The sale-leaseback concept is the perfect quid pro quo (a Latin term meaning something for something) between two businesses. One company is looking to dispose of an asset to free up needed cash and the other is looking to add to its portfolio of assets and generate monthly income from that asset. The buyer has the cash or access to reasonable-cost financing to secure a positive capitalization (cap) rate from the lease.
However, risks are always involved in any business transaction and each side involved in the sale and lease-back real estate transaction will undertake a few risks and several benefits. Understanding the sale-leaseback arrangement and how to mitigate those risks is crucial for any party considering such a transaction. Take a look at the process:
What is a Sale-Leaseback Arrangement
A sale-leaseback arrangement is a business transaction in which one company sells an asset, such as real estate and then immediately leases it back from the new owner for a specified time frame. It is a two-part transaction that requires contracts to be signed by both parties. There are many advantages to the sale-leaseback for both sides, but there are also some disadvantages to pursuing this type of deal.
Understanding Leasebacks
A sale-leaseback arrangement provides the seller with needed capital while freeing up the equity in ownership. It provides the buyer with a real estate asset with an automatic tenant and likely a long-term lease.
Unlocking the capital from its real estate asset allows the seller to reinvest in the business, pay down debt or provide value to shareholders and investors. The business's financial ratios may improve, making it more attractive to investors or lenders.
The seller disposes of some risks involved in owning real estate, such as depreciation and obsolescence. Unless the arrangement is a triple-net lease, the seller also reduces any previous responsibility to maintain the property. This allows the seller to focus more on the business and not spend time and money on property management. In addition, the seller can negotiate an acceptable lease agreement with the acquirer.
Although the sale may result in a capital gain tax, leasing the property may be tax-deductible as an operating expense.
Why Would Someone Need a Sale-Leaseback
A sale-leaseback arrangement is mainly used to free up capital tied to a fixed asset, such as real estate or even heavy equipment and machinery. When businesses are trying to grow and expand, they often find they don’t have sufficient capital and have the risk of losing an expensive asset during an unforeseen financial crisis.
The lease-back brings quick cash without disrupting business operations in any way. The lease-back also reduces tax liabilities, debt to improve the balance sheet and costs if the rent is less expensive than the mortgage. Profits from the sale of the asset can be deferred for the duration of the lease contract if desired.
How to Identify a Sale-Leaseback Transaction
There are several ways to identify a sale-leaseback transaction. These are:
- The seller simultaneously enters into a lease with the buyer to continue using the property.
- The seller continues to use the property as a tenant after the sale.
- The seller receives immediate capital while still controlling the asset.
- The seller seeks to improve capital, restructure its debt or adjust its financial statements through the transaction.
- A sale agreement and lease agreement between the parties involving the same asset must be present.
- The asset type, such as real estate or manufacturing equipment, is highly valued.
How Does a Sale-Leaseback Transaction Work
There are two parts to the sale-leaseback transaction: the sale agreement and the lease agreement. The sale agreement contains all the details of the sale, such as names of both parties, property address, sale price, disclosure of property condition or any hazards, contingencies and terms and conditions of the sale. The buyer must perform the usual due diligence for buying a commercial property and consider metrics like location, tenant quality and market trends.
The lease agreement is a contract between the new owner, now the landlord and the former owner, now the tenant. The typical lease agreement ranges from 5-10 years and this should be clearly stated. If there’s an option to extend the lease, it should also be stated, along with any conditions that would change with such an extension (e.g., rent increases). Other terms in the lease agreement include names and contact information for both parties, the security deposit amount and additional costs such as parking, maintenance or taxes and insurance if it is a triple-net lease.
The difference between a lease and a sale-leaseback is that, in the former, the asset has not changed hands and the landlord does not give the tenant money. In the latter, the asset does change hands with an exchange of money for the asset.
The Pros of a Sale-Leaseback
There are many pros to both sides of a sale-leaseback arrangement. These are the pros for the seller-lessee:
- The seller can convert an illiquid asset (real estate) into liquid capital that can be used for paying down debt, purchases or growing the business in other ways.
- Improves the seller’s debt-to-equity ratio, allowing them to secure future debt financing.
- The seller can extract 100% of the fair market value of the real estate, compared to only 80% with a cash-out refinance loan.
- The seller can lock in a long-term rental rate and terms that create security and predictability for the future.
- The seller gets a new tax write-off by leasing the property.
- The seller maintains full operational control of the property.
- The seller gains a long-term capital partner, which may be beneficial should they need capital again.
The Pros for the Buyer-Lessor are:
- Acquisition of an asset to increase long-term rental revenue.
- A guaranteed long-term tenant from day one with no vacancy.
- The ability to secure a triple-net lease with annual rent escalations.
- Growth of asset equity.
- Potential future appreciation of the asset.
The Cons of a Sale-Leaseback
All business transactions or investments involve risk, especially in commercial real estate. Although the sale-leaseback arrangement offers many advantages for both parties, it also has potential cons or disadvantages.
The cons or disadvantages, of a Sale-leaseback arrangement to the seller-lessee are:
- The removal of the asset from the seller’s balance sheet.
- Incurring a capital-gains tax for that tax year.
- Increased rental costs for the seller going forward.
- The seller no longer builds equity in the asset for themselves.
- The seller misses out on potential appreciation.
The cons or disadvantages, to the buyer-lessor are:
- Having to renegotiate the contract if the seller defaults on rent.
- The buyer becomes the primary creditor/owner should the seller file for bankruptcy.
- The buyer sees a reduction in capital or takes on additional debt to finance the asset.
- The risk of asset depreciation.
- Ensuring compliance with landlord-tenant laws.
Example of a Sale-Leaseback Transaction
So, how does a sale-leaseback work? One example occurred on Dec. 29, 2023. Four Corners Property Trust Inc (NYSE: FCPT), a diversified Retail Real Estate Investment Trust (REIT), purchased a Tire Discounters property in Kentucky for $1.8 million in a sale-leaseback transaction.
With this purchase, the buyer-lessor, Four Corners Property Trust, secured a long-term, triple-net lease with Tire Discounters (seller-lessee), in which the tenant pays all operating costs, such as taxes, building insurance, maintenance and rent.
With this sale-leaseback, Tire Discounters immediately increased its capital by $1.8 million (excluding closing costs) and became the lessee of the building it formerly owned.
Thus, in this sale-leaseback agreement, each party received something they wanted: Tire Discounters received the cash they needed and Four Corners acquired another property with a long-term tenant.
Conclusion
One can easily see why the sale-leaseback arrangement is the perfect Quid pro quo, with both sides having their immediate needs met legally and ethically. It is an ideal arrangement for two companies with opposite needs and the assets to make it happen. While each side has disadvantages in a sale-leaseback transaction, the benefits seem to outweigh any risks or challenges of the deal.