Sale-Leaseback of Commercial Real Estate
Sale-Leaseback of Commercial Real Estate: Pros and Cons
This article discusses some of the advantages and disadvantages of a commercial real estate sale-leaseback transaction with respect to both the seller and the purchaser.
Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.
A “sale-leaseback” is a transaction whereby the owner of a property enters into an agreement or simultaneous agreements to (1) sell the property to a buyer and (2) lease the property from the buyer for a designated period.
For commercial sale-leaseback transactions, the property typically involved is a commercial building, e.g., a warehouse, but could also be for the land itself. The lease is usually a “triple net lease,” meaning the seller-tenant agrees to pay all real estate taxes, maintenance, and building insurance on the property in addition to any other costs (e.g., utilities) that are designated under the lease.
There are two parties to a commercial sale-leaseback transaction who assume four different roles: the (1) seller and (2) buyer, who become, respectively, the (3) tenant and (4) landlord. Each role comes with various advantages and disadvantages that should be considered before negotiating and entering into a sale-leaseback transaction.
Advantages of a Sale-Leaseback Transaction
Depending on whether you are the seller-tenant or the buyer-landlord, there are different advantages to a sale-leaseback transaction.
A. Seller-Tenant.
One of a seller-tenant’s primary advantages to a sale-leaseback transaction is the ability to remove whatever remaining debt that was encumbering the property from its books, while simultaneously liquidating whatever equity it had obtained in the property. The result of the transaction is that the property will no longer be carried by the seller as an asset at cost, but as an operating lease. Because the property’s purchase price will be higher than the remaining previous financing in most circumstances, the seller’s debt to equity ratio will be reduced. In short, a sale-leaseback transaction allows the seller to choose when it wants to reap the monetary benefits of any increased equity in the property while continuing to operate within the facility, instead of waiting to sell until the property is no longer needed.
Another advantage for a seller-tenant is the ability to maintain possession and effective control of the property without tying up financial resources. Although the seller-tenant will not be the actual owner of the property after the transaction, it will be able to negotiate the length of the lease, affordable payment terms, and other contractual conditions that are appropriate for future operations in the property.
A third advantage for a seller-tenant is the potential to benefit from certain tax considerations. If the subject property has been fully depreciated, the seller-tenant—had it kept the property—would not be able to use depreciation as a tax deduction in future filings. However, upon sale, the seller-tenant’s overall bottom line would likely increase as the lease payments would be deductible at the property’s current basis.
B. Buyer-Landlord. One advantage of a sale-leaseback transaction for a buyer-landlord is the opportunity to obtain a specified return on investment (ROI) with relatively low risk. By properly structuring the lease, the buyer-landlord will be able to earn a set ROI for the life of the lease. The main risk for a buyer-landlord is the viability of the seller-tenant. If the seller-tenant defaults, then restructuring the lease or ending the relationship entirely is likely. However, this risk is involved in any leasing transaction, and the buyer-landlord can gauge the likelihood of default before executing the transaction.
Another advantage for a buyer-landlord is the ability to contract out of several other risk areas through the use of a triple-net-lease. Through this customary type of lease, the seller-tenant bears the financial responsibility for taxes, maintenance, and property insurance.
A further advantage for a buyer-landlord is the protection it has from market swings. If the fair rental value for commercial real estate decreases, the seller-tenant will still be obligated to pay the contractual rental amount. Thus, a sale-leaseback transaction is effectively a hedge for a buyer-landlord because if the real estate market appreciates, the buyer-landlord will be unable to recognize that increase until the lease comes to term, but if the rental market depreciates, the seller-tenant is locked into the higher rental rate from the lease.
Other possible advantages to a buyer-landlord include tax benefits from depreciation and investment tax credits, if available. Depreciation of the property and investment tax credits will help offset some of the gains the buyer-landlord will earn through rental income.
Finally, if the seller-tenant provides purchase money as tender for the transaction, the buyer-landlord has more flexibility than a mortgage holder in similar situations. The buyer-landlord can simply evict the seller-tenant and take control of the property pursuant to the lease, which is less convoluted than mortgage foreclosure.
Disadvantages of a Sale-Leaseback Transaction
While there are numerous potential advantages to a sale-leaseback transaction, there are several disadvantages as well.
A. Seller-Tenant. The obvious disadvantage for a seller-tenant in a sale-leaseback transaction is that at the end of the lease term, the seller-tenant will no longer have an ownership interest in the property or the right to receive any appreciation in the property’s value. Instead, at the end of the lease, the seller-tenant will have to do one of the following: negotiate for a lease extension, repurchase the property at its then market value, or move. In like manner, although the seller-tenant retains some measure of control over the property, the seller-tenant is restrained by the lease’s terms regarding remodeling or modification.
Additionally, a seller-tenant will be obligated to pay higher-than-fair-market rent if the commercial rental market depreciates. In a typical sale-leaseback transaction, the seller-tenant will enter into the rental agreement for an extended period, and if the commercial rental market decreases, the seller-tenant must pay the contractual rental amount.
Finally, tax considerations—while possibly a benefit—could also be a potential problem for a seller-tenant. If the seller-tenant owned the property for a long period of time and the basis in the property is less than its current value, the seller-tenant may have to pay higher taxes on the actual sale transaction.
B. Buyer-Landlord. The primary disadvantage for the buyer-landlord arises from the seller-tenant itself. If anything happens to the seller-tenant and default occurs, the buyer-landlord will be forced to expend resources and time to either renegotiate the lease or evict and find a new tenant at a profitable rate.
Moreover, if the seller-tenant enters bankruptcy and no purchase money was provided, the buyer-landlord will be a mere general creditor of the seller-tenant rather than a secured creditor as would a mortgagee.
Finally, the buyer-landlord will have to expend resources to supervise the use of the property, which could prove problematic as the seller-tenant will be accustomed to using the property as if it were its own. In doing so, the buyer-landlord should ensure that all aspects of the triple-net-lease are being satisfied or else it will be responsible for the charges. The buyer-landlord must also confirm that no waste is occurring on the property, as the property is now the landlord’s asset.