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Sale-Leasebacks May Provide A Safe Financing Alternative

Amid rising interest rates, unpredictable market conditions and persistent inflation, sale-leasebacks—where a property owner sells an asset and then immediately leases it from the buyer—are gaining popularity as a safe alternative to traditional financing.

According to recent data from SLB Capital Advisors, a real estate advisory firm, dollar volume of sale-leaseback deals surged 8.3% to $5.1 billion in the second quarter of 2023 over the first quarter.

In an interesting twist, industrial sale-leaseback transactions slumped—representing just 39% of all transactions for the second quarter—while retail spiked to its highest level of sale-leaseback activity since the onset of the pandemic.

This trend is evidenced by Realty Income’s acquisition earlier this year of EG America’s convenience store portfolio—comprised of 415 single tenant properties throughout the Northeast—for $1.5 billion.

Under terms of the sale-leaseback transaction, EG America continues to operate the convenience stores, which include Cumberland Farms, Tom Thumb, Fastrac and Sprint locations.

How They Work

The structure of a sale-leaseback is fairly straightforward. In the commercial real estate industry, a property owner sells the property to a buyer who then leases the property to the seller under a long-term lease with fixed monthly rent payments.

A sale-leaseback typically offers flexible terms and interest rates because it is negotiated between the parties outside of a traditional lending institution.

Most often, the parties enter into a triple net lease, wherein the tenant maintains control of the property and is responsible for all expenses, including utilities, property insurance, real estate taxes and any common area maintenance. The typical lease term ranges between 15 and 20 years, with options for multiple-year renewals.

Why a Sale-Leaseback

Sale-leasebacks can be useful to both parties involved when capital markets tighten, and cash is tied up in real estate. They allow financial benefits to remain the same despite changes in the market’s environment.

With respect to the seller, they receive an immediate cash influx that they can invest in their business or use to pay off debts and still maintain possession of the property to continue operations without disruption.

Further, the seller’s business can benefit from the tax deduction of rental expenses, and the seller may list the property as an operating expense on balance sheets, allowing them to borrow from more lenders because they are seen as a trustworthy business owner with fewer liabilities. All of the above provide business stability under the long-term leaseback.

As for the buyer, sale-leasebacks are an attractive investment because the buyer avoids future interest rate increases and gains steady rental income and a higher rate of return on their investment.

Drawbacks of Sale Leasebacks

However, sale-leasebacks can also have potential drawbacks.

There are at least five drawbacks a seller should consider.

• The transaction takes place outside of a traditional lending institution and the transaction is dependent on the buyer’s capital and stability;
• The seller must adhere to the terms of the lease, which may encompass rent increases and property improvements;
• If the seller’s intent is to repurchase the property at some point, the seller must consider that the buyer may not offer the seller to repurchase the property at the expiration of the lease term, though this can be addressed by negotiating a right of first refusal option as part of the lease;
• Over a long period of time, the lease payments may exceed the initial cost of the property; and
• The seller has limited options to renovate or relocate the property under a sale-leaseback, as the seller is locked into the lease for a fixed term, subject to a penalty if the seller wants to relocate the business.

A drawback for a buyer is that significant capital may be tied up in an asset. Also, the buyer could be affected if the seller undergoes financial challenges or defaults on the lease.

As the buyer, it is important to consider which market is most profitable before purchasing a property and entering into a sale-leaseback. The market determines which types of properties are most desirable in sale-leaseback deals.

Conclusion

With today’s unpredictable economic climate and the accompanying tight capital market resulting in lenders becoming more cautious, sale-leasebacks are an appealing investment option due to their mutual benefits for both the buyer and the seller.

As a buyer, one can obtain the full equitable value of the property, maintain possession of the property and continue business operations without interruption. Furthermore, sale-leasebacks are particularly useful for long-term leases in which a potential property owner can minimize short-term changes in the markets.

However, sellers should research their buyers to determine whether they would be a good landlord and are the best fit for the seller’s business. This includes contacting current existing tenants, reviewing their investment history and access to capital and ensuring they understand the business, which aids the buyer in negotiating current long-term deal terms as well as future needs and deal terms.

The same applies to buyers in determining whether the selling company would make for a quality tenant. Specifically, researching the stability of their business and whether they are able to maintain their obligations under the lease for the entirety of the lease term.

In any real estate transaction, relationships are key — knowing and understanding the intentions of your sale-leaseback partner is fundamental to a successful transaction.

Whether a buyer or a seller, it is important to pivot during uncertain times to continue successful operations of a business or to maximize investment opportunities. Sale-leasebacks allow parties to act now rather than to wait out this uncertain time. They are, therefore, an attractive alternative to the traditional avenues.

The article was published in Law360.