Originally published in Blakes Bulletin on Real Estate Leasing, November 2007
Though not a new concept, we have seen an increased volume of sale-leaseback transactions, both for owners of operating businesses that wish to "monetize" the real estate they use, and for governmental agencies transferring the risk of management and ownership of buildings the government uses to third parties.
Generally, a sale-leaseback transaction involves an operating business that no longer wishes to carry the real estate on its books or wishes to find an alternative source of financing without showing debt on its books, selling its office or industrial premises and leasing them back from the new owner. The seller finds a buyer who will become the landlord under the new arrangement and the seller becomes the tenant of this landlord.
Often, purchasers may involve pension fund clients which would not pay income tax on the income from the property if properly structured. Further, as pension fund entities typically do not pay capital taxes, a sale-leaseback can eliminate this cost. These tax advantages can result in a premium being paid for buildings that provide a stable and reliable income flow from tenants with solid covenants.
Some of the matters that are dealt with differently in a sale-leaseback transaction than in a normal leasing transaction are as follows:
- Rental Rates. Typically, the rent in a straight leasing transaction is set at market rental rates. In a sale-leaseback transaction, it is possible for the seller/tenant with a good financial rating to be able to sell the asset for more than its "fair market value" by increasing the lease rate beyond fair market rates thereby transforming the lease to a form of financing whereby the landlord accepts the risk of termination or insolvency of the tenant if it can satisfy itself that the covenant of that tenant is strong enough to support the lease rates agreed upon.
- Term Duration. Usually the term of a lease under a sale-leaseback transaction is longer than under normal leasing circumstances – often 20 years with extensive renewal rights.
- Condition of the Property at Lease Commencement. As the tenant is both the seller and the occupant, it cannot expect the landlord to "stand behind" the building or its environmental condition. Accordingly, in a sale-leaseback transaction, the lease often provides that the tenant is fully responsible for the premises and that the landlord can look to the tenant for all maintenance and capital expenses whether arising from normal wear and tear or insured or uninsured casualty.
- Signage, Expansion and Alteration. As the usual sale-leaseback transaction involves a single user, the rights to signage, expansion and alteration are usually fairly extensive in favour of the tenant, subject to the landlord’s concerns that alterations be done in a manner that enhances the value of the building. Obviously, special purpose alterations that are not of value to any other user would be something to be avoided by the landlord. The capital costs of expansion rights can be difficult for a landlord to budget for unless taken into account when the landlord arranges for its financing.
- Option to Purchase. An option to purchase, other than at fair market value, is something to be considered carefully by tax advisors to both the tenant and the landlord. If the option to purchase at the end of the lease term is less than at fair market value, there is a potential for the lease payments not to be fully deductible from the tenant’s income as a business expense.
- Sale Restrictions. If the tenant is in a highly competitive business, it may wish to include provisions in the lease that the landlord may not transfer the asset to a competitor of the tenant as such a transfer may have unacceptable ramifications to the tenant. Though at first blush such a restriction may seem acceptable, it may be that such restriction on transfers will result in the landlord being unable to find a lender, as the most likely buyer for certain manufacturing facilities are those companies which are direct competitors of the tenant. Restricting the ability of the landlord to transfer can result in restrictions on the lender’s ability to enforce its security as the likely buyers in an enforcement scenario are not permitted transferees under the lease. Sometimes, a restriction on transfer can be avoided by providing to the tenant a right of first refusal and/or offer so that if it has an issue with the proposed new transferee/landlord, it can buy the landlord’s interest rather than have its landlord be replaced by a competitor.
- Hell or High Water. Generally, the lease will be most "financeable" if there are no circumstances in which the tenant may either terminate the lease or set off any obligations it may have against those that are owed to it by the landlord. Accordingly, leases typically are structured so as to never allow the tenant to not make payments irrespective of the state of the property (i.e., whether the entire building is destroyed or not) or to terminate (except towards the end of the lease term).
As mortgage debt has become restricted, sale-leasebacks offer alternatives to traditional financing, offering freed-up capital for operating business. For those owners that do not consider real estate ownership as part of their core competencies, sale-leasebacks can be an attractive option.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.