What Is a Sale and Leaseback Agreement?
A sale leaseback contract is a type of real estate deal in which the property owner sells the property to another party and then leases it back for an agreed-upon period of time. It is most common among commercial real estate properties, but it can also apply to residential real estate and non-real estate assets.
The basic idea behind a sale and leaseback contract is the immediate conversion of an owned asset into cash that is usable by your business. In order to best understand the concept, you must consider it through the lens of your own real estate or physical assets.
Let’s say you own a facility that houses your business. When you no longer need that facility, you can sell and lease back a comparably sized facility that meets your needs only for a proportion of the week or month. Suppose you spend 25 hours a week at your facility (typically one-third the week or less) . Your lease will likely be one-third the amount of an equivalent full-time lease on another facility, thus making it comparable to the sale of your facility and lease back on a comparable facility for that one-third period of usage.
This deal benefits property owners with excess space; business owners who desire to maintain their location without the extra responsibility (and cost) of building ownership; and lenders in need of a relatively safe, fixed-income producing investment. For a transaction to work, all parties must do a cost/benefit analysis and determine whether the risks are worth the significant financial rewards.
Your business gets immediate liquidity, while the buyer or landlord receives what they could get from any other tenant, based on their cash flow. If you can keep your costs associated with leasing the new space at or below the amount of interest you would have paid on your mortgage, you’ll still come out ahead on the sale leaseback.
Advantages of Sale and Leaseback
A sale leaseback contract can be advantageous for you the property owner as well as the investor. With a typical real estate transaction, a property owner will sell their property for a lump sum. With a sale leaseback deal, you become a tenant and the investor becomes your landlord. Selling an existing property will give you more capital and assets to reinvest into your business or to pay off debt. You can also obtain capital for renovations on current properties or to build a brand new location. The investor will want a minimum rental rate and lease length to ensure that the investment will gross enough interest over time. The investor will want a long-term lease so that you have a commitment to stay in the space for a specific period of time. This is especially true if the investor is issuing a loan to you in addition to purchasing the real estate for cash. Some businesses, like movie theaters, will get generous tax breaks by leasing their space within a new shopping center.
How Sale and Leaseback Operates
Until the final execution of the contract, the two parties will continue to discuss the terms of the agreement. When both parties are in agreement on the sale leaseback contract itself, and other details that may be necessary for the transaction, a Sale Leaseback Transaction or Agreement is executed. While the contract itself outlines the terms of the arrangement, parties may negotiate the letter of intent, which details the basic idea of the sale leaseback agreement. It may contain the general terms of the agreement, including any material issues.
Upon agreement of the terms outlined in the Sale Leaseback Transaction the contract is executed. In certain circumstances, the Landlord/Lessor may require the Tenant/Lessee to deposit funds at the time this agreement is executed. Once the funds are deposited, this agrees that the investor will use capital to negotiate the purchase of the property. The tenant will then continue to lease back the property under the terms agreed upon by the parties in the agreement. This type of arrangement can provide flexibility in changing certain aspects of the agreement if the parties reach a consensus of the need for adjustments and changes.
Potential Pitfalls
The flexibility and speed of sale leasebacks mean they are not without risk and caution. For buyers or firms looking to inject cash into their business through a sale leaseback, they need to remember that the value is largely determined by the value of the property market, which means it can fall as well as rise.
Since property funds make up the majority of buyers in the UK, the main risk for sellers is that they will be unable to find an investor to purchase their property through the sale and leaseback. Then the seller will be hampered with extra costs for valuations and legal fees and could suffer vast amounts of wasted time trying to negotiate the terms of the lease.
Whilst it is arguable that the buyer occupies a stronger position in negotiations, a sale leaseback can be a transactional headache for both parties if they are not properly prepared. For instance, sale leaseback deals are usually a package that includes the sale of the asset prior to (or as part of) a lease of that same asset back to the seller. While one may be separate from the other, buyers and sellers alike should be aware that both the sale of the property and the lease back over it have UK Stamp Duty Land Tax (SDLT) implications.
Whilst they usually find themselves on the winning side, buyers need to know the risks of buying a property that has been agency or sublet prior to the leaseback. Any such attachments to the property have the potential to have a significant impact on the financial aspects of the leaseback term, as it realistically reduces their assets should the seller default.
Likewise, the complexity of a sale and leaseback can be an issue with respect to taxation, which is why both parties need to seek thorough legal and accounting advice when negotiating the terms of a sale and leaseback agreement.
Legal Considerations
The legal implications of a sale leaseback agreement can be complex. As with all types of contracts, it must be appropriately documented and the terms must be negotiated before the contract is agreed.
