The financier

Founded in 2003 by former executives of Franchise Finance Corporation of America, Spirit Finance is a publicly listed REIT focused on sale-leasebacks for the retail, service and distribution industries. With balance sheet assets of approximately $2.5 billion, Spirit recently completed the largest retail sale-leaseback ever, the $815 million acquisition of the real estate assets of ShopKo, the retailer recently acquired by Sun Capital Partners. Here, Christopher Volk talks about the ShopKo deal, the economic environment for retailers and why corporate capital efficiency may be the next big wave in corporate America.

What is Spirit's business strategy?
The focus of Spirit is to invest in what we call “single tenant, operationally essential real estate,” which is retail, distribution and service companies and the facilities they use.

The way we see it—our background tends to be as much finance-related as real estate-related—from a financial perspective, companies were better off having an organization like Spirit own their real estate than own it themselves. That way they didn't have to dedicate any of their shareholder equity to passive real estate investments and could generate higher returns on equity without raising their leverage.

There are some companies that get this, companies like CVS or Walgreens that don't own any real estate. But there are a lot of companies out there that own a tremendous amount of real estate. ShopKo was one of the companies. Albertson's is another.

What do you like about the retail sector?
We look at a lot of transactions and we try to be selective. Last year, we only did 10 percent of what we looked at. So at the right price, we like retail. At the right price, we like service.

Spirit is a company that tries not to invest more than replacement cost in assets. In the case of retail assets, we like to make sure that the stores are profitable for the companies that will use them. In the case of free-standing assets, store-level profitability is a key measure of how vital the asset is. And, therefore, is partially indicative of value. In the case of retail, we also try to invest [in assets] where if we have to rent it out to someone else, we could.

Above all, we're looking for solid management teams who understand what their mission is and what they're doing. In the case of ShopKo and Pamida—the brands that Sun bought—we were confident in the brands. And over a long history, the cash flows had been pretty stable.

Was the ShopKo deal the largest transaction Spirit has done?
According to The Wall Street Journal, it was the largest retail saleleaseback ever done. I don't know if that's true or not, but since The Wall Street Journal said it, I'm going to say that it is.

Our view is that the market for what we do is very large. Let's start there. When The Wall Street Journal announced that [ShopKo] was the largest sale-leaseback done, it was somewhat surprising to us because we see so many really large opportunities. Albertson's had $8 billion worth of gross book real estate to it. There are a tremendous number of companies that own tons and tons of real estate. So we think the opportunity and the market size is large.

What is the economic environment like right now for retailers?
Well, the economic environment overall—and this is without making a comment on the health of the economy—is that it is getting more and more difficult for multi-unit operators to create shareholder value.

First, it is getting more difficult to expand. The relative expansion opportunities for most large retailers are smaller than they once were. They are no longer growth stocks in other words.

The second thing is the competitive environment is such that it is very difficult to pass on price increases. So retailers have looked to cut on costs wherever possible. But it is becoming more and more difficult to wrench costs out of the system.

The third thing that we have seen companies do is focus on minimizing the amount of shareholder capital they have to put into inventory and their balance sheet receivables. We have seen companies selling their credit card businesses, controlling the amount of inventory on the floor or managing the amount of inventory flow they have.

So the last leg of the stool is, in our view, capital efficiency, where companies are going to have to lower their cost of capital. And a sale-leaseback is an ideal tool for a retailer to lower their cost of capital.

What have been some of the biggest changes in the financing markets for retail assets?
In the case of the capital markets, what's happened is that the capital markets for real estate have just gotten deeper, especially on the debt side. A transaction like ShopKo, for example, may not have happened four or five years ago. The CMBS markets have gotten so deep and so broad that you could do that [deal] today. In addition, those markets were less open to single-tenant, free-standing real estate in the past. Today, they are much more open.

Do you see more activity ahead?
If one takes a look at the number of retailers out there, public or large privates, many of them have significant real estate holdings. So if you're looking at equity investors like Sun, many, if not most, equity investors will see the benefits of doing sale-leaseback financing because they can generate higher returns on their investment.

If private equity capital is going to do that corporate reconfiguration, part of the question is whether or not some of the public corporates will want to do the same thing.

Using sale-leasebacks as a treasury tool for companies, which is really where we come from, has huge value and will have huge value going forward. We think that corporate capital efficiency is the next wave of shareholder value creation in corporate America. And it is most applicable for companies with substantial real estate holdings.