Sale Leaseback of Net Leased Properties

More and more savvy real estate investors are turning to sale-leasebacks. A sale-leaseback is when a business sells its commercial real estate property to an investor with prearrangement to lease the property back long-term from the new owner/investor. The business receives the market value of the property and gains liquidity, while the investor earns a return on his investment from a credit worthy tenant with a track record and commitment to the property.

Structure of Sale-Leaseback Properties

Structuring the lease properly will create a secure sale-leaseback for investment purposes and/or resale at a later time. The following are four different types of leases set forth below:

• Modified Net – The tenant pays utilities, maintenance, repairs and insurance. Landlord is responsible for property taxes and everything else.
• Triple Net (NNN) – There are usually limitations on capital expenses. Tenant is responsible for property expenses including tax, insurance and maintenance
• Net Net or Double Net (NN) – Similar to NNN lease, except that landlord may be responsible for structural damage such as roof or bearing walls.
• Bond – The tenant is fully responsible for operating expenses, maintenance, repairs and replacement cost.

Some points to consider in lease structure:

• Lease Term – The term of the lease is usually for as long as the business needs it, anywhere from a minimum of 8 years to more than 25 years.
• Rent Increases – Periodic rent escalations are sometimes tied to the Consumer Price Index (CPI) or are based upon pre-negotiated fixed rent increases. During periods of low to moderate inflation, rent increases intend to provide a consistent inflation adjusted return.
• Financial Covenants and Event Risk Language – Provisions which include anti-dilution provisions and net worth tests for protection against loss of value because of an adverse financial event that could diminish the credit-worthiness of the tenant. The structure of the lease shall ensure that the tenant is required to pay rent under all circumstances- unexpected in the normal course of business or under troubled circumstances.
• Competitively Located Businesses in Strong Market Areas – Property that is located in competitive markets with a strong supply allows for less price elasticity.

Reasons to Invest in a Sale-Leaseback

If you are looking to own property, collect rent and reduce your management responsibilities while your tenant shares expenses and maintenance responsibilities, then a sale leaseback might be an investment option to consider. Here are just a few other benefits and reasons why investors should consider sale-leasebacks:

• Long-term lease with a single tenant, which has a vested interest in the property.
• More consistent cash flow stream with a known tenant on long term lease.
• Inflationary hedges, real estate historically, has performed better than other forms of fixed assets in regards to outpacing inflation.
• Less time required in management responsibilities than other forms of real estate, particularly multi-tenant properties. Leases can be structured so that the landlord retains no management responsibilities.

Discussion of Risks for Investors

There are risks associated with sale-leasebacks. The following is an overview of some of the key risks, but does not represent all risks in their entirety:

Tenant Credit Risk. First and foremost, the credit risk of the tenant should be considered. Investors are relying on one tenant’s business success. It is imperative in the due diligence process to verify that the estimated return on the property appropriately compensates the investor for the risk level of the tenant. If your tenant defaults or files bankruptcy, there may be a period of nonpayment of rent followed by a renegotiation of the lease.

Tenant Improvements. By customizing the real estate property for one particular type of tenant, there may be remodeling or redevelopment costs at the time of the lease renewal or when you replace the original tenant.

Overvalued Leases. It is not atypical to see leases that are above market rents on Net Leased properties. This occurs because the original tenant’s business model justifies the cost of the lease and improvements, but that value may not translate to other tenants. In the event the tenant terminates or completes the occupancy prior to the original planned exit, the owner could bare financial risk to the difference in market and original tenant rates. The difference in rent values could substantially affect the market value of the property.

Systemic Market Risk. As with any real estate investment, there are systemic risks associated with holding real estate. Net Lease investments are not immune to these risks.

Reasons for Sellers to Consider Sale-Leasebacks

The number one reason business property owners consider sale-leasebacks is the sale can free up their corporate capital thereby providing more cash available to be used in expansion or in other areas of the business. Companies like Home Depot, Walgreen’s, CVS, McDonalds and Starbucks all lease their property. The reason is that long-term leases take the real estate asset and subsequent debt off their books and place it on the investor’s. Sale-leasebacks can be one of the strongest tools to help a company grow. Retail, industrial, office or manufacturing properties with real estate market values between $300,000 and $20,000,000 per property can all be good candidates for sale leasebacks.

Sale-leasebacks can also provide an exit strategy for the business owner, by separating their largest asset (the real estate) from the rest of the business. Selling the business along with what is frequently the largest asset on the balance sheet can greatly affect the saleability of the business. By selling the property 5-10 years prior to the owner’s planned exit, the company improves its flexibility and marketability of the company.

Tax advantages can be another reason why one would engage in a sale leaseback. Depreciation and interest write-offs typically decrease the longer property is held on the balance sheet, effectively lowering tax deductions. Leases, if structured properly, can provide a consistent deduction for the entire amount of the lease and reduce tax liability.

Lastly, sale-leasebacks can eliminate debt, freeing up the balance sheet and providing credit worthiness.

Disadvantages to Sellers

Sale-leasebacks do have a few disadvantages that affect sellers. The main disadvantage being some loss of control of the property. For instance, major changes or add-ons might need the new owner’s approval.

Another issue involves taxes. While a marginal or unprofitable business can benefit by pulling cash out of the property in a sale-leaseback, there will be little or no tax benefit to engage in the transaction.

Finally, the reassessment of property taxes at the sale of the building is something to seriously consider. Florida, for example, has experienced a dramatic rise in property values over the past 20 years. If the business has owned the property for a long period of time, there is a reasonable chance that the sale will trigger the property appraiser’s department to take a closer look at the value of the property and hence the tax assessed value of the property. Since most sale-leasebacks are structured in a net lease arrangement, meaning tenants are responsible for paying taxes, in all probability, the result will be the selling business and future tenant will end up with an increased tax bill.

It is important for you to consult with your tax advisor before making any decisions on the financial viability of a sale-leaseback for your business.