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Is the time right for a sale-leaseback? The current state of the capital markets and an influx of capital have created a prime situation for such a transaction, writes a real estate finance expert.

Corporate America owns an estimated $2.3 trillion of non-specialized "investable" real estate. Yet historical returns from equity investments have consistently exceeded those of real estate. As a general rule, any dollar that can be "monetized" or sourced from the sale of corporate real estate and reinvested in that company's listed stock would create positive leverage. That's why any CFO whose company owns real estate should consider a sale-leaseback transaction.

Although they have been used for more than 50 years, many companies do not fully understand how sale-leasebacks work--or the benefits they can offer to corporate investors. In it simplest form, a sale-leaseback entails the sale of corporate real estate and the simultaneous commitment to a long-term lease, generally 15 years or longer. This combination allows a company to redeploy the capital invested in real estate into the core business. Even if you believe your firm currently has sufficient capital, sale-leaseback financing can enhance the efficiency of your company's capital structure.

Because a corporation is both the lessee and the seller, it has greater bargaining power than would an average tenant in a typical lease negotiation. The seller-lessee can use that leverage to maintain uninterrupted control of its facilities, including operations, maintenance and alterations. It can also negotiate the rights to assign and sublet the facilities, as well as to enjoy lengthy initial and renewal terms. Depending on a company's specific needs, it may choose to divide a sale-leaseback into separate leases with differing terms, rents and covenants.

Why Now?

Although interest rates have begun to creep upwards, initiating a sale-leaseback now can help secure long-term capital at historically low rates. It's also especially compelling due to the recent decline in equity markets, which has diverted more institutional capital to corporate fixed-income assets, compressing corporate spreads to historically low levels. Moreover, the real estate yield curve that measures the margin between the cost of debt and the cost of equity is inverted.

This rare and likely temporary phenomenon means that equity dividends are actually less than equivalent debt costs for many components of institutional real estate investment. Since most sale-leaseback investments consider both debt and equity markets, the ultimate lease cost to a CFO today could be the lowest it has ever been.

In addition, large amounts of capital are currently competing for deals. As a result, institutional underwriting requirements have been significantly loosened. Unlike most London Inter-bank offered rate (LIBOR)-based bank financing, the typical financial covenants in sale-leaseback transactions can be reduced or even eliminated. Savvy CFOs may be able to increase a company's financial flexibility by off-loading real estate at extremely attractive long-term rates, while maintaining the availability of bank financing for a future date.

Case Study

Consider the case of a publicly traded and A-rated financial services company facing continued lack of growth in its stock price while earnings were increasing. The CFO wanted to raise low-cost capital, without incurring on-balance-sheet debt, and achieve positive arbitrage on the proceeds. The company owned first-class office space consisting of a two-building campus of approximately 206,000 square feet on almost 18 acres of land, and required a base lease rental rate of less than 7 percent annually (well below market) to meet one of the critical Financial Accounting Standards Board (FASB) tests for the transaction to be considered an operating lease.

Given the below-market rent requirement, the company proposed adding a contingent rent amount to compensate the sale-leaseback investor. However, this severely limited any investor's financing options and as such, the number of potential investors.

The property had a book value of $29 million and fair market value of $34 million. This difference was entirely attributable to depreciation previously taken. If the property were sold at fair market value, the $5 million gain would be fully taxed at the corporate 40 percent tax rate, yielding after-tax proceeds of only $32 million. According to generally accepted accounting principles (GAAP), because of the simultaneous 15-year leaseback, the entire pre-tax gain of $5 million would be recognizable over the life of the lease, rather than in the year of the sale.

Realizing the company could create a significant amount of additional shareholder equity by monetizing its real estate and acquiring a similar amount of outstanding stock, the CFO opted to sell the corporate headquarters to a private investment company in a sale-leaseback financing transaction, as follows:

* The purchase price would be the book value on the company's balance sheet, $29 million, which avoided any taxable gain, and reduced its future rent obligation.

