GUEST SUBMISSION: Sale-leaseback transactions are nothing new, but they are a worthwhile tool for all building owner/operators to understand, particularly as the capital markets tighten.
Over the past six months, we have seen the Bank of Canada raise the benchmark rate five times for a total increase of 3.25 per cent (prime rate is now 5.45 per cent), with the latest increase of 75 bps occurring on Sept. 7. Furthermore, there are impending threats of additional increases down the pipeline.
What this means for the average business operator is that it is more challenging to get affordable working capital and the debt load can be crippling if their current mortgage term is coming up for renewal, or variable.
Aside from financing, all other costs of doing business have concurrently increased, from labour to transportation, construction to inventory. These all affect the financial health of a business and can jeopardize the financial ratios banks must see maintained in order to avoid disruptions.
The sale-leaseback transaction
One tool not often considered by building owners is the sale-leaseback transaction, which can have immediate positive outcomes for their financial statements and perhaps even allow for further growth and expansion if implemented properly.
The sale-leaseback provides an opportunity for a win-win transaction between the owner/operator and investor, where all parties share involvement in the framework of a deal that meets their goals.
Sale leaseback, simplified: Owner/user sells their real estate, collecting sale proceeds and immediately leases back the property from the new building owner, thereby becoming the tenant.
So why would a building owner/operator consider this, after putting their blood, sweat and tears into purchasing and paying down a commercial real estate building in which to operate their business? It’s the Canadian dream to own your own building after all, right?
This is obviously a personal question and one that strongly correlates with the goals of a business, but I would wager that many businesses own their buildings without knowing the positive alternative benefits of leasing.
For example, the margins can at times be much greater on inventory than real estate for a business. The amount of equity tied up when owning real estate may restrict company possibilities, while leasing can at times provide more opportunity to reinvest into additional products, services and growth opportunities.
To further elaborate, I’ve outlined additional reasons an owner/operator should consider a sale leaseback:
– Instantly unlock maximum equity out of their commercial real estate. The owner will have access to 100 per cent “financing” which means they are unlocking 100 per cent of the value of their property that is currently tied up in an illiquid form. If a company needed to access financing from the bank (e.g. refinancing), in today’s market they could likely only get about 50 – 60 per cent LTV, vs. 100 per cent from a sale.
– This will then dramatically and instantly improve the balance sheet. This takes place twofold by 1) taking a long-term illiquid asset and converting it into working capital, and 2) removing a mortgage liability, instead converting it to an operating lease which is an off-balance-sheet transaction.
– A sale-leaseback allows a business to take advantage of tax benefits awarded to tenants. While mortgage interest is only a partial deduction, lease payments can be 100 per cent written off as an expense.
– Lastly, the owner/operator maintains control of the asset by mirroring ownership through a tailored lease agreement. Whether that be triple net, or net and carefree, it can feel as though the business maintains autonomy and management of the asset. A side benefit is avoiding the often-exorbitant costs of relocation which would be incurred through a traditional sale.
Now I’ve outlined why a building owner/operator may consider this opportunity to strengthen their business, but the sale-leaseback transaction should be equally beneficial for the investor who is acquiring a steady flow of income from a trusted tenant.
The biggest buyer considerations in this structure revolve around managing risk, which is most often analyzed on the following terms:
Buyer risk management:
– The rent (rent-to-sales ratio) must be negotiated to a sustainable level for the business in the long term, while also being in line with market rents. All savvy investors will consider vacancy risk and exit strategy to ensure the building would be leasable at similar rates on the open market. The lease rate negotiated will correspond to the sale proceeds the seller will earn, but a balance needs to be struck between both parties.
– Strength and size of the company is an important factor in the sale-leaseback because the buyer needs some certainty the lease will hold as agreed upon. A smaller, local company will find it more challenging to find an investor partner due to the higher risk of sustainability, while a large company, or multi-unit entity, will have plenty of demand.
– Length of lease for a sale-leaseback usually ranges from 10 – 20 years, where the longer the term and security of income, the higher the value of the asset. The more flexibility there is in the lease, the lower the demand and proceeds.
– Lastly, the age and condition of the building will be something considered by the buyer as any major upcoming capital expenditures will obviously affect the sale price. The maintenance and management of the facility are aspects to be mindful of when negotiating the lease agreement, particularly considering the building condition at sale.
The sale leaseback transaction and structure is not for everyone, but it can provide a unique spin on company trajectory, whether a business is pushing in growth mode and needs extra working capital, or looking to bridge a gap or clear debt due to many of the uncontrollable market conditions of the past few years.
If this is something you’re interested in understanding better, and how it could affect your real estate and business outlook, please reach out to your trusted advisor for additional insight.