Sale-Leaseback Transactions

Sale-Leaseback Transactions

1. What Is a Sale-Leaseback? A sale-leaseback transaction is one in which the owner of a property sells it to a third party and then leases it back from the buyer. These transactions are very common in corporate real estate. Most real estate decisions by corporations are really financial decisions. If a corporation determines that certain real estate is necessary for its business operations—the real estate decision—the corporation then makes a financial decision—how should the corporation pay for/finance the cost of the property. There are four basic alternatives: own the property for all cash; own the property partially financed via mortgage debt [often 50%+ of market value]; lease the property from a third party; or lease the property via a sale-leaseback. In the typical sale-leaseback, a property owner sells real estate used in its business or acquired for the specific purpose of the sale-leaseback transaction, to an unrelated private investor or to an institutional investor. Simultaneously with the sale, the property is leased back to the seller for a mutually agreed-upon lease term, usually 10 to 30 years. The sale-leaseback may include either or both the land and the improvements. Lease payments typically are fixed to provide for amortization of the purchase price over the term of the lease plus a specified investment rate of return for the buyer’s investment. Typically, the sale-leaseback transaction is a “triple-net-lease.” Sale-leasebacks generally also include an option for the seller-tenant to renew its lease, and on occasion, repurchase the property.

2. Purpose of Sale-Leaseback Transaction.

2.1 Seller-Tenant Advantages.

2.1.1 With a sale-leaseback, the seller can free up ‘frozen’ capital held as ‘equity’ tied up in property ownership; at the same time, the seller retains possession and continued use of the property for the lease term.

2.1.2 The seller-tenant can typically raise more cash with a sale-leaseback than through a conventional mortgage financing. For example, if the company seeks to liquidate the value of both land and improvements, conventional mortgage financing normally funds no more than 70 percent to 80 percent of a property’s value. By comparison, in a sale-leaseback the seller receives 100 percent of the property’s market value (less any capital gains tax).

2.1.3 The seller-tenant can pre-negotiate many of the sale-leaseback terms according to what best serves its financial interests, depending on its bargaining power, which in turn is based on its prior and anticipated financial success. So the seller-tenant usually can structure the initial lease term for a desired time period without the burden of balloon payments, call provisions, refinancing, or the other conventional financing difficulties. Further, the seller-tenant avoids conventional financing’ additional costs such as points, appraisal fees, and legal fees, which may be the substantial costs. The seller-tenant may also include in the sale-leaseback renewal options, while conventional mortgage financing has no guarantee for refinancing.

2.1.4 In a sale-leaseback, the seller can remove from its balance sheet the property’s value and the debt burden incurred by it and replace them with net sales proceeds obtained from liquidating the property, while not needing to report the lease on the balance sheet. The seller replaces a fixed asset (the real estate) with a current asset (the cash proceeds from the sale). If the lease is classified as an operating lease, the seller’s rent obligation usually is disclosed in a footnote to the balance sheet rather than as a liability. This results in an increase in the seller’s current ratio, or the ratio of current assets to current liabilities – which often serves as an indicator of a borrower’s ability to service its short-term debt obligations. Thus, an increased current ratio improves the seller’s position for borrowing future additional funds. [However, if the lease is classified as a capital lease, or a financial lease that does not constitute a real sale, the advantages of the sale-leaseback arrangement from an accounting perspective are altered considerably. Statement of Financial Accounting Standards No. 13 on accounting for leases requires that a capital lease be recorded as an asset and capitalized and requires the obligation to make future lease payments to be shown as a liability.]

2.1.5 Undervalued real estate on a company’s books often serves as a target for corporate raiders—a time-worn technique in the leveraged buyout. Having structured one or more sale-leaseback transactions could assist management in two ways—additional funds available to fend off the takeover, and the financial obligation of a long-term lease [not as inviting to raiders as undervalued real estate].

2.1.6 Because a sale-leaseback is not considered a loan, state usury laws do not apply, so a seller-tenant can offer the buyer in a sale-leaseback a higher rate of return on its investment than if the buyer instead merely financed the property still owned by the seller.

