How Does a Sale-Leaseback Affect Your Balance Sheet and