By William Carr
With the Dow at or near an all-time high and bond yields at abnormally low levels, so-called “sale-leasebacks” have risen in popularity among alternative investments.
Although sale-leasebacks can cover many types of assets, this article focuses on transactions in which an on-going business sells property it intends to continue to use. The business retains possession of the property, leasing it back for a rent payable over a relatively long term (often with renewal options).
As in all deals with complex documents and issues, there are a number of nuances. While the word limitation of this article means we can’t begin to cover all of them, we can explore the broader risks investors face.
The buyer-landlord’s incentive is, presumably, an attractive return on his investment, in the form of rent payable over the term of the lease. A possible additional bonus is that he may be able to leverage his investment by borrowing a substantial part of the purchase price of the property based on the credit of the seller-tenant or his own credit (possibly, at least to some extent, on a non-recourse basis). However, the true worth of the investment to the buyer-landlord may not be known until the end of the leaseback term, when the buyer-landlord goes to sell or relet the property (which obviously could be for more
or less than the original purchase price or rent, depending on market conditions at that time).
The documentation for the deal consists of two primary documents—a contract for sale and a lease agreement, each of which can be lengthy and complex.
Is a sale-leaseback “a win-win” situation? It has that potential when things turn out well. But there are some real, substantial risks being undertaken on the part of the buyer-landlord, which he needs to be aware of in light of the investment being made to purchase the property and the rental yield being received under the lease.
First, the possibility always exists that during the term of the leaseback, the seller-tenant may go bankrupt or otherwise default in payment of the rent and performance of its other obligations. Indeed, a prominent Kansas City real estate investor recently told me that he is usually dubious of these deals, since the seller-tenant may really need the cash, which heightens his concerns about the seller-tenant’s credit worthiness.
Second, the sale-leaseback documents may restrict the use of the property by the buyer-landlord after the expiration of the term of the leaseback, which in turn may reduce the property’s resale or reletting value.
Third, while the buyer-landlord seeks a leaseback where the rent must be paid “come hell or high water” without any offset or deduction, the leaseback documents may contain provisions providing for the reduction or abatement of the rent payable by the seller-tenant upon the occurrence of certain events.
Fourth, the leaseback documents might not have been drafted to protect the buyer-landlord against bearing expenses that may arise with respect to the property during the leaseback term. Those expenses could have the effect of undercutting the rental yield and, thus, the reason the buyer-landlord may have wanted to do the deal in the first place.
To mitigate against the foregoing risks, before entering into the transaction, the buyer-landlord should undertake due diligence to determine whether (a) the credit of the seller-tenant is sufficient to support throughout the term of the leaseback the payment of the rental and performance of the other leaseback obligations to be undertaken by the seller-tenant; (b) the property is expected to at least retain its sale and rental value during the term of the leaseback if the seller-tenant goes bust; (c) the property is also expected to at least retain its sales and rental value at the end of the leaseback and (d) the sale-leaseback documents allow the seller-tenant to abate rent or expose the buyer-landlord to expense, liability or reduction in value of the property.
There are a host of other issues in a leaseback transaction. The buyer-landlord will need to very carefully review the documents to make sure they reflect his understanding of the deal and to avoid being surprised later by provisions eroding or abating the rent or requiring the buyer-landlord to incur expenses not originally contemplated.
While I have never met a client yet who loves (as opposed to loathes) to pay legal fees, this is a clear instance where a buyer-landlord would be wise to hire a competent real estate lawyer who regularly handles these types of transactions.