What is a Sale-Leaseback?
Sale-leasebacks in the Commercial Real Estate Sector
Throughout 2022, sale-leaseback activity has continued to rise. Recent data reveal that “2021 sale-leaseback activity rebounded from a pandemic-induced slowdown in 2020 to post some of the highest levels recorded in terms of both deal count and transaction volume. … For the full year 2021, 790 sale-leasebacks generated a total of $24.3 billion of proceeds, up 56 percent by deal count and 92 percent by dollar volume over 2020, and nearly reached the 795 deal count and $27.5 billion of volume in what was a banner 2019, the highest year on record since SLB Capital Advisors began tracking the market.”
Moving into 2023, experts report that sale-leaseback activity shows “few signs of slowing down in the face of elevated inflation and rising interest rates.” Tenants across all industries are leveraging demand to access capital previously unavailable. This article dives deeper into what a sale-leaseback is, the pros and cons of such a transaction, and tips for those participating in a sale-leaseback disposition or acquisition.
What is a sale-leaseback in commercial real estate?
A sale-leaseback refers to an arrangement whereby a company sells its real estate and leases the property back from the buyer. The terms of the lease, including the lease rate and duration, are generally negotiated prior to the sale of the asset, and upon close of escrow, the seller becomes the tenant or lessee.
Is a sale-leaseback the same thing as a capital lease?
A sale-leaseback is not to be confused with a capital lease, which essentially represents the opposite transaction. In a capital lease, the lessor, or property owner, agrees to transfer the ownership rights of a property to the lessee, or tenant, at the end of the lease term.
What is an equipment sale-leaseback?
In some cases, tenants want to keep their real estate and sell their equipment instead via a sale-leaseback. Like a traditional sale-leaseback, an equipment sale-leaseback involves selling equipment and leasing it back under specific terms. This type of arrangement, however, is not generally used by real estate investors since they are looking to access the benefits of real property. Therefore, this article focuses only on commercial sale-leaseback transactions.
The Pros of a Sale-Leaseback
A sale-leaseback transaction is attractive to both tenants and real estate investors because it offers benefits that can help both parties further meet their investment or business objectives. Here are some of the common reasons sale-leasebacks have gained traction in recent years.
Pros for the Seller of a Sale-Leaseback
A sale-leaseback enables tenants to remain in control of their assets while accessing the equity in their real estate. Prior to the transaction, most sellers identify the rate, length, options, and other terms of the lease. These terms are generally favorable to the tenant and can provide long-term stability as well as an improved ability to plan for future changes or growth.
Following a sale-leaseback transaction, the seller can pay off any existing debt or leverage the profits to further invest in the business. For those looking to grow, a sale-leaseback can be an optimal financing solution, especially when compared to taking on additional debt. Furthermore, once a property sells, most businesses can reduce their debt-to-equity ratio – thus improving their books and allowing them to access additional tax benefits. Rent is now an expense rather than a liability and thus becomes a deduction for tax purposes.
Pros for the Buyer of a Sale-Leaseback
Buyers in a sale-leaseback transaction are typically real estate investors seeking stable, low-risk investments. Tenants tend to sign longer-term leases at market rates that include rental bumps based on their industry and market. As a result, buyers can rely on a predictable rate of return.
In some cases, the buyer can negotiate the lease with the tenant, which can offer certain benefits when compared to purchasing an already occupied property. For example, a landlord can negotiate an absolute triple-net lease, which ultimately reduces all of the landlord’s responsibility for the property. With the seller-tenant now responsible for taxes, maintenance, and property insurance, the buyer-landlord has a near passive investment.
Lastly, as with other real estate investments, the buyer can access tax advantages, such as depreciation and tax credits. Buyers, however, should always discuss potential tax advantages with a certified public accountant (CPA).
The Cons of Sale-Leaseback
All real estate transactions have cons, and both sellers and buyers should consider the downside of partaking in a sale-leaseback transaction. While every sale varies, here is a glimpse of some of the cons parties can expect.
Cons for the Seller of a Sale-Leaseback
The most significant downside for sellers is the limited timeframe they have for accessing real estate at a predetermined rate. At some point in the future, the lease will expire, and the tenant will need to make decisions regarding the future of the business and the existing location. At this point, fluctuating market conditions may present certain risks for the tenant. For example, if the lease rate is substantially below market rent, the tenant may need to prepare for increased expenses.
To that same point, sellers may also be at risk of paying above-market rent during some period of the lease term. Since the rate and terms are predetermined, the tenant does not have the ability to renegotiate lease terms in the future. This could pose a risk during economic downturns, such as during the COVID-19 pandemic, when businesses were forced to close but had to continue paying rent.
Cons for the Buyer of a Sale-Leaseback
The risks for the buyer in a sale-leaseback transaction are like those in other real estate investments. The buyer has in some respects invested in the business that occupies the property. If that business fails and defaults on the loan, the landlord may end up with a vacant property. In this scenario, they need to lease the asset and may be required to pay tenant improvements in order to get a qualified tenant to take over the space.
Additionally, the landlord may risk losing returns due to predetermined market rents. However, the landlord also has access to a more stable investment.
What happens after the lease term?
All leases end, and in a sale-leaseback arrangement, the end of the term can result in two scenarios: the tenant either renews the lease or vacates the property. Determining which scenario will occur is nearly impossible due to market conditions, business success or failure, and other factors.
With all this uncertainty, business owners and investors would be wise to consider a few key things before executing a sale-leaseback agreement. Most importantly, both parties should consider the location. Tenants should ask themselves whether the location is suitable for their current operations and future growth. Landlords, on the other hand, should ask whether the location can be leased if the seller-tenant vacates the space. Both parties should also consider traffic count, demographics, zoning, and more to determine the future feasibility of the site.
Transacting in a Sale-Leaseback
Both seller-tenants and buyer-landlords should collaborate with a qualified professional when considering a sale-leaseback transaction. Those who have experience can help tenants and landlords navigate lease negotiations, research possible risks and setbacks, conduct market suitability, and much more. Overall, a sale-leaseback arrangement offers mutual benefits to both the seller-tenant and buyer-landlord if structured and implemented appropriately. Due to the increased volatility and uncertainty in the global economy, sellers are increasingly looking to unlock value in their assets but also retain possession of the property. Buyers are looking to secure long-term, steady rental incomes and take advantage of property appreciation. A sale-leaseback can be a win for both parties.
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