The deterioration of the credit markets in the past year has generated added interest in sale/leaseback transactions - long accepted throughout the European markets as a well-perfected secured debt instrument. But in more complicated structures such as asset securitizations - where the waterfall and priority of the payments are embedded in the structure - the terms of the operating lease take on added significance, particularly when determining the debt ranking of the lessee.

A credit downgrade in such cases is not necessarily terminal, provided the company shows that whatever investments they are putting in at the moment will allow them to grow their operating cash flow base. But operating leases may act as an additional hurdle when lessees start to recover, and could slow down the waterfall debt repayments.

"As the company starts to recover and grow its operating cash flow base, it will have to grow it by a larger amount after the operating lease has been introduced in order to get the cash flows to where they should be. It's almost like having to overcome an additional hurdle," explained Anna Overton, an associate of Standard & Poor's Corporate Ratings Group. "It's all clearly set out in the structure. The operating lease rental is an operating cost, so it comes out of the cash flow ahead of any debt-related payments. It effectively slots itself on top of the interest payments."

However, it's unlikely that operating leases would play a seminal role in downgrades. Case in point: a transaction for hotel operator Welcome Break that suffered a series of downgrades earlier this year. A delay in raising funds and higher amounts of capital expenditure than the company had originally envisioned were the catalyst of this year's downgrades, but the role of its sale/leaseback transaction could affect the company's recovery rate in the future.

According to Fitch, the company had planned for future sale/leaseback deals which would not be used for the purpose of repaying debt, but instead for further capital expenditure programs. This would essentially increase the company's leverage and potentially cause further rating actions. S&P's Overton also noted that bondholders must consider that the Welcome Break transaction has to compensate for the lease that has been inserted into the cashflow structure as a means of raising capital.

"Welcome Break is a highly leveraged transaction," said one market source. "Raising debt on an unsecured basis would have been expensive, so they managed to optimize their debt by going the securitized route. But even the best of plans can have flaws. If you are structuring your transaction based on a slowly-but-steadily growing EBITDA and it has flat returns, obviously you have to make adjustments."

Typically the analysis of a sale/leaseback looks at both the materiality of the sale and the application of proceeds. If the sale is material and applies the proceeds of the transaction to the replacement of existing debt, the effect is neutral. If the proceeds are not used on any existing debt but rather invested in other projects, then the operating cash flow is investigated to determine whether it will be enough to compensate for the increase.

Industry specific issues

The recent announcement by Hilton Group PLC of a planned sale/leaseback transaction similar to its GBP312 million deal with the Royal Bank of Scotland completed last year has renewed market interest in the lodging and leisure sector, said S&P.

Overton said that in the analysis of these deals, a sale/leaseback transaction is put on equal footing with an operating lease. "You used to own the asset but then you decided you'd rather not; either way, it's still integral to your operations."

But the in the more complicated deal structures common within the hotel and catering industries, the focus is on the fundamental variances between management contracts and operating leases. This underlying difference lies in who picks up the whole economic benefit and liability and who doesn't, said Overton.

In the case of a mangement contract, a Hotel operator's function would be to collect the management fee for the service they perform. They are neither buying nor leasing the asset; they are just responsible for collecting the fee.

If the hotel owns the assets, however, it gets the full economic benefit of the hotel but also full liability and operating risk. Management contract from a cashflow perspective is the preferred model because it is less volatile than straightforward ownership.

There is an analytical grey area, however, as some management contracts gravitate towards taking more and more operating risks.

Last week Thistle Hotel was in the market with a GBP531 million commercial mortgage-backed, floating rate transaction. The underlying collateral in the deal is a single loan on 32 hotel assets.

The management contract for Thistle Hotels contains strict language regarding guaranteed amounts of operating profit - limiting if not eliminating any transfer of risk to the owner.

"As the structure of management contracts in the lodging and leisure markets evolves, we will have to take a closer look at these contracts on an individual basis," said Overton. "In some management contracts we may discover that levels of guaranteed performance are too high, and that there is no real difference between somebody who runs the business under a management contract and somebody who owns the business outright."

In the Thistle deal, the property owner has entered into agreements with the operator, Thistle Hotels Ltd. The operator is required to ensure that the property owner receives a minimum EBITDA on a quarterly basis for each property over a period of 10 years. Thistle is not entitled to a management fee unless the minimum EBITDA total is met. If one of the 32 hotels in the portfolio is sold within the 10-year period, that hotel's minimum EBITDA will be deducted from the overall minimum EBITDA of the portfolio.

But the loan covenants mitigate any potential shortfall. In the Thistle Hotel deal, the borrower is obliged to apply for planning consent for residential conversion for two of the London hotels within the first six months of the term and a third within the next three months, and to dispose of the hotels once planning permission has been granted. The alternative-use value for these units as development opportunities and the release pricing formula imposed upon disposal provide additional protection to the lenders.

"It's believed that they can in fact turn these hotels into development properties - someone has already approached the borrower with an offer of GBP250 million," said one market source.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.