2.1.7 A company subject to debt financing limitations by prior loan/bond agreements may circumvent these limits via a sale-leaseback. Generally, rent payments under a sale-leaseback are not treated as indebtedness.

2.2 Seller-Tenant Disadvantages.

2.2.1 Perhaps the major disadvantage of the sale-leaseback is that the seller-tenant transfers title to the buyer-landlord. Owners can minimize this disadvantage by including a repurchase option in the leaseback. However, a repurchase option changes how the sale-leaseback arrangement is reported for accounting purposes–the lease will be recorded as an asset and capitalized, and the obligation to make the future lease payments will be reported as a liability.

2.2.2 A potentially large risk is that if the buyer files for bankruptcy, the trustee in bankruptcy may reject any agreement to renew the leaseback or the seller’s option to purchase the property.

2.2.3 The seller-tenant loses the flexibility associated with property ownership, such as remodeling improvements or changing or discontinuing the use of the property, which may be mitigated to a certain extent via protective lease provisions. The sale-leaseback often restricts the seller-tenant’s right to transfer the leasehold interest, and even if possible, generally it is more difficult to dispose of a leasehold interest than a fee-ownership interest.

2.2.4 A poorly drafted sale-leaseback may leave the seller-tenant foundering for a lease extension or relocation at then-current market rents.

2.2.5 If the rental market softens, the seller will likely be locked into the higher rental rate negotiated at the time of the sale-leaseback. Rental payments under the lease cannot be adjusted without the buyer-landlord’s consent—the seller-tenant is tied to the interest rate implicit in the sale-leaseback for the full lease term.

2.2.6 The cost of capital for a seller-tenant seeking to improve the leased property will likely be higher because financing will only be secured by a leasehold interest. Moreover, the leasehold may contain provisions that prohibit the seller-tenant from mortgaging the leasehold interest.

2.2.7 The interest rate, i.e., the rent, in a sale-leaseback arrangement generally is higher than what the seller-tenant would pay through conventional mortgage financing. The economic rationale for this is that the buyer-landlord’s investment in the leased property may be less liquid or marketable than a loan. Moreover, the buyer-landlord assumes additional risks by ‘financing’ the property’s entire fair market value.

2.3. Buyer-Landlord Advantages.

2.3.1 In a sale-leaseback, the buyer-landlord typically receives a higher rate of return in a sale-leaseback than in a conventional loan arrangement. Also, the buyer-landlord should circumvent state usury laws that limit the rate of interest charged with conventional financing. At the expiration of the lease term, the buyer-landlord also receives the benefit of any appreciation in the value of the property. Finally, the buyer-landlord can leverage the purchase with mortgage financing, further amplifying the return rate on the cash invested.

2.3.2 The buyer-landlord has a built-in tenant, i.e., the seller-tenant, which is a cost and time savings.

2.3.3 The long-term net lease enables the buyer-landlord to estimate accurately the expected future rate of return. Also, the extended term of the lease provides the buyer-landlord with protection from downturns in the real estate market and, assuming the property’s value appreciates over time, a hedge against inflation.

2.3.4 If the seller-tenant defaults under the lease, the buyer-landlord can simply terminate the lease and have the seller-tenant evicted. The buyer-landlord’s greatest risk then may have trouble finding another tenant, particular if the property is a special use. 2.3.5 The buyer-landlord owns the reversionary interest in the property, possibly whipsawed if the seller-tenant has an option to purchase or an option to renew the lease, this may limit or postpone the time that the buyer-landlord actually realizes the profit potential. The buyer-landlord, of course, also bears the risk that the property’s value might decline over the lease

2.4 Buyer-Landlord Disadvantages.

2.4.1 Perhaps the biggest risk for the buyer-landlord isa lease default by the seller-tenant, probably leaving leave the buyer-landlord without a tenant, as lest for a time. If the seller-tenant files for bankruptcy, the buyer-landlord is considered a general creditor. If the arrangement were a conventional mortgage, the buyer-landlord would be considered a secured creditor. If the seller-tenant files bankruptcy in a soft real estate market, the buyer-landlord may have a difficult time finding a new tenant.

