A Company That Operates Out of a Building it Owns Initiates a Sale-Leaseback to Convert the Equity in its Real Estate Asset into Cash
Every profession has its own unique lingo and commercial real estate (CRE) is no exception. CRE is riddled with hyphenated and compound terms that convey concepts in shorthand, and “sale-leaseback” is among one of the most colorful and least understood.
The term, as it’s generally used by real estate professionals, refers to a transaction in which the owner of a building, who also occupies and runs their business from it, sells it to an investor. Rather than vacate the building after selling it, the previous owner continues to occupy the building by leasing it back from the new owner.
A “Sale-Leaseback” transaction is carried out primarily to “raise cash that might be more useful in the operation of the business than tied up in the real estate asset.
Who Carries Out a Sale-Leaseback?
A sale-leaseback can be undertaken by a small business that owns and works out of just one building or by a large corporation with thousands of employees that owns and occupies numerous properties across many markets. In either case, the overarching objective is to monetize their real estate asset.
With a smaller company, the motivation to initiate a sale-leaseback might be an opportunity to open additional offices or locations. The cash infusion can help fund those efforts and a lease agreement with the new building owner enables the business to continue to operate from its existing location.
For a large company, the enticement might be the realization that a building “is a non-essential asset and they want to get it off their balance sheet.” Instead of having equity tied up in the real estate, the company can create liquidity, reallocate the funds and remain in the building.
Think of this as having your cake and eating it too: you sell your building and take the cash, while avoiding the disruption of relocating your business, thereby remaining easily accessible to clients, employees, suppliers, etc.
Seller Motivations Beyond Cash
For both small and large companies, there are additional reasons beyond financial incentives for initiating a sale-leaseback.
Focus on mission not real estate. In some cases, business operators simply want to get out of the real estate business. Owning, operating and maintaining a real estate asset can be an unnecessary burden, especially for business owners that want to focus exclusively on their company mission. Many do not have the skills, interest or capacity to shovel snow from sidewalks and parking lots; monitor and pay utilities, insurance and taxes; or continuously fix things that break or wear out.
Flexibility. The need for flexibility, either immediately or in the future, is another significant driver of sale-leasebacks. Companies both big and small watch as conditions affecting their businesses change and locations come into or fall out of favor. Leasing space enables companies to expand and contract as necessary.
However, while they won’t have the responsibility of managing and maintaining a building, this flexibility will present risks when the lease expires. Rental rates will likely be higher, the space the company wants may not be available, and the hassle of moving could be very disruptive for clients and employees.
Applicable to Retirement as Well as Corporate Strategy
Sale-leasebacks are tools that help companies of all sizes, from entrepreneurial firms with principals preparing for retirement to corporations continuously strategizing and managing their assets.
Lump sum and cash flow. For a small company, this type of transaction typically takes place when a small business, like a law firm or a restaurant, has operated from a building it has owned for many years. The long-time business/building owner wants to continue to operate their business in that location and wants to convert the equity they have accumulated in the asset into cash.
Consider an entrepreneur that owns both a building and the operating company working in it. As an example: She sells her ownership stake in the building to an investor and her operating company (be it a law firm, a medical practice, a restaurant, a wholesale establishment, etc.) rents the property back from the new purchaser. It’s usually a situation where the building ownership wants to monetize the asset. Maybe the person who owns [the building and the company] is approaching retirement, so she wants to monetize the physical asset to get a lump sum for retirement, but retain ownership of the operating company, to maintain an income stream.
Corporate strategy and mitigating risks. A sale-leaseback can be part of a larger corporate real estate strategy that completely rearranges a real estate portfolio by disposing, acquiring and leasing assets in markets across the globe. Some large business owners initiate sale-leasebacks, occasionally or on an ongoing basis, as part of an overall real estate approach that enables them to modify their real estate portfolio as business needs change.
Corporate real estate divisions are charged with following economic and employment trends so they can readily access skilled workers, raw materials or other resources that are necessary for a company to function. They are also expected to follow real estate market conditions so they can optimize when to enter, renew or exit a market and sale-leasebacks are tools that help them do this. Timing a building purchase, sale or lease agreement perfectly is nearly impossible, but selling a building and leasing it back years in advance of a planned departure mitigates the risks associated with selling in future unknown market or economic conditions.
Key Conditions for a Purchaser
What makes a sale-leaseback attractive to a purchaser? Let’s identify four characteristics that are fundamental to virtually any real estate purchase. He stated that apart from appropriate cashflow the purchaser is looking for a long-term lease, a creditworthy tenant, a flexible and reusable real estate asset and a solid location.
Length of lease. The longer the lease the more a purchaser will pay for a property in most cases. A longer lease means expenses such as legal fees, broker commissions and buildout allowances can be spread out over a longer period, and the costs and time involved in executing short-term leases or renewals can be avoided. Let’s emphasize that “usually you need at least five to seven preferably ten years, for a purchaser to be interested in purchasing a sale-leaseback.”
Creditworthy tenant.
The stronger the credit of the tenant the more valuable the asset. This is the case because a tenant with strong financial statements and a history of paying rent on time is more likely to pay rent, avoid bankruptcy and see the lease through to the end of the term.
It’s important to note that strong credit tenants in a sale-leaseback negotiation will discuss more than just rental rate and length of lease. Strong credit tenants in healthy and growing industries may also obtain concessions such as free rent and tenant improvement allowances. It may seem odd to think of a business that currently owns and occupies a building negotiating for concessions, but the would-be tenant in a sale-leaseback must iron out the details of the lease as if they were negotiating a new lease in an alternative building.
Building reuse. A purchaser must consider the costs associated with preparing the building to be leased again in the future. If a tenant leaves, is the building fairly reusable without spending considerable amounts of money to refit and refurbish it? A building that was significantly customized for an owner/occupier may require a significant expenditure to make it appealing to a broad variety of potential tenants. The more reusable it is, the more valuable it is to a purchaser.
Location. There is also the age-old consideration of location. Location will drive the reusability and the velocity of finding another tenant or selling the asset.
For both buyers and sellers, a sale-leaseback transaction presents unique opportunities, as well as possible complications. In an ideal scenario, though, it creates liquidity and fosters flexibility for business owners, while enabling them to focus on their core mission. Simultaneously, it provides property owners with a new asset that features an existing rental income stream and a long-term dedicated tenant.
