What is Sales & Leaseback?
A sale & leaseback is a commercial real estate transaction in which the owner sells his property and signs a long term lease with the buyer to become the lessee near escrow. The seller maintains the building for his business and receives the proceeds from the sale. While restaurants are a common sale & leaseback property, almost all single-tenant properties are occupied by owners, e.g. auto repair shops (Christian Brother Automotive), medical office buildings, etc. can be a sell & lease back property. When you see the phrase “new lease to sign at closing escrow” on a property listing or brochure, chances are it is a sale & leaseback.
Why Sell & Rent Back?
As an investor, one can speculate if the sale & leaseback is a sign that the business owner is in financial trouble and thus should sell his most valuable asset. It’s a legitimate concern because cash-strapped tenants may not be able to pay rent down the road and you end up with an empty property. However, there are many good reasons why a property owner would want to sell a property and lease it back:
- Financial business expansion.For example, Joe, a restaurant operator, has built 5 build-to-suit restaurants. All 5 restaurants are now open and have been running smoothly for the last 2-3 years. He now wants to build 3 more new restaurants. However, Joe will need capital for construction because the restaurant chain has such a unique building design that he cannot rent just any building. He can apply for a construction loan which may take up to 12 months from application to funding, … a very time consuming process that requires a lot of paperwork from architectural drawings, permits, detailed construction bids, proof of workers compensation insurance, to business plans. In addition, if he is lucky, he can get 70% financing of the total construction cost (excluding land acquisition costs) of the project if he can overcome the loan application hurdle. Alternatively, it can sell some or all of its existing restaurants at market value and sign a 20-year NNN lease to the buyer. That way, he can cash out 100% of his equity in 5 restaurants. So selling & leasing back is a very fast, smart and effective way for Joe to raise capital so he can focus on expanding his business. He might even be able to sell the property for more than it costs and thus make a profit!
- Pay debts & fix balance sheet.Real estate owned by a company is a depreciable asset which means it has a lower & lower book value on the balance sheet. The IRS does not allow companies to adjust balance sheets at a higher market value. By selling his real estate at a higher market value, he can liquidate all of the equity. The money can be used to pay off debt to strengthen the balance sheet, or to expand the business or for research & development. This can have a positive impact on the value of the stock. In a lean year, some publicly traded companies may sell their real estate assets to meet analysts’ projected performance. Sometimes a major shareholder may sue the company to sell its real estate assets to make the company more profitable in the short term.
- Reduce income tax.Walmart sold and leased back many of the stores from real estate investment trusts owned by Walmart as a way to reduce its income taxes.
What is important to investors?
Apart from location and various other factors, there are other financial aspects that you should consider to determine how risky your investment in this sell & leaseback property is. In general, the higher the risk, the higher the return you should ask or expect from the seller.
- Tenant’s financial statements: The seller can provide you with 2 to 3 years of past income tax returns. Ideally you want a tenant with a profitable business after paying rent and other occupancy costs, such as property taxes, insurance and maintenance costs. You also want to see higher & higher profits year after year. This will minimize the risk of the tenant not having the money to pay the rent. However, it is not possible for a business, for example a restaurant especially in a new location to be immediately profitable in the first few years. In this case, the risk is higher.
- Tenant’s business track record: You want to find out how long the tenant has been in business, and how many locations he or she currently owns. Business experience really matters. As a general rule of thumb, the fewer locations an operator has, the higher the stamp rate he offers you.
- rental guarantee: Tenants often provide some kind of lease guarantee that if the tenant fails to pay the rent, then you can pursue the guarantor’s assets to recover the lost rental income. A long-term lease is only good if the entity that guarantees the lease payments has strong assets and/or a good credit rating. A seller with multiple locations may structure his company in such a way that each location is owned by a single entity, such as a Limited Liability Company (LLC) to limit its liability exposure. All single entity LLCs are then owned by the parent company. In this case, the guarantee from the parent company is better than the guarantee from the single entity LLC. Sometimes you can also get a personal guarantee from the principal from the company. If the guarantor is a public company, then the S&P credit rating is a good indication that you are likely to receive rent checks in the future.
- Rental terms: In the sale & leaseback transaction, the terms of the lease are negotiable and may differ from those stated in the marketing brochure.
