By Nate Erickson and Harrison Wagenseil
October 20, 2020
In today’s economic climate, having access to capital is vital for businesses to take the necessary action to keep operations running smoothly. For companies that own real estate, one way to accomplish this is through a sale-leaseback. In these transactions, the property owner sells its ownership stake and leases back the property from the new owner, thus maintaining occupancy as a tenant and guaranteeing rental income for the new property owner. With more liquid cash, the seller-lessee can reinvest those funds back into the business, reduce debt, or fund expansion plans. There are many advantages and disadvantages to a sale-leaseback, as well as some prerequisites for a successful transaction that any companies contemplating a sale-leaseback should consider.
First, let’s explore the advantages of a sale-leaseback.
Recapitalizing 100% of the property’s value
The traditional route to accessing capital is through taking out a loan. While there are certainly benefits to utilizing debt, including accessing the funds faster, lower transaction costs, and lower financing costs, there are also some benefits to raising cash through a sale-leaseback. Whereas lines of credit and traditional financing allow property owners to extract up to 80% of the value of the real estate, a sale-leaseback allows property owners to extract the full value of the real estate.
Predictability and favorable terms
Many debt solutions for real estate are amortized over 20 years, but the term typically runs from five to 10 years. The term and variability of mortgage loan payments can create considerable interest rate and risk exposure to future economic downturns, particularly if there is a large balloon payment. By locking in real estate operating costs for 15 to 20 years, a sale-leaseback scenario can create security and predictability for a company.
Maintaining tenancy and control
The seller-lessee has a lot of control over the form and structure of the leaseback. Typically, the seller-lessee will work with a broker to define the total lease rate and operating costs of occupancy that are both appropriate for the market and for the company over the lease period. The lease payments and terms may include more flexibility than an amortized mortgage with onerous and restrictive debt covenants. The new lease could include lower rent for a specified number of years, option control over expansion space and the option to buy back the property in the future. Responsibility for operating expenses, property taxes, management duties and other factors are also up for discussion and negotiation. If structured as an absolute net lease, the seller-lessee will be able to manage the property to its liking and maintain cost control measures.
Reinvesting in the core business
What is the return on owned real estate compared to the return on a company’s core business? Any company that owns its real estate should know this information. While real estate is a highly tax efficient investment and current IRS rules governing real estate sales – such as IRC 1031 – make it an attractive investment, this should always be weighed against the alternative. If a company can make a 7% annual return on real estate but a 12% return on the sale or manufacture of a product or service, those funds are likely better spent elsewhere.
Cleaning up balance sheets
Most long-term leases will be considered a capitalized lease and will be viewed as an asset, with the remaining lease obligation viewed as a liability on the balance sheet. As a result, there is no “off-balance-sheet financing” benefit to sale-leasebacks like there was prior to the change in accounting rules by FASB (Financial Accounting Standards Board) in 2019. However, there is still one significant accounting benefit to a sale-leaseback: the seller-lessee likely will be in a much better cash position and reflect a lower amount of financing after the sale. The improved debt-to-equity ratio could be critical when obtaining a loan for equipment or expansion in a new market.
A sale-leaseback can be used as a tool to create immense value in relatively short amount of time. For example, Company A purchases a 100,000-square-foot building for $60 per square foot or $6 million. It invests an additional $500,000 to make updates and occupy the building for its own use. The company has $65 per square foot invested into the building, but its core business is medical devices, not real estate. In the current market, considering the insatiable demand for single-tenant industrial assets, capitalization rates in the Minneapolis/St. Paul market are in the 5.75% to 6.5% range for well-located assets with strong credit. Assuming a market rental rate on that same 100,000-square-foot building is $5.50 per square foot, or $550,000 annual net rent, applying a cap to that comes to $8,461,000, or $84.62 per square foot. In other words, by leveraging the credit of the company, a nearly 30% increase in value can be created purely by having that tenant in place.
While this is a highly simplified example, it demonstrates the potential value. One could argue the annual rent on the lease would far exceed a loan payment, or that managing operating expenses in a buy-and-hold scenario could be far lower than the sale-leaseback scenario. The company must ask which is more important: A large cash infusion today for expansion efforts and reinvestment, or the annual cash flow? Certainly, there are pros and cons to each scenario, but it’s important to know what options are available.
Preparing for an upcoming sale of the business
A sale-leaseback can be an excellent first step when preparing for the upcoming or potential sale of the operating business. In most transactions, companies are sold on a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). Many times, the buyer may not be interested in owning the building or unwilling to pay full value for the facilities, but rather the buyer values a long-term location for business operations. In these cases, the sale of the building separate from the operating entity can maximize the total proceeds received for the business.
As with any complex business decision, there are also disadvantages to consider.
By relinquishing ownership rights and opting for a lease, growing equity through a 1031 exchange, or collateralizing the asset for a line of credit or other financing vehicles, will no longer be advantages to leverage.
Prudent forecasting of business needs is essential when considering changing real estate strategy. Unfortunately, it’s tough to predict what space needs will look like in five, 10, or 15 years. There is a certain amount of flexibility that can be built into a lease, but it’s difficult to change once the lease commences. Simply put, a company can’t vacate the property without some headache.
Higher cost to financing
The transaction costs associated with traditional debt are typically less than those associated with the sale of a net-leased asset.
Loss of residual value
After selling an asset, the seller-lessee doesn’t capture the residual value and appreciation after a strong real estate cycle.
Due to multiple market factors, there is high demand from both entrepreneurial and institutional investors for single-tenant, industrial and medical net-leased assets. During the past 12 months, sales volume for industrial investment properties exceeded $470 million in the Twin Cities alone. The ideal scenario is to create the most “bondable” lease possible, and investors will pay a premium for real estate leased to companies with excellent credit. A trusted real estate advisor can help shepherd company leadership through the process of analyzing the cost/benefit of a sale-leaseback, identify prospective buyers, leverage the market to drive the highest value, and execute on a sophisticated real estate strategy.
Nate Erickson is a Vice President in Transwestern’s Minneapolis/St. Paul office, where he specializes in representing companies in the manufacturing, distribution and life sciences fields.
Harrison Wagenseil is a Managing Director and team lead for Transwestern’s Minneapolis-St. Paul capital markets and investment sales practice.
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