How Is Rent Set in a Sale-Leaseback?

In an ordinary lease the landlord already owns the building and quotes a rent. You negotiate it down as far as the market allows. In a sale-leaseback there is no landlord yet. You and the buyer are creating the lease from nothing, and you sit on both sides of the rent question: as the future tenant you want it low, and as the seller you know that a higher rent produces a higher price.

That gives the seller unusual influence over the number, and unusual responsibility for it. Nobody will stop you from agreeing to a rent that is too high. The buyer's protection is your credit and the lease. Yours is your own judgment and your advisor's.

A sound rent sits where three separate tests agree.

• Market rent. What would a comparable building in the same area lease for today in an arm's-length deal? This is found from recent lease transactions for similar size, age, features and location, adjusted for a net lease structure and for anything unusual about your building.
• Affordability. What can the business pay, including scheduled increases, without strain in a poor year? This comes from your income statement, not from the real estate market.
• Proceeds. What price do you need to accomplish the purpose of the transaction? Working backward from that price at a realistic cap rate gives the rent required to support it.

When all three land in the same range, the deal is straightforward. When the rent needed for your target proceeds is well above market rent or above what the business can carry, the answer is to revisit the target, not to stretch the rent.

The following is hypothetical, for illustration only. The figures are round, invented and not market data.

Assume comparable buildings suggest a market rent of $400,000 a year for a company's plant, and that investors would price this particular deal at a cap rate of 8 percent. Consider two versions.

• Version A: rent of $400,000. Price is $400,000 divided by 0.08, or $5,000,000.
• Version B: rent of $480,000. Price is $480,000 divided by 0.08, or $6,000,000.

Version B puts an extra $1,000,000 in the seller's hands at closing. It also costs an extra $80,000 in the first year, more in each later year if the rent increases by a percentage, and it continues for the entire term and into any renewal priced off the same base. Over a long lease the additional rent can far exceed the additional proceeds. The extra million is, in substance, money advanced by the investor and repaid through rent.

In practice an investor may also demand a higher cap rate for Version B, because rent above market is less secure. That would shrink the extra proceeds while leaving the extra rent in place.

Owners' guides from the investment side of the industry name over-market rent as one of the main risks in these transactions. The problems show up later and in several places.

• Profitability. Rent is a fixed cost. A level that looked manageable in a strong year can squeeze margins in a weak one.
• Selling the business. A buyer of your company inherits the lease. Rent above market reduces earnings and therefore the value of the company, and a careful buyer will price that in.
• Renewals and subleasing. If you need to sublet surplus space, the subtenant will pay market rent, and you cover the gap. Renewal rents that step up from an inflated base compound the problem.
• Negotiating position. An investor that knows the rent could not be replaced by another tenant has less reason to be flexible with you.
• Accounting. Guidance on ASC 842 explains that when a sale-leaseback is not at market terms, the sale price is adjusted for accounting purposes, and a reduction of the stated sale price is recorded as additional financing. The extra proceeds may be reported as borrowing, not as sale proceeds.
• Tax. The IRS states that a rental deduction cannot be taken for unreasonable rents. Confirm with your CPA how the rent in your deal would be viewed.

Rent below market is the mirror image. It lowers occupancy cost and lowers proceeds, and the same accounting guidance treats the shortfall in price as a prepayment of rent. Some owners choose it deliberately when cash needs are modest and long-run cost matters more.

The starting figure is only part of what you will pay. Three other terms determine the real cost.

Increases. Leases in these transactions normally raise the rent over time, through fixed annual increases, periodic step-ups every few years, or adjustments tied to an inflation index. Fixed increases are predictable. Index-linked increases follow inflation and should be considered with a cap. Project the rent for every year of the term before agreeing to a starting number.

Expenses. Under a triple net lease you pay property taxes, insurance and maintenance in addition to base rent. Total occupancy cost is the sum of all of these. If the lease also makes you responsible for replacing the roof or major systems, budget for that as well.

Term and renewals. A longer term generally supports a better price, and it also fixes the rent schedule for longer. Renewal options matter because they decide what you pay after the initial term: a stated continuation of the same increases, a reset to market rent at that time, or some combination.

Ask for a year-by-year rent schedule for the full initial term and each renewal option. A starting rent that looks comfortable can look quite different in year fifteen.

1. Establish market rent from comparable lease transactions for buildings like yours.
2. Test affordability against your own financial statements, using a weak year, not an average one.
3. Estimate the cap rate range investors are likely to apply to your credit, lease and building.
4. Calculate the price that market rent supports at that cap rate and compare it with the proceeds you need.
5. If there is a gap, look first at the use of proceeds, the lease term and credit support before considering rent above market.
6. Model the full rent schedule with increases, plus taxes, insurance and maintenance.
7. Review the result with your CPA for accounting and tax treatment, then set the rent you will take to investors.

TAG does this work from the tenant's side of the table. We negotiate rents for occupiers every day, so we come to a sale-leaseback knowing what comparable space leases for and what a rent obligation feels like several years into a term.