In a turbulent market, a sale and leaseback may be a win-win for both investor and tenant. The arrangement provides a liquidity solution for businesses wishing to release locked-up capital and gives investors access to assets that would not have otherwise been on the market. But how does a sale and leaseback work and what are the common issues to be aware of?
The what and the why?
A sale and leaseback involves the sale of a property (or portfolio of properties) from party A (the seller) to party B (the investor) in return for a lump sum. Party B then immediately leases the property back to party A (now the tenant) for an agreed term and rent structure (usually open market rack rent; index-linked; or calculated by reference to the purchase price). Sale and leasebacks have been popular with supermarket chains for a number of years and use in other asset classes is increasing too, notably hotels, logistics and life sciences – for example, Oxford Biomedica has recently agreed a strategic £60 million sale and leaseback of its headquarters in Oxford.
On top of accessibility of assets, sale and leasebacks are also popular with investors due to the stable nature and predictable flow of returns – the properties are already operating, a tenant is guaranteed and rental payments will likely be regular and fixed, at least until the first rent review (which would usually be upwards only or framed with a cap and collar). Since the investor will own the property, it will also benefit from any increased property value, sometimes without conducting any repair or capex works itself. For the tenant, the arrangement releases locked-up capital from its balance sheet which can be used to pay down debt, to re-invest cash into the business or to pursue new opportunities. The business's operations, and importantly the location of those operations, remain unaffected.
Common issues to consider
Should the deal be on or off the record? Both parties should think carefully about the confidential nature of the terms of the transaction and whether all terms should be set out in the lease which, in most cases, will be publicly available at the Land Registry (to the extent unredacted). Alternatively, a separate framework agreement, which will remain private, could house the commercial terms. An investor will not want to prejudice its future negotiating position by revealing to the market the terms it has agreed to previously. A tenant will not, for example, want its competitors seeing the reporting requirements and other financial or capex covenants.
Appropriate repair and capex provisions. Landlords will favour a triple net/FRI lease whereby the tenant is responsible for taxes, insurance and maintenance of the property – this allows for maximum returns (in the form of rental payments and rise in property value) with minimum input. The repair clause should be carefully drafted to ensure the property is maintained to an appropriate standard. In many cases, capex provisions (which require the tenant to invest above and beyond the repair provisions in a typical occupational lease) may also be appropriate. Such provisions retain the tenant's feeling of owning the property and controlling the works. However, the tenant should ensure that it can comply with the covenants included, not only financially but also in terms of the frequency and standard of the required maintenance and development works.
In uncertain times, find certainty in reporting. Landlords will want to ensure that the tenant is operating profitably and able to comply with rent, repair and capex covenants. Information is key. A landlord will include stringent reporting requirements in the lease or framework agreement for the provision of turnover related information, evidence of covenant compliance etc. However, as the landlord will want access to a wide range of supporting data, a well-advised tenant will impose stringent confidentiality obligations. The confidentiality clause should not be overlooked.
Catering for the next liquidity event. Although long-term investors are often attracted to sale and leasebacks, they will not want to be locked-in forever and may wish to sell the investment, particularly if the lease has a long term. Leases rarely prohibit a landlord from transferring its interest, but a tenant in a strong negotiating position may limit the category of persons to whom the landlord could sell to (e.g., not to the tenant's competitors).
The tenant may also want to exit before term expiry, be that due to financial difficulties or otherwise. Since the landlord transacted based upon the identity and covenant-strength of the tenant, the landlord may restrict the tenant's ability to assign the lease. If the lease contains open-market rent reviews, the landlord should ensure that any provisions restricting the tenant's right to assign the lease are disregarded on rent review so that the tenant cannot rely upon the onerous nature of the restrictions to secure a below market rent. More favourable underletting provisions may be a suitable compromise.
Whilst change of control clauses are uncommon in English law leases, depending on the identity of the tenant, adequate flexibility may need to be built into any change of control clause to permit an indirect owner of the tenant to exit its investment.
Any renewal options should also be discussed at the outset. If the landlord is opposed to granting a renewal option, it should also contract out of the security of tenure provisions in the Landlord and Tenant Act 1954 to ensure it is not obliged to grant a further lease to the same tenant. Adequate forfeiture provisions that cover the risk of tenant default are a must-have. Any break rights (mutual or otherwise) will also need to be agreed.
What's next?
The popularity of sale and leaseback transactions continues. It is a trend that will likely develop further during the months ahead as businesses seek to release locked-up capital in a time of economic uncertainty and restricted debt markets. As the terms of the arrangement extend beyond those of a typical occupational lease, a balance will need to be struck between the need for liquidity and future proofing lease terms.
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.
