Is a Sale-Leaseback Right for your Business?
What is a Sale-Leaseback?
Before we dive into a discussion about the merits of a sale-leaseback, we must first define the term. These deals can take on various structures; however, the underlying premise of a sale-leaseback remains the same.
In any type of commercial real estate transaction, you have either a buyer and seller or landlord and tenant.
In a traditional sale-leaseback transaction, the property owner sells the real estate in which they operate a business, usually to an investor, and simultaneously signs a lease agreement for the space with the new owner. Hence, a sale and a subsequent leaseback of the space.
Today's Market Uncertainty May Be Conducive to a Sale & Leaseback
There are a variety of reasons a business may consider a sale-leaseback. Greater market forces, the overall health of a localized economy, or a business's unique circumstances can all drive the need to divest real estate.
We live in a world where low-interest rates have expanded access to real estate ownership but, at the same time, caused investors to seek higher yields through alternative assets. Concurrently, the recent liquidity contraction has caused many businesses' demands for cash to soar.
So, when banks aren't lending, and businesses need cash, the question is, where will the liquidity come from? A leaseback can help bridge this gap.
Sale-Leaseback Benefits as a Business Owner
1. Control your lease terms: As a property owner, you have carte blanche over your real estate. Unless, of course, you fail to pay your property taxes, or you need the city council to approve a sketch plan for on-site development, or the county wants to widen their right of way, and on and on. There is a misconception that you lose control of the asset once you sell your real estate and lease it back. Sure, the asset no longer resides on your balance sheet, but it's important to understand that what you do with your property is restricted whether you own or lease it.
As the future lessee, the property seller has significant bargaining power in structuring a leaseback arrangement. The lessee has the opportunity to negotiate the rental rate, possible extension options, an early termination agreement, or even favorable sublease language. This helps ensure maximum flexibility while keeping occupancy costs at a predictable cash outflow over the rental period.
Additionally, most sale & leaseback arrangements are structured as triple-net leases, meaning the tenant is responsible for the taxes, insurance, and common area maintenance of the property. Under this structure, investors are happy to remain hands-off, giving the tenant a level of freedom similar to what they enjoyed as owners.
2. Avoid restrictive debt covenants: Very simply, restrictive debt covenants are agreements between the borrower and lender and place guidelines on what the borrower can and can't do while paying off the note. In many cases, a lender will prevent a borrower from issuing any debt senior to their current outstanding notes. It is also common to see minimum thresholds placed on a business's debt to asset ratio or a specific property's debt service coverage ratio.
These debt covenants are meant to solve agency conflicts. Still, they can be cumbersome, and in some circumstances, could result in the lender calling a note payable in full, even if the borrower hasn't missed a payment. Fewer covenants provide a business with greater flexibility and control over their capital and ultimately reduce the risk of a contract breach in challenging operating environments.
3. Tax considerations: In some cases, there are tax advantages to a sale & leaseback as a business owner. First, lessees can deduct their total lease payment as an expense for tax purposes. Traditional mortgage financing only allows for the deduction of depreciation and interest payments.
Businesses can also benefit from timing a gain or loss recognition on the sale of their property. If timed correctly, a gain or loss on the transaction could be used to offset a net operating loss carryover or to offset income and ultimately reduce a business's tax exposure. Additionally, since most owner-occupied real estate is held for the business's use, the IRS qualifies it for capital gain-ordinary loss treatment under section 1231. This means that real estate held for longer than one year is subject to long-term capital gains tax instead of the ordinary income rate.
Care must be taken when designing the lease arrangement, though. To avoid the IRS classifying a sale-leaseback as a financing transaction, the lease should avoid any repurchase option language. This could create a situation where the lessee is actually deemed to own the real estate for tax purposes, possibly negating any positive impact from the property's sale.
4. Alternative to conventional financing: A business's capital structure directly influences its cost of capital; the rate at which a firm can borrow funds to finance future growth, or alternatively, the return required by the investors who provide the firm capital through both debt and equity financing. Known as the king of off-balance-sheet financing, a sale-leaseback offers a unique alternative to outdated funding growth strategies.