* The rental would be calculated based upon a $29 million sale--with +/- 7 percent base rent and a contingent rent equal to +/-1.7 percent annually, on average.

* The lease would be "bond-type," with management of the property to remain the responsibility of the company's professional facility managers.

* The primary lease term would be 15 years, with five additional renewal options, each for an additional five-year term.

* The company had no repurchase option at the end of any term, but a right of first offer.

The entire net sale proceeds were used to buy back stock on the open market, and the lease proposal met all of the company's financial/accounting requirements.

The earnings before interest, taxes, depreciation and amortization (EBIT-DA) of the company, $220 million at the time, were not materially affected by the rental payments embedded in the sale-leaseback transaction. The company's adjusted earnings were to be divided over a considerably smaller equity base. The going-concern value of the company was approximately $1.5 billion, and management owned a considerable amount of the remaining shares outstanding. The remaining shareholders realized significant positive leverage from employing the sale-leaseback financing alternative.

What's the Catch?

While sale-leaseback can be a worthwhile strategy, it is not without risk. However, proper structuring can help improve the likelihood that your company will benefit from its use. Some of the risks to consider are:

Loss of residual property value. In most cases, the value of any single-tenant property will be lower than today's sale price, since real property generally depreciates over time. However, should the residual value increase over the primary lease term, the potential rental income from the property will have increased as well. By negotiating a renewal option past the primary term at fixed rents, the seller/lessee can enjoy below-market rental costs while getting greater potential sublease income.

Possible Relocation. At the end of a lease without any renewal options, a seller may be forced to negotiate an extension at current market rents or relocate. To prevent such a situation, a company should consider a sale-leaseback with a long-term (50-60 years) lease, thereby delaying the need to relocate or renegotiate until the asset will likely be obsolete. When the term comes due, the buyer/lessor almost always would allow lease renewal, and on a worst-case basis, at the same price the seller/lessee would pay for alternative space.

Loss of Flexibility. A seller generally loses the flexibility to change or discontinue the use of the property or modify a building. In a sale-leaseback, it may be difficult for a seller to obtain financing secured merely by a leasehold interest to make property improvements. Moreover, the lease may contain provisions that restrict the seller/lessee's right to transfer or mortgage the leasehold interest. To minimize these restrictions, the seller/lessee should negotiate the lease so as to provide reasonable and customary flexibility for the entire lease term.

High Rental Payment. Rental payments under the lease cannot be adjusted without the lessor's consent, and, if the market softens after a sale-leaseback, a seller may be locked into a higher-than-market rate. Yet, the company has protected itself from a fall in property value and still enjoys use of the capital. In addition, assuming the property is still useful to the seller/lessee, a drop in rental rates offers a good opportunity to renegotiate at a lower rate for a new primary term, while the original sale price was predicated on the original rental rate.

Operating vs. Capital Lease. Corporate seller/lessees generally want the completed sale-leaseback transaction treated as an operating lease for financial statement presentation. Unlike capital leases, neither an asset nor an obligation is recorded for operating leases. Rather, a material transaction would be described in financial statement footnotes. Rental payments are recorded as rental expense in the income statement, which is usually a straight-line presentation.

FASB has recently created new, stricter accounting rules regarding disclosure and consideration of entities involved in off-balance-sheet financing. As result, sale-leaseback transactions have become viewed more favorably by the major rating agencies, since the disclosure requirements have become more standardized. Similarly, the standards have made lenders and equity investors more comfortable with the transactions. Combined with the improved financial ratio analysis created by replacing real estate with cash without adding an equal balance sheet liability, these considerations make the sale-leaseback transaction very attractive to any corporate treasury department.

Gerald J. Levin, CPA (, is Senior Managing Director at Mesirow Financial in Chicago, where he heads the Sale-Leaseback Capital business. He can be reached at 312.595.6070.
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Title Annotation:Real Estate; analysis
Author:Levin, Gerald J.
Publication:Financial Executive
Geographic Code:1USA
Date:Sep 1, 2004
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