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The Road to Success is Paved with Capital (from Sale/Leasebacks)

Originally published on
04/26/2022 08:04 pm

By Guy Messick

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In 2006, Alan Mulally, then Ford CEO, made a bold move. Ford borrowed $23.6 billion and mortgaged its real estate holdings to finance necessary improvements to keep Ford competitive. He knew that having untapped equity in real estate holdings was not helping Ford meet its business goals. As a result of that bold action, Ford had the cash and capital to weather the financial crisis in 2009.

While Mr. Mulally did not know that a financial crisis was quickly approaching, having reserves of cash and capital enabled Ford to control its own destiny. General Motors and Chrysler almost went bankrupt and had to take federal funding, with the restrictions that come with such funding, in order to survive.

In studying the 2009 financial crisis, the Fed concluded that the best way for financial institutions to survive financial downturns is to have more capital.  NCUA has adopted the theme of more capital is safer, including the implementation of the risk-based capital rule. As economic times become more challenging, there is no doubt that the chief concern of NCUA will be adequacy of capital and that NCUA’s measurement of capital adequacy will be trending upward.

The combination of COVID and the war in the Ukraine has disrupted supply chains, reduced the pool of available employees for businesses, caused a reemergence of inflation that reduces consumer buying power, and dramatically increased energy costs. As a consequence, investor confidence has been shaken.  All of this is a drag on the economy and reduces loan demand. Some credit unions may be tempted to reduce underwriting standards to generate interest income.

At the same time, the competition from fintechs in financial services means that credit unions will have to make significant investments in staff expertise and digital services in order to remain competitive.

How to Increase Capital?

How does a credit union increase its capital?  Capital will be increased organically over time if the credit union’s revenue consistently exceeds its operating expenses. However, it can take many years to realize significant increases in capital. With razor thin net interest margins and the pressures to make investments in IT and infrastructure, credit unions face challenges to their ability to grow capital organically.

A credit union can raise capital through a secondary capital offering.  The process of obtaining NCUA approval is long, costly, and often not successful. If NCUA approval is given and a secondary capital investor is found, it is not an ideal solution. Regulators keep a close eye on how a credit union utilizes secondary capital to ensure that a credit union adheres to the plan in their application, allowing little room for little flexibility.

Secondary capital is also considered subordinated debt that has to be paid back. If the credit union is not able to meet the terms of the repayment, the penalties are stiff. I consider secondary capital as “temporary” capital to help a credit union grow its “permanent” capital organically, capital that does not have to be repaid.

The Third Option

If a credit union is fortunate to own real estate, such as its headquarters building, operations center, or branch network, the credit union may have a third option to grow capital. If a credit union has owned the real estate for a number of years, a portion of the cost of the real estate has been written down and there is a good chance that the market value of the real estate has appreciated in value.

If a credit union sells its real estate, the difference in the sale price and the value of the real estate on the credit union’s books can be recognized as capital. The full amount of the capital can be immediately recognized upon the sale date due to an accounting rule change effective in 2022. If the credit union desires to retain the use of the real estate for its operations, it can lease back the real estate for a period of time, typically for ten to twenty years with options to extend. The credit union continues to operate and maintain the building as they did before the sale. This is a standard sale/leaseback transaction.

There is no lack of sale/leaseback buyers. It is a good business. The buyer buys the property, enters into a long-term lease with the seller and then, typically, sells the leased building and pockets a big profit. That has worked very well for private funds for years, but now credit unions have the option of selling to a CUSO and not a private fund.

CU Capital Management, LLC, itself a CUSO, has created a network of CUSOs to buy and lease credit union real estate. The profits no longer go to private funds. The profits remain in the credit union industry. Credit unions provide both the equity and the loans to finance the purchases.

Level of Comfort

The selling credit unions have the comfort of knowing that their long-term landlord is a CUSO that is managed by credit union colleagues. Why is that important? You do not want a box of chocolates, never knowing what you will get with a landlord. You might be unfortunate to have the same experience as the credit union that sold and leased back its office building and was so unhappy with their non-CUSO landlord that they bought their building back at a premium.

Wescom Central Credit Union was the first credit union to sell to a CUSO organized by CU Capital Management. Wescom sold its office building in Pasadena to a CUSO on Feb. 18, 2022 for $59 million and booked approximately $50 million in capital. Wescom raised its capital ratio from 7.79% to 8.5%. Wescom now has more capacity to invest in new services, service upgrades, new delivery channels, more IT assets, more branches, more benefits to attract and retain employees, and more CUSOs. There will be more capital to hedge against risks Wescom elects to take.  Wescom is better prepared to meet higher regulatory capital requirements and to survive an economic downturn.

However Wescom decides to use the extra capital, the financial strength of the credit union has increased. Wescom can also use some of the additional capital to invest in other sale/leaseback transactions in the CU Capital Management Network. The projected annual returns to the credit union investors funding the Wescom building purchase range from 5% to 8%. Other purchases are expected to have similar investment returns.

Never a Better Time

Wescom recognized that there has never been a better time to execute a sale/leaseback transaction to add capital.  The accounting rules are favorable, the real estate market is strong, and the financing costs are still historically low. Wescom was able to obtain a very favorable sales price. Wescom’s landlord is a CUSO owned by twenty credit union investors.  The lease is 15 years with options to extend. The CUSO does not have any plans to sell the building and the lease. Through collaboration, credit unions made this happen.

Ford made its bold decision before the last major financial crisis occurred while the economic climate was good and the sun was still shining.  Now is the time for credit unions to build up their capital before future economic and regulatory challenges are upon us.

Guy Messick is the CEO of NACUSO Business Services, Inc., (NBS) a wholly owned subsidiary of the National Association of Credit Union Service Organizations, Inc. CU Capital Management, LLC is an NBS Promotion Partner. 

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