In the current tightening credit market, sale-leaseback transactions have re-emerged as an attractive vehicle for owners and investors of real estate to tap a readily available source of capital. In addition, in light of the current cautious investment climate with respect to other investment vehicles, the sale-leaseback financing structure has a rooted history, and its widespread acceptance makes the sale-leaseback structure a compelling alternative for borrowers and investors.
Traditionally, sale-leaseback transactions have primarily been available to only investment grade or near investment grade type companies, because of the purchasers' strong desires to have well-established and reliable income streams. Today, however, as numerous investors have entered the sale-leaseback arena, all with varying motivations and investment objectives, more below investment grade transactions are being completed, and even leveraged buyout purchasers of companies are finding investors for their targets' real estate assets. They are thus able to employ real estate sale-leaseback transactions as a means of obtaining additional financing for their acquisitions.
In its most basic form, a sale-leaseback of real estate involves the sale of improved or unimproved real estate to an investor that in turn leases the real estate back to the original owner pursuant to a long-term triple net lease. The transaction permits the seller-lessee to liquidate its equity in the real estate while creating a stable investment opportunity for the investor. Aside from serving as a viable alternative to other, less stable investments, sale-leaseback transactions have become increasingly useful in providing replacement property under Internal Revenue Code § 1031 tax-free exchange programs. The net or "bondable" leased property inherent in the sale-leaseback structure is an attractive acquisition for sellers who need to identify a replacement property within the time constraints imposed under IRC § 1031.
Structure and Parties
The sale-leaseback structure has several variants, each being dependent upon the nature of the property and the transaction. A sale-leaseback may be limited to just one property (because of the higher transaction costs of the sale-leaseback structure, single-site transactions are often limited to high value property) or may include hundreds of properties spanning multiple jurisdictions. The sale-leaseback may also not be limited to a single type of property, as office, retail, warehousing, distribution and manufacturing uses have been suitable subjects of recent sale-leaseback transactions.
From the buyer-lessor's perspective, the buyer-lessor may also elect, as it often does, to obtain third-party financing to purchase the property from the seller-lessee. In so doing, the buyer-lessor may utilize a single lender or may "place" the debt through a private placement or in the CMBS (Commercial Mortgage Backed Security) market. A private placement or CMBS transaction usually results in a more efficient pricing for the financing and thus translates into a better purchase price or lease rate for the seller-lessee.
These types of financing transactions will, however, certainly add to the complexity of the overall transaction, lengthen time necessary to complete the underlying transaction and substantially increase the upfront costs for the overall transaction (which is usually, ultimately borne on the seller-lessee side of the transaction). The buyer-lessor may also elect to not participate in the remainder interest. Instead, the buyer-lessor may seek another investor to purchase the remainder interest, thereby limiting the buyer-lessor's investment to the income stream produced during the term of the lease. Regardless of the variant chosen, the sale-leaseback structure affords numerous advantages to both seller-lessee and buyer-lessor.
From the seller-lessee's perspective, the sale-leaseback structure allows the seller-lessee to generate an infusion of cash from an otherwise illiquid investment. The sale-leaseback structure allows the seller-lessee to obtain 100 percent financing of the property by converting all of the seller-lessee's equity in the property into immediate cash. This factor alone makes the sale-leaseback structure more appealing than conventional mortgage financing, in which lenders rarely allow loan-to-value ratios to exceed 75-80 percent of the fair market value of the property.
The sale-leaseback structure also allows the seller-lessee to improve its financial balance sheet. Oftentimes, the property to be sold into the sale-leaseback structure has appreciated in value, but is reflected on the seller-lessee's financial statements at historical cost (less depreciation). In reality, however, the property may have appreciated greatly and have a fair market value well in excess of its historical cost figures. Accordingly, proceeds received from such a sale can have a direct and positive impact on the seller-lessee's financial picture.
Additionally, today, many seller-lessees are utilizing these excess sale proceeds to pay down existing company indebtedness to aid compliance with existing credit facility requirements. In addition, if a sale and subsequent leaseback of property qualifies for sale-leaseback accounting treatment, the seller-lessee may be entitled to record the sale on its books, remove all property and any related liabilities from its balance sheet and recognize the profit or loss on the sale. If structured properly, the seller-lessee's record profit is recorded on the sale of the property is typically deferred and amortized in proportion to the related gross rental charged to expense over the lease term.
The sale-leaseback structure also has some favorable tax characteristics for the seller-lessee. Structured properly, the sale-leaseback allows the seller-lessee to deduct 100 percent of all rental payments made under the subsequent leaseback. These deductions make the sale-leaseback structure more appealing than conventional financing, in which the borrower is only entitled to deduct the interest portion of its debt service payments, but not that portion relating to the repayment of principal.