You usually want to get:
- A long-term lease, for example 10-20 years, so you don’t have to worry about finding new tenants for a while. In addition, longer leases make financing purchases easier.
- Triple net rent where the lessee pays all operating expenses. This will minimize your investment risk as you don’t have much control over property taxes, insurance and especially maintenance costs. Ideally, you don’t want any owner responsibility or having to take care of anything, like roofing, HVAC, or changing parking spaces.
- Some type of periodic rent increase, preferably 2% per year or 10% every 5 years to keep up with inflation. In addition, an increase in rent also ensures that the property will increase in value when you sell it.
- Rent at or below market. This motivates the tenant to stay there for a long time because he or she will pay a higher rent elsewhere. If a tenant is vacating the property, it is always easier to find new tenants for the property when the rental rates are below market.
- Multiple levels of approval for possible future construction or remodeling of the property. Franchised restaurants are required to remodel restaurants to new formats to reflect changing consumer tastes. So the lease should be flexible to allow this to some degree. For example, the lease must state that any structural changes will require the owner’s approval.
- Tenant’s financial statements, if required, especially for the location you purchased. When you need to refinance or sell a property at a later date, the tenant’s financial information, for example sales revenue, income statement will be very important for lenders to provide profitable financing and potential buyers to make the strongest offer.
Preferably, you don’t want to have this in a lease:
- Right of first refusal (ROFR): This gives the tenant the option to buy the property whenever you receive an offer matching the same price. ROFR makes a property less desirable when you need to sell it later. The buyer, after making an offer, must wait for the lessee to decide whether he wants to exercise the option. This discourages some buyers from making an offer because they hesitate to take the time to negotiate and find out later that they can’t buy it because the tenant exercised the option. In addition, if you have a cash offer from a buyer, you still give the tenant the option to buy it and time to apply for a loan that may be declined later.
- Early termination or kick out clause: This allows the lessee to terminate the lease when the property is partially damaged, for example 20% by fire, other hazard or if sales revenue does not reach a certain figure. As a landlord, you want a property that will continue to generate income. So you don’t like leases with early termination clauses. You want tenants to make every effort to repair, rebuild property, and reopen business quickly. If you cannot remove this right from the lease, then try to keep the damage percentage threshold as high as possible, say 50%.
- Responsibilities of land owners to environmental issues. This is mainly because you are just a passive investor and have nothing to do with this matter.
- Ability to obtain profitable financing.It doesn’t make sense to get a good property and have to pay an excessive amount for financing. Of course, if you’re buying property in a small town in the middle of nowhere, getting a loan will be a challenge and will include very high interest rates. If you buy a property with a non-franchise tenant with weak or unavailable financial statements, then you will have a hard time borrowing money. Please refer to “What Investors Should Know About Commercial Loans” written by the same author.
Do’s & Don’ts
- Hire a CPA to review financial documents. Some financial information may be very complex. The tenant may have a very good accountant prepare his tax return to show the IRS that his taxable income is low so he doesn’t have to pay a lot of taxes. Revenue from franchisees may be more accurate due to contractual obligations to franchisees for the purpose of collecting royalties. For non-franchised tenants, reported income may be lower than actual income because the tenant may not report cash income. The CPA must be able to give an opinion on the financial strength of the tenant.
- Hire a commercial real estate attorney to work on the lease. You want to make sure that the lease addresses any potential legal issues that may arise in the next 10-20 years. The lease can be revised several times between the seller and the buyer during the negotiation process. So you may want to work with an attorney who has a flat fee, say $2500, not a lawyer who charges an hourly fee.
- Have a broker with experience in sales & leasing on your behalf. Selling and leasing back is a very complex transaction that requires an experienced broker, along with a CPA and attorney to guide you.
- See the background of the tenant/seller.Since you will have a long-term business relationship with someone you don’t know much, it may be wise to do a background check on the business owner and even criminal records to see if there are any red flags. A simple Google search should be minimal.
Thinking Out-of-the-box
Today most, if not all, sale & leaseback transactions involve properties owned by individuals, private and public companies. However, there is no good reason why public property, eg libraries, schools, government office buildings cannot be structured as a sale & leaseback transaction. It can be a way for cities, counties, states, and even the federal government to raise money for important projects or to tackle budget deficits without raising taxes. After all, the government is the primary tenant everywhere in the US.