2.4.2 Because the typical sale-leaseback usually must be structured to meet the specific needs and requirements of both parties, it may require more time and thus higher expenses, e.g., legal, appraisal, financial costs, than a conventional loan transaction. 2.4.3 The seller-tenant typically assumes in a sale-leaseback responsibility and expense for day-to-day property management matters during the lease term, aka a triple-net lease. The buyer-landlord must therefore verify that the seller-tenant pays the property taxes on time and that tax assessments are reviewed and challenged when appropriate. The buyer-landlord also must periodically review the insurance coverage on the property and inspect the property periodically for proper maintenance.

2.5 Tax Considerations for the Seller-Tenant.

2.5.1 Tax Benefits for the Seller-Tenant. A seller-tenant’s decision to raise funds through a sale-leaseback is typically derived from the substantial income-tax advantages that flow from the transaction, savings producing cash for the seller-tenant to use more productively.

2.5.1.1 The key tax advantage of a valid sale-leaseback is that rental payments under the lease are fully deductible. With conventional mortgage financing, a borrower deducts interest and depreciation only. The rental deduction may exceed the depreciation if: [1] the property consists primarily of a non-depreciable asset, such as land (although land is not depreciable, rental payments for the lease of land may be deducted); [2] the property has appreciated in value (while depreciation deductions are limited by the cost of the property, rental deductions may equal the fair market value of the property); or [3] the property has been fully depreciated.

2.5.1.2 A seller-tenant can use the sale-leaseback transaction affirmatively to time recognition of gains or losses while retaining the use of a property. A business may want to recognize gains, for example, to use business credits or net operating loss carryovers. If the business owns appreciated property, a sale of assets will produce a gain that could be offset by the credits or net operating loss carryovers. If the adjusted basis of the assets exceeds its fair market value, however, a recognized loss will reduce tax liability.

2.5.1.3 Because the property involved in a sale-leaseback generally is held for use in the seller-tenant’s trade or business, it qualifies for capital gain-ordinary loss treatment under IRC § 1231. If the property is held for the long-term holding period, then ordinarily gain on the sale will be taxable as long-term capital gain to the extent that the gain exceeds the losses in the same year from the sale of other Section 1231 property. [But to the extent of recapture income, the gain will be taxable as ordinary income. If the sale instead results in a loss, it will be deductible in full as an ordinary loss to the extent the loss exceeds Section 1231 gains from the sale of other property in the same year.

2.5.1 Tax Disadvantages for the Seller-Tenant.

2.5.1.1 The ordinary loss deduction ordinarily allowable on a sale-leaseback transaction might be barred if the lease term is for 30 years or more, on the theory that it is a nontaxable exchange of like-kind property under IRC Section 1031. Still, the seller-tenant would be entitled to depreciation on its basis for the leasehold over the lease term.

2.5.1.2 If the sale-leaseback transaction gives the seller-tenant an option to repurchase the property or if the seller-tenant retains substantial ownership rights, the Internal Revenue Service may view the transaction as a mortgage. In that case, the seller-tenant would not be allowed a deduction for rent but could deduct depreciation and a portion of the rent payments as interest.

2.5.1.3 Recapture on a sale-leaseback transaction may be onerous, because the sale of the property under a sale-leaseback may trigger depreciation, investment tax credit, and other types of recapture.

2.6 Tax Considerations for the Buyer-Landlord.

2.6.1 The buyer-landlord in a sale-leaseback reports rental payments entirely as ordinary income as they are received over the lease term. If instead the transaction were structured as a loan transaction, the lender is taxed only on the interest portion of the payment and not on the amount that represents the repayment of principal.

2.6.2 The buyer-landlord in a sale-leaseback as a real property owner still derives beneficial tax treatment. Rental income may be offset, in part, with available deductions and credits. Interest on mortgage debt, subject to certain limitations, also would be deductible. The buyer-landlord may also claim depreciation deductions for eligible property, and available tax credits.

Reference: National Business Institute, Inc. Real Estate Transactions: Buying and Selling Commercial Real Estate [78952] Pages: 87-105 (2018)

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