saw two different pools from the firm.

One of the pools was made up of properties that were huge corporate headquarters located in the middle of nowhere. The rating agency asked for upfront reserves equal to almost a third of the proceeds the company was asking for, which made the deal uneconomical for the company to pursue.

In the second pool, the buildings were somewhat more fungible; therefore Fitch was more comfortable that the buildings would eventually be re-tenanted. Again, however, the rating agency asked for substantial upfront reserves. Ultimately the company ended up not pursuing either deal.

Fitch said that borrowers must have enough reserve - in the form of cash or a letter of credit - for debt service and re-tenanting costs to lessen losses to the bondholders in case a tenant leaves.

Additionally, the rating agency also warned about sale/leaseback deals where a company creates a subsidiary to which it could sell the underlying property - thus the same company would be both a landlord and a tenant.

"This situation creates a great concern because if the company - which is both the landlord and tenant - were to go out of business, there would be no funds available to pay bondholders their debt service, further emphasizing the need for upfront reserves," Fitch said.

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