Regulatory Reasons

The definition of well-capitalized is evolving upward. NCUA’s risk-based capital rule will require that credit unions have a minimum risk-based capital ratio of 10% as well as a net worth to assets ratio of 7%. If the credit union engages in certain activity as set forth in the NCUA matrix, additional risk-based capital may be needed. Credit unions are required to adopt the new Current Expected Credit Loss (CECL) accounting rules beginning in 2023 which will also result in increased capital requirements. The future is clear. Credit unions will face increased capital requirements from NCUA.

Off-Set Risk in Challenging Times

We are in a rapidly rising interest rate environment that has not been seen in decades. Managing assets and liabilities will be difficult. Loan demand is declining. Non-interest income from interchange fees and overdraft fees is declining or disappearing. Borrowers are taking on much higher mortgage loan obligations due to the rapid increase in real estate prices. Inflation will adversely impact the ability of borrowers to make loan payments. Recession or not, there will be loan and revenue losses that the credit unions will have to absorb.

Increased Need to Invest in People and Technology Resources

In order to remain relevant to their members, credit unions have to keep pace with consumer expectations. Fintechs continue to create higher and higher service expectations, such as applying for an unsecured loan on your mobile phone and having it underwritten and funded within a minute. Credit unions have to invest in the people and technology to be competitive in the 21st Century in order to survive. Providing attractive salaries and benefits is critical to attracting and retaining talented employees which in turn will allow credit unions to provide better services and experiences to members.

A credit union that sells its operational real estate can immediately book as capital the difference between the sales price and the depreciated carrying value of the real estate. Unlike with secondary capital, there is no obligation to pay back the capital; there is no long, expensive and cumbersome process to apply for approval from the NCUA; and there is no strict business plan that must be followed as a condition of regulatory approval. A credit union can also raise capital organically through net income but this can be slow and is often not enough if a credit union is in need of additional capital for regulatory purposes or growth purposes.

The most important reason is that as of 2022, the new FASB Lease Accounting Rules permit credit unions to recognize all the capital upon the closing of the transaction as opposed to spreading the capital recognition over the term of the lease. FASB Rules come and go and there is no guarantee that this rule will be permanent. Credit unions should take advantage of the rule while it is in effect. Prior to the new Lease Accounting Rule being implemented in 2022, sale/leaseback transactions could be helpful to credit unions but were substantially less beneficial than they are today.

Real estate prices have never been higher. However, with interest rates rising, stimulus money ebbing from the economy, and economic outlook and demand for office space growing increasingly uncertain, there will be a dampening effect on real estate values. The positive factors remain in alignment now, but they will not last.

The property that is sold with a twenty year leaseback is much more valuable to a buyer than just the property alone. The value to a buyer is both the fair market value of the property plus an income stream from the lease that will increase as periodic rent increases kick in. An appraisal of a sale/leaseback should account for the value of the twenty year lease with a highly qualified tenant. Having a lease is that is triple net with the credit union tenant being responsible for all building related costs, including insurance, taxes, routine maintenance, and structural repairs; increases the value of the property. The triple net lease gives the buyer/landlord the assurance that the rental income will not be diminished by unanticipated expenses. While the risk of building related expenses remains with the credit union tenant, the credit union has the advantage of continuing to maintain control over its building’s condition, upkeep and appearance, just as it did when it owned the property. To obtain maximum value, it is also important for the credit union tenant to lease back 100% of the property, with minor subletting generally permissible. Finally, the longer the initial lease term, the higher the sales price. A minimum of ten years is generally required but twenty years tends to be the norm. Options to extend the term are provided to the credit union tenant.

With the permission of the CUSO landlord and the credit union lenders, a credit union tenant can lease a portion of the building to others. However, as a rule of thumb, a credit union tenant should not expect permission to sublease more than 20% of the building. From a regulatory standpoint, a CUSO can own and lease real property to credit unions and CUSOs but not to third parties. Subletting a minor portion of the property does not change the credit union centric character of the transaction, particularly if the tenant credit union is the master tenant for 100% of the property. For credit unions that believe they need substantially less office space going forward than they currently own and use, there are other solutions available that provide more benefit than trying to sublease a majority of the space or initially only leasing back a minor percentage of the available space. Please contact us for more information.

The credit union’s relationship with a long-term landlord is important. In typical sale/leaseback transactions, the property and attached lease are often sold by the original buyer and even subsequently resold, leaving the tenant with no control over who their landlord(s) will be. One credit union that previously engaged in a sale/leaseback transaction with a non-CUSO buyer was so frustrated with their non-CUSO landlord that the credit union decided to buy back the building at a premium. A CUSO buyer intends to hold the property for the duration of the credit union’s tenancy. A CUSO landlord is managed by credit union colleagues and not by strangers. In the event there are any landlord/tenant issues, a credit union tenant is better able to work through those with a CUSO landlord rather than a non-CUSO landlord focused on maximizing profit. In order to have true sale treatment, the selling credit union cannot have a written options to buy back the building throughout the lease or at the end of the lease term. Notwithstanding that, a credit union can make an offer to repurchase the property at any time and a CUSO landlord is more likely to engage in an open and productive discussion around selling back to the credit union at market price if asked to consider it.