Essential clauses
There are a few essential clauses which a sale and leaseback contract needs to have. These include the following:
Legal due diligence
Due diligence will need to be undertaken in relation to the title to the property , as well as the costs and liabilities that will be incurred. Completion of the sale will be conditional on matters such as:
Legal compliance
As a landlord, you need to ensure there is not a breach of laws or planning conditions regarding the use of the property. Indeed, you will have undertaken to comply with these aspects in the contract. It is likely that a condition precedent to completion will include obtaining necessary consents.
Sale and Leaseback vs Traditional Leasing
The Differences Between Sale Leaseback Contracts and Traditional Leasing
Once the owner of an asset sells it to someone else, the asset is then leased to rent it back. Hence, the term sale leaseback. However, a simple comparison of sale leaseback contracts with regular rental/lease contracts would be helpful to address how sale leaseback contracts work. For instance, in a regular rental/lease contract, the lessee pays the rent pursuant to the provisions provided in the contract until the termination date and if the lessee fails to pay the rent, the rent may be legally asked by the lessor through legal actions. Yet, in a sale leaseback contract, the price reflected in the market price of the sold asset is paid back through the lease payments over a period of time. Therefore, with regard to the difference of the duration of the repayment period, while in a traditional rental/lease contract, the rents are paid until the termination of the contract or some specific period, in a sale leaseback contract, the rents are paid over a long period. For example, if a hotel owner sells his/her hotel property, they can rent the same property for years. According to the conditions of the market, in the below-mentioned table the advantages and disadvantages can be found regarding the parties to these types of agreements: However, in a sale leaseback contract, the contract may be sometimes signed for a long term even when the lessee has the right to purchase the property at some point.
Case Studies in Sale and Leaseback
We turn next to two particularly compelling examples of successful sale leaseback transactions, each involving some of the biggest names in American business.
First, consider Starbucks, the ubiquitous chain of coffee houses that dot the streets, airports, and shopping malls of at least 55 countries. The company has successfully utilized an average annual ratio of about $1.2 billion in sale leasebacks over the last decade. According to the company’s 2018 Annual Report (available at www.starbucks.com/ir), approximately 12% of Starbucks’ global stores are owned under SBL agreements. Each SBL transaction with Starbucks has been structured as a ground lease with a long term (80 to 120 years), low lease payments (based on an 8% yield), and fixed renewal options (in 10 year increments). The terms are standardized, using a master lease and master lease guarantees for Starbucks’ international corporate entities. No credit rating is required, but Starbucks has an investment grade credit rating (A- to A3). The majority of Starbucks’ SBL deals are completed with institutional real estate investors, although the company also states that it will "consider select non-institutional investors on an individual basis." Starbucks has always been careful to properly identify the value of its real property assets, and this has proven to be a successful strategy. Many of its SBL transactions have traded up in the market at above its initial cost basis.
As a second example, consider the more mundane, but equally impressive, state-mandated sale leasebacks undertaken by the University of California system. A hotbed of research and development activity, the system has been highly successful at both cooperative and competitive use of its SBLs, with about $3.5 billion in completed sale leasebacks over the last 15 years. In a 2016 report (available at www.ucop.edu/ucday/pdf/report_highres.pdf) , the UC system said that it has saved about $450 million in avoided debt service, and generated net proceeds of about $4.8 billion. In particular, the UC system is able "to recover other costs associated with constructing, operating, and maintaining buildings through yearly rental revenues from long-term leases" for its sale leaseback projects. As the UC report points out, "[i]nstead of spending debt service payments on bond principal and interest, the campus uses lease revenue it receives to fund operating and capital expenditures over the same lease period." The UC system has had a long-standing credit rating of both Aa3 (Moody’s) and AA- (Standard & Poor’s), and most of its investors include premium real estate funds and sovereign wealth funds. Once again, this creditworthiness results from the university’s reputation as a premier academic and research institution. In addition, the funding benefits are made possible by smart and efficient management of the university system’s real property assets.
The third and final likely candidate for the "best practice" award is the Orange County Water District (OCWD), which, like the University of California system, is a quasi-governmental entity. The OCWD has managed to close at least $200 million in SBL deals just since 2015. Notably, the OCWD’s SBL transactions have been used to retire municipal debt, finance capital projects, and assist local developers to enhance the value of their retail and mixed-use developments. Unlike the University of California system, the OCWD prefers to use leaseback proceeds to purchase real property assets rather than paying down debt. The OCWD has obtained a credit rating of Aa1 (Moody’s) and AA+ (Standard & Poor’s). Most OCWD SBL transactions involve the trust and agency arms of insurance companies or large financial institutions (such as Wells Fargo Bank, Citibank, and Southern California Edison).