Raising cash through a sale-leaseback

A useful but infrequently used tool for raising cash for a small business is the sale-leaseback transaction. While public companies are more likely to use it, the device is also available to private companies that use real estate in their business.

The process is best-suited for businesses that carry their real estate on their books as an asset, and which have significant equity in the assets. These companies can generate working capital by selling the real estate and re-investing it in the business. Typical property types that are the subject of sale-leasebacks are warehouse and distribution facilities, office buildings and medical offices.

In such a transaction, the business sells the real estate to an investor, who simultaneously leases the space back to the business on a long-term basis. This allows the business to continue operations in the same facility while generating cash for the business. It also provides the investor with an instant tenant on a long-term basis.

As with any real estate transaction, there are advantages and disadvantages for both the business seller and the investor buyer.

Business advantages

The most obvious benefit is that the sale-leaseback allows the business to convert equity in its real estate into capital that it can use in its business, while still retaining control (via a lease) of the property it has been operating in.

The sale-leaseback also can be an attractive alternative to refinancing, due to the costs and fees associated with a refinance.

For companies that need to improve their balance sheets and credit standing, the sale-leaseback allows them to get the real estate off their books and remove the debt connected with it.

While ownership of the real estate is given up, the sale-leaseback allows the business to fix its occupancy costs long-term, as most leases extend for many years with the lease rates pre-determined. This makes it easier for the business to do long-term financial planning.

If a property is not easily marketable because of the special use by the business, the sale-leaseback offers an exit strategy for a user who might not be able to readily sell the property.

From a tax perspective, rental payments can be deducted in full, while only interest payments and depreciation are available to owners. The selling business can generally treat the proceeds of the sale as capital gains, and in some cases might even be able to realize an ordinary loss, but depreciation will be recaptured at the time of sale.

Business disadvantages

While the sale-leaseback allows the business to pull out the current equity in the property, the business loses out on the residual value of the property. In theory, the equity could be higher if the business held on to the property as long as it needed it, and continued to pay off the existing mortgage.

By entering into a lease rather than continuing to own the property, the business puts itself in the position of possibly having to relocate at the end of the lease term if the investor decides to do something else with the property or to seek a different tenant.

The business also loses some flexibility in developing the site in the future, although this might be allowed under the lease.

While not generally a problem, the bankruptcy of the buyer investor could threaten either the renewal of the lease or the option to repurchase the property, if such a provision is in the lease.

Many businesses that own real estate often sell both the business and the real estate at the same time when a new owner takes over. This scenario is not guaranteed if the real estate has been sold previously to a third-party investor.

If the business falters and an exit strategy is needed, it may not be possible to sublease the property, again depending on the terms of the lease.

With respect to taxes, there are some situations in which the sale-leaseback might not be recognized or the selling business might not be entitled to an ordinary loss deduction on the sale.

Investor advantages

A predictable and secure return rate is important to all investors, and the sale-leaseback provides that (obviously depending on the credit standing of the selling business).

By acquiring title to the property, the investor also acquires the residual value of the property, including any appreciation. When highly functional properties are involved, this benefit can be huge, allowing the investor to re-tenant the property with few renovations.

The investor can easily handle any default by the selling business by evicting it, following the requirements of the lease and applicable laws.

On the positive side, the investor gains a built-in tenant that is already comfortable with the property and the market. This is much more favorable than buying an empty building and trying to find a tenant (especially in today’s market).

The sale-leaseback also presents fewer management issues for the investor, since most leases require the business tenant to take care of all issues, including the real estate taxes, insurance, maintenance, etc.

The certainty of the lease payments provides the investor with somewhat of a hedge against inflation as well as the tax benefits of ownership, including the deductibility of interest on the mortgage and cost recovery (depreciation).

Investor disadvantages

In a single-tenant lease, the biggest worry for the investor is a default by the tenant, because that leaves the property 100 percent vacant. Whether the vacancy is caused by the selling business ceasing operations or filing bankruptcy, the landlord has to find a new tenant. In a tenant’s market, it may be difficult to find a tenant, and the terms of the new lease could be less advantageous than the sale-leaseback lease.

Many single-tenant properties are built for the special needs of the business that occupies them. If the selling business defaults, the costs to renovate the property for a new user can be significantly higher than with most properties.

Single-tenant properties also might generate a lower return than multi-tenant properties, because tenants change frequently in multi-tenant properties, allowing for more frequent rent increases (again depending on the market).

On the tax side, rental payments are fully taxable as opposed to only interest being taxable if the investor were a lender rather than an owner.

In the end, the decision whether to continue to hold, do a sale-leaseback or simply refinance will require a cash flow analysis to determine which option has the highest positive present value. But as with any real estate transaction, there are numerous legal, financial and tax issues, including some that go beyond the scope of this column, that must be carefully analyzed, and any business or investor looking at a sale-leaseback should consult with its team of advisers.

<p>
Dan Scanlon of Grubb & Ellis|Coldstream Real Estate Advisors Inc., Bedford, can be reached at 603-206-9605 or dscanlon@coldstreamre.com.