If the initial sale involves unimproved property with the improvements to be thereafter constructed by or for the seller-lessee, and provided that the initial term of the leaseback is not less than the recovery period of the improvements (or useful life, if applicable), the seller-lessee may be able to depreciate the improvements on an accelerated basis (provided all other rules for accelerated depreciation apply). If the initial sale involves improved property that has already been partially or fully depreciated, the seller-lessee may be able to gain a tax advantage by replacing the limited remaining depreciation deductions with rental expense deductions over the term of the lease.
From the buyer-lessor's perspective, the sale-leaseback provides a secure income stream and a predictable return from a lessee often having investment grade credit. The leaseback is typically structured as a "triple net" or "bondable" lease with all operating responsibilities being assumed by the lessee, thus passing through any expenses of ownership.
The basic rental rate under the leaseback is often determined based on a rental constant for the term of the lease. Rent is typically increased by inflation or other agreed upon escalations every one to five years during the initial term. The duration of the initial term is often determined on the basis of an amortization of the buyer-lessor's initial investment. The number, duration and pricing of any extension options will often be affected by among other factors, the seller-lessee's desired accounting treatment of the leaseback.
The sale-leaseback structure also provides the buyer-lessor with more effective remedies than those afforded under a conventional mortgage. In the event of a lessee default under a leaseback, the buyer-lessor can terminate the lease and recover the property often significantly faster than a mortgagee who must trudge through the foreclosure process. In addition, the buyer-lessor is typically not faced with equitable or statutory rights of redemption, which, in some states, can extend well beyond the date of foreclosure. Finally, if structured properly, the transaction may also allow the buyer-lessor to recover the present value of lost future rent payments, which is akin to a deficiency judgment.
Perhaps the most obvious drawback to the sale-leaseback structure from the seller-lessee's perspective is the seller-lessee's relinquishment of its reversionary interest in the property. In a sale-leaseback transaction the seller-lessee converts a fee interest in the property to a leasehold interest for a stated term, thus relinquishing any rights in and to the property after the stated expiration of the term.
The seller-lessee also incurs immediate negative tax consequences by having to recognize all of the gain on the initial sale of the property into the sale-leaseback structure. In addition, by converting its fee interest into a leasehold, the seller-lessee foregoes the benefit of any long-term appreciation of the property. Appreciation, however, is a two-way street, and the relinquishment of the reversionary interest may prove over time to be an advantage to the seller-lessee in the event of any depreciation or less-than-expected appreciation of the property.
The drawbacks to the sale-leaseback structure from the buyer-lessor's perspective are similar to the risks typically associated with any lending decision, most notably the risk of default. Aside from risk of default, additional risk unique to the sale-leaseback structure comes in the form of the uncertainty of the residual value in the property. By holding legal title to the property, the buyer-lessor retains both the "downside" risk of any depreciation or less-than-expected appreciation of the property and the "upside" advantage of any more-than-expected appreciation. Because of these risks, the buyer-lessor will typically discount substantially the assumed residual value of the property. Despite these drawbacks, a properly structured sale-leaseback can yield significant rewards to both seller-lessee and buyer-lessor.
Structuring the Transaction
Accounting Issues: The overall structure of the sale-leaseback is largely dictated by the goals of receiving sale-leaseback accounting treatment while avoiding recharacterization under tax, bankruptcy and state laws. From an accounting perspective, the transaction is typically structured so as to meet a series of tests for "sale leaseback accounting" and, in many cases, operating lease accounting treatment. To navigate through these series of tests, the seller-lessee should seek and obtain sound accounting advice before and throughout the process of structuring the sale-leaseback transaction.
Tax Issues: From a tax perspective, the issue of recharacterization centers on whether the sale-leaseback constitutes a "true sale" for tax purposes such that the seller-lessee can realize the gain on the sale and the buyer-lessor can thereafter depreciate the cost of the improvements. The courts will generally look to the economic substance of the transaction, not the labels assigned to the arrangement by the parties.
As a general matter, the seller-lessee and buyer-lessor should consider the following four factors:
- the burdens and risks on the buyer-lessor and seller-lessee should be consistent with customary substantive bargains made in the marketplace between lessors and lessees;
- the sale-leaseback should not grant the seller-lessee broad powers with regard to benefits traditionally reserved to the owner of the property;
- rentals should reflect the fair rental value of the property; and
- any repurchase provision should not be geared to the unamortized principal advanced by the buyer-lessor or provide for any so-called "bargain purchase" option.
Though these factors are by no means exhaustive, they lay the framework for determining the "economic substance" of the transaction.