The implicit financing rate in a sale-leaseback transaction is the same as the buyer's capitalization rate, which is the equivalent of the expected year-1 net income as a percent of the purchase price. This is higher than conventional mortgage financing but offers greater protection to the seller. The buyer only has recourse to the real estate as collateral and only has a relationship with the seller through the leaseback agreement.
5. Greater value in real estate: Most traditional mortgages only finance up to a certain threshold of a property's appraised value, often times forcing businesses to tie up cash to fund a down payment. Sale-leasebacks are often structured to finance up to 100% of the appraised building and land value. The result is a much more efficient allocation of a firm's finite capital resources.
Equity tied up in real estate holdings does very little to fund growth. Sure, a properly positioned property provides a business with a certain level of diversification, as real estate is not highly correlated to other asset classes. But, real estate is traditionally illiquid, and in some circumstances, an unproductive deployment of a company's dollars.
When Should You Consider a Sale & Leaseback?
When capital is needed for growth: Conventional mortgage financing rates are at historic lows, but that doesn't mean the marketplace is ripe with liquidity. Because you can't fund corporate investing or growth activities through a mortgage, businesses are looking for alternative financing means. A sale-leaseback can be used to free up cash to fund growth through acquisition, investing activities, or through the purchase of equipment, technology, or additional facilities.
When packaging a business for sale: During the purchase and sale of a company, the buyer typically has a choice: the deal can be structured as either an asset or equity purchase. Most small business sales are structured as asset transactions, in which the buyer will purchase a firm's specific assets and liabilities. This usually affords a buyer certain tax advantages but has back end implications for the business owner.
Most private equity groups and business buyers aren't interested in owning and managing real estate. They value a firm based on their best assessment of future cash flows and growth prospects. An owner contemplating a sale of their business would be well served to separate the real estate from a company sales transaction. This would maximize the value of the real estate and increase the proceeds from any sale transaction.
You need to clean up your balance sheet: The composition of a business's balance sheet plays a vital role in how lenders, investors, and shareholders view the firm's riskiness. Liquidity benchmarks and existing debt and lease obligations all impact a firm's ability to secure future financing. A sale-leaseback can be used as an off-balance-sheet financing structure that allows the seller to turn a non-earning asset into growth capital.
Another important consideration is the cost of raising additional funds. The goal would be to structure a sale-leaseback that provides a lower price of funds than debt or equity financing. By paying off the mortgage and recapitalizing the firm's debt to equity blend, a business can avoid equity dilution and ensure cheaper funding than the “all-in-cost” of traditional convertible debt, mezzanine funding, or a pure equity offering.
You run a high margin business: Commercial real estate is typically a 6-7% return business. The use of leverage can generate a higher return on cash invested. Still, companies running 12-15% margin operations may be better served to divest their real estate holdings to fund their core business processes instead. Generally, reducing one's investment in non-core business assets helps by flexing capital growth dollars, ultimately assisting in pursuing economies of scale in higher-margin operations.
How a Real Estate Strategy Advisor Can Help
Business doesn't provide us with a neatly drawn roadmap to help our decision-making process. Real estate adds another layer of nuance to an operating environment already overly laden with complexities.
Many business owners end up as commercial landlords by accident, and their real estate may not be optimized for their operations. Principals need to look at their overall portfolio as two separate entities, their business, and their real estate. The legal structure and treatment of that real estate ultimately impacts the bottom line, and some business owners haven't stopped to ask – does ownership even make sense?
There is no best answer. A business's capital allocation needs, legal and accounting considerations, and market conditions all play a role in how to best leverage one's real estate. As a business or real estate owner, it's essential to remain agile and allow yourself maximum flexibility to make decisions. Structuring your portfolio properly is the first step.
I am excited to have a conversation about you and your businesses short and long-term goals, and how I can help.