The credit unions owning property that has been partially or substantially written down (depreciated) on the credit union’s books and/or that has experienced appreciation in fair market value, are the best candidates to sell and lease back their properties. These credit unions will have the most “gain” to apply to capital. However, even a credit union that buys new property can see a gain. Remember that the value of the property to a buyer in a sale/leaseback transaction includes both (1) the fair market value of the property and (2) the value attributed to the long-term lease. We have seen that the value of the long-term lease often bumps the fair market value by 20% to 30%. Thus, if a credit union buys a property for $10 million and then sells it in a sale/leaseback the sales price may be $12 to $13 million depending on the terms of the lease and location of the property, resulting in $2 million to $3 million in new capital to the selling credit union.

There is no doubt that how credit union use real property will change. Maybe only a handful of employees have permanent offices. Some employees may work partially from home and have shared offices at the credit union’s location. Maybe there will be a need for office space for CUSOs yet to be formed. Perhaps some space will be dedicated for employee training for one or multiple credit unions. Credit unions may dedicate space for community meeting rooms. However real estate assets are used, real estate will continue to have a role in the evolving credit union business models. A credit union can invest a portion of its gain from a sale/leaseback into reconfiguring their office space or branch networks for a “post-covid” environment.

Credit unions may sell and lease back any real estate that is currently owned and utilized by the credit union. This includes their headquarters building(s), operations center(s) and branch networks. The main consideration is that a credit union must intend to continue to occupy and utilize all (or a significant majority) of the space in order for any given property to be considered for a sale leaseback with the CUSO. Individual branch locations are unlikely to be candidates for a sale/leaseback with the CUSO simply because the transaction size will be too small but are ok when included along with a credit union's office property or as a larger network of the credit union's branches. Overall, the best properties for a sale/leaseback are those that are critical to the operations of the credit union and that are part of its long term growth plan.

The boost to capital from a sale/leaseback is immediately available to credit unions to hold in reserve or use as they see fit. Credit unions need capital to weather adverse economic times that are developing in front of our eyes. They need capital to grow and take advantage of opportunities. By deploying the additional capital realized in the sales transaction, credit unions will put themselves in position to grow faster. With that growth comes the ability to make additional loans and investments, providing additional income to more than offset the added cost of rent payments.

Are credit unions in the business of providing better financial services to members or in the business of growing a real estate portfolio? The capital to grow the credit union and improve member services is there for the taking. Capital tied up in real estate value is just that, tied up. It is unavailable for the credit union to access and does not further the mission of the credit union. We are at an inflection point for the future of the credit union industry. If credit unions delay in making the necessary investments to remain competitive, members will find other service providers and at some point it will be too late to get them back. Now is the time for credit unions to use all the resources available to them to better serve current members and bring in new members.

Many markets have seen unprecedented growth in real estate values over the last few decades. Credit unions that own real estate have probably benefited from this growth. However, there is absolutely no guarantee these real estate growth rates will continue and credit unions are not in the business of betting on future real estate values. Credit unions should take this opportunity to capitalize on the real estate gains available to them and invest that newly available capital back in the credit union. Well-run, well-capitalized credit union growth rates can and should far exceed the growth rate of real estate values.

Selling credit unions have priority in participating as investors in CUSOs that buy other credit union properties and as originators or loan participants in loans funding the purchase of other credit union properties. Credit union investors that fund CUSO buyers can earn annual returns that are generally projected to be between 5% and 8% which is well above investment instruments permitted under the investment rules. These investment returns are paid in the form of a quarterly dividend with an annual true-up. CU Capital Management has also structured the CUSO Network in a way that provides reasonable liquidity to all CUSO investors should there be a need for a credit union to sell its ownership in the CUSO. As this is a CUSO investment, the limitations in the investment rules do not apply. Lending opportunities to well-capitalized credit unions are also very attractive. The CUSO investments and loans in the CU Capital Management Sale/Leaseback Network are all backed by high-quality real estate and long-term leases to well-capitalized credit unions. In the CU Capital Management Sale/Leaseback Network, credit unions can be sellers/tenants, investors, and/or lenders and there are no non-credit union investors in the CUSOs, thereby allowing all the benefits stay within the credit union industry.

Please email info@cucapitalmanagement.com with any additional questions or to schedule a conversation to discuss sale/leasebacks for credit unions in more detail.