Bankruptcy Issues: In the bankruptcy context, recharacterization of the sale-leaseback as a mortgage means that the leased property will be deemed property of the seller-lessee's estate. As in the tax arena, the courts typically look to the economic substance of the transaction. However, in this context, the buyer-lessor is at odds with the seller-lessee in making the case for recharacterization. If the sale-leaseback is recharacterized, the claim of the buyer-lessor would likely be bifurcated into a secured claim (to the extent of the value of the collateral) and an unsecured claim (as to the balance). Moreover, the seller-lessee would be precluded from rejecting the leaseback as an unexpired lease. Absent recharacterization, the seller-lessee may reject the leaseback and the buyer-lessor would be left with an unsecured claim as limited by § 502(b)(6) of the Bankruptcy Code.
State Law Remedies Issues
The economic substance of the transaction also bears on the question of recharacterization under state law. From a state law remedies perspective, recharacterization of the sale-leaseback transaction means that the buyer-lessor would be viewed as a mortgagee. Thus, the buyer-lessor would be forced to proceed under the applicable state's foreclosure laws without the aid of any waiver of redemption or any other lender protections typically found in customary loan transactions.
The buyer-lessor can typically seek solace in its title insurance policy. Though title insurers typically include an exception in the policy for the potential recharacterization of the transaction as an equitable mortgage, most title insurers are willing to issue a special recharacterization endorsement (insuring in substance that the mortgagee will have a right to enforce the mortgage through judicial foreclosure in the event of recharacterization). Aside from these general constructs, several other competing concerns help shape the details of the sale-leaseback structure.
Rights to Sell Uneconomic Property or Rights of Substitution:
In structuring the details of the sale-leaseback transaction, the seller-lessee and buyer-lessor have competing concerns that require careful attention. By locking itself into a long-term net lease, the seller-lessee is concerned that it will not be able to shed itself of the rental payments in the event that any one or more of the properties comprising the sale-leaseback shall at any time become obsolete or burdensome to the seller-lessee (a concern typically associated with multiple-site transactions involving retail locations).
In any such case, the seller-lessee may want to negotiate for the right to cause the sale of any one or more under-performing properties out of the sale-leaseback or replace the under-performing properties with viable substitute properties. However, the buyer-lessor's concern lies in the residual value of the properties comprising the sale-leaseback. Thus, in any such instance the buyer-lessor would want to impose strict controls over the seller-lessee's sale or substitution rights so as to preserve the anticipated aggregate residual value of all properties comprising the sale-leaseback.
Alterations and Expansions to the Property:
Both the seller-lessee and the buyer-lessor are concerned with the vesting of title to any improvements to the property subject to the sale-leaseback. In transactions wherein the improvements pre-date the sale-leaseback, the buyer-lessor will want title to such improvements to vest in the buyer-lessor at the outset of the transaction, thereby allowing the buyer-lessor to depreciate the improvements.
In transactions where the sale-leaseback involves land to be improved by the seller-lessee or where the adjusted basis in the existing improvements remains sufficiently great, the seller-lessee will want to retain title in and to the new improvements or existing improvements, as the case may be, thereby allowing the seller-lessee to depreciate the improvements (of course, the trade off being that the rental payments, may be affected as the buyer-lessor is not obtaining the benefit of the depreciation deduction).
Unique concerns also arise in the context of title to alterations or expansions. Due to the long-term nature of the leaseback, the seller-lessee will often want the flexibility to alter or even expand the property subject to the sale-leaseback. In contrast, the buyer-lessor is concerned with the value of its remainder interest and, hence, will want to protect against any alteration or expansion that would decrease the estimated residual value of the property. Thus, the parties should negotiate their rights and obligations with respect to alterations or expansions at the outset of the sale-leaseback transaction. The seller-lessee may want title in and to any alterations or expansions to remain with the seller-lessee during the tenure of the leaseback, thereby allowing the seller-lessee to depreciate the value of any such alteration or expansion. However, alterations or expansions (whether required or permitted under the sale-leaseback) which greatly enhance the value of the property could create a windfall to the buyer-lessor who retains the remainder interest therein. Accordingly, the seller-lessee may want to consider a mechanism whereby the buyer-lessor is forced to "buy out" the seller-lessee's interest in and to any such alterations or expansions at the expiration or termination of the leasehold. Though by no means exhaustive, these issues and concerns help to shape the details of the sale-leaseback transaction.
In summary, in light of the current tightening credit market and the cautious investment climate, the sale-leaseback transaction has re-emerged as an attractive vehicle for owners and investors of real estate. With its widespread and historical acceptance in the real estate community, sale-leaseback transactions allow the seller-lessee to realize the full value of their properties. At the same time, sale-leaseback financing provides the buyer-lessee with a secure, long-term income stream with the potential for property appreciation, thus giving it a distinct advantage to other current investment opportunities. These factors and others have and will continue to cause the resurgence of the sale-leaseback transaction.
Stephen G. Tomlinson is a partner at Kirkland & Ellis in the New York office. Brian E. Davis is an associate with the firm in its Chicago office.
This article is reprinted with permission from the November 25, 2002 edition of New York Law Journal. © 2002 IP Company. All rights reserved. Further duplication without permission is prohibited.