By Kurt Schoeb
Sale-leasebacks continue to provide attractive financial opportunities for both real-estate investors and companies seeking to use their real-estate assets in the most efficient manner. Although long-term interest rates have spiked recently, those rates and property-capitalization rates remain at historic lows, and the rise in interest rates appears to have had little effect on investor demand or property prices. Because central bank monetary policies continue to depress returns on competing investment opportunities, equity yield requirements are still very low. Thus, high-quality sale-leasebacks and similarly structured build-to-suit and buy-to-suit opportunities are in high demand.
A sale-leaseback allows a company to sell an asset and lease it back under a long-term lease with the buyer. The effect is that the purchaser supplies long-term capital, while allowing the seller to continue to use the facility and control the day-to-day operation of the asset and property-related costs. Lease-extension rights, rights of first offer and first refusal, and even options to reacquire the property at a pre-negotiated price and terms can be structured to ensure that the seller retains control over a property that is important to its business enterprise.
Properly structured, a sale/leaseback transaction addresses the current and future real-estate needs of the seller/lessee, the seller/lessee’s financial structure, current access to capital and future capital requirements, tax consequences of a sale and lease, and the effect on external performance measures and existing financial covenants.
In its simplest form, a sale/leaseback features a high-quality credit tenant who sells an asset that it will continue to use in its business operations to an investor, and simultaneously executes a long-term lease with the purchaser, typically with a 10- to 25-year remaining term. Payment of all property-related expenses, including roof and structural elements, continues to be the responsibility of the tenant. Residual value risk (the value of the real estate remaining at the end of the lease term) is shifted to the purchaser.
Aggressive investors can include public and non-public REITs, institutional real-estate funds, pensions, and private equity. These investors look for predictable returns with limited risk and represent a relatively stable source of long-term financing. In analyzing this type of opportunity, these investors tend to focus on the creditworthiness of the tenant, the competitive position of the property in the marketplace, and, of course, the terms of the lease.
However, variations on this structure are common. The financial arrangements between the seller/tenant and buyer/landlord can be extremely flexible, depending upon the sophistication of the buyer, the tenant’s needs, its credit quality, type and location of real estate, and the terms of the lease relative to the overall market.
A sale/leaseback can still be attractive to companies that do not enjoy a high credit rating if investors believe that the business model will generate consistent income and that the seller will be able to honor lease commitments. Given the higher credit risk, investors will rely more heavily on the underlying fundamentals of the real estate—whether the property is desirable to other potential tenants in the event of default, the contractual rental rate as measured against comparable properties, and the expected fair market value of real estate upon termination of the lease for any reason.
For investors, the advantages include a stable, predictable income stream, potential appreciation, positive leverage, attractive yields relative to other investments, and partial tax shelter through depreciation and interest deductions.
Typical mortgage financing provides borrowers with capital equal to about 60 percent to 75 percent of fair market value. A sale/leaseback transaction can effectively monetize 100 percent of the fair value of those real estate assets, freeing up cash for other corporate purposes. The company can use the net proceeds from a sale-leaseback to reinvest cash in opportunities that are financially more efficient or will produce a higher yield.
Sale/leasebacks may also provide companies with the means to manage taxes more efficiently. For example, a sale may result in a capital gain (or loss), which can offset losses (or gains) on other assets. Similarly, whereas a company’s tax deductions are limited to the interest component of debt service plus remaining depreciation deductions, rental payments are typically 100 percent deductible to the tenant.
Be advised that accounting organizations are considering changes in the ways leases are recognized on balance sheets. But even in the absence of guidelines there, these transactions will continue to be attractive alternative sources of financing with potential tax advantages.