Sale/Leasebacks: What Are They and How Do They Work?

A sale/leaseback is a transaction structure that involves a company selling a real estate asset to an investor with the intent to “lease back” the facility for a period of time.  This presents a compelling opportunity for corporations to access capital through the monetization of real estate assets, which is proving valuable in the wake of the coronavirus pandemic, as many companies search for alternative sources of liquidity.

Why do corporations enter into sale/leasebacks?  

The book values stated on a company’s balance sheet are often well below market value due to depreciation over the course of ownership. Sale/leasebacks create the ability to extract that capital at market value without sacrificing the operational benefits of occupying the facility. This cash can then be redeployed to productive uses,  such as business acquisitions and new equipment.  Further, assuming the corporation has a strong credit rating and is willing to commit to a long term (often longer than 12 or 15 years), triple net lease, this bondable credit lease structure can be used to leverage the capital markets much like a bond instrument. This allows a corporation to optimize its debt-to-equity ratio while maximizing present benefits. It also allows them to take advantage of tax deductions for the newly established lease payments, providing short-term P&L benefits.

Beyond these basic financial benefits,  sale/leasebacks can also help companies achieve operating efficiencies. By shifting from an ownership to a  leasehold interest,  the company arguably increases flexibility in its occupancy decisions, especially if the sale/leaseback includes a portfolio of assets where property swapping rights may be arranged.   

Although sacrificing the bondable nature of a credit lease, a company can also establish an exit strategy by committing: 1) to a shorter-term lease; or 2) to only a portion of the space.  In the first case, a short-term lease is effectively a sale of the real estate with the increased value extracted resulting from the mitigation of the investor’s re-leasing risk.  The short-term lease provides the purchaser time to reposition the asset while receiving positive cash flow,  which should result in a higher purchase price compared to a sale of a vacant property.  In the second case, where a  company leases back only a  portion of the facility,  operating efficiencies are captured by immediately transferring the operating costs and risk of re-leasing vacant space to the real estate investor, who should be better positioned to manage and resolve these risks. 

As contrasted with a credit deal, the flexibility garnered from a real estate deal takes into greater consideration the predicted value of the real estate at lease expiration, resulting in a different set of economic assumptions and pricing.  Due to the risk inherent in the terminal value of the real estate, a real estate deal usually has a higher capitalization rate, resulting in a lower purchase price than would be expected with a credit lease.

Sale/leasebacks require a balancing act.

An additional balancing of value is based on whether the corporation is trying to achieve maximized sale proceeds versus minimized rental expense over the lease term.  This relationship is illustrated by the equation:  P = r/C.  The Purchase Price (P) is the quotient of Annual Net Operating Income (r) over a Capitalization Rate (C), which is based on risk factors primarily related to the corporation’s credit rating and the value of the real estate.  The higher the purchase price is set, the higher the rent payments will be and vice versa. 

Understand the potential drawbacks of a sale/leaseback.

While sale/leasebacks offer many benefits for corporations, they are not without their downsides. For example, a company selling its assets will lose its ability to hold those assets as collateral for other business loans.  They will also lose any tax benefits associated with the depreciation of that property (although this is often offset by the lease deductions).

Companies renting back previously owned facilities also expose themselves to shifting market dynamics such as rent inflation. A short-term benefit may not be worth it in the event the long-term risk of rising rates or finding a new facility is not acceptable to a corporation. Changing market dynamics can work the opposite way as well – a company selling their property loses the right to any future appreciation of value. They will miss out on any positive market movements.

Determining if a sale/leaseback makes sense and selecting the right structure involves several considerations.

If the benefits of a  sale/leaseback align with your corporate objectives, your next question might be “how can I get started?” A company should work with a real estate consultant to conduct an objective evaluation that takes into account the corporate objectives, the real estate assets, and the market conditions before deciding to go to market. 

While many conventional real estate brokers may offer to do the front-end analysis for “free”, many times the corporate decision-makers question whether they are merely “selling the idea” to set up the opportunity to earn a commission.  A real estate consultant working for a fixed fee or hourly rate structure can provide the objectivity desired to evaluate sale/leasebacks compared to other recapitalization strategies. 

After comparing the alternatives (including both projected financial results and qualitative assessments) the company, equipped with the support from its financial, accounting and legal resources, may decide to go to market.  If so, the real estate advisor proceeds with identifying the right universe of investors, which may include institutional investors in the case of credit deals and more traditional real estate investors in real estate deals. Once the marketplace is determined,  the real estate advisor manages seller due diligence activities,  marketing and RFP packages, collaboration with the corporation’s lawyers and accountants, transaction negotiations, and support of legal counsel through the documentation and closing processes.

While sale/leasebacks are complicated by the balancing of considerations in both conventional sale and lease transactions,  they can be fairly straightforward alternatives to commercial real estate loans. There are many reasons to consider sale/leaseback structures; astute organizations will take the time to evaluate all of the factors impacting the decision to ensure that they employ a strategy aligned with their operational and financial goals.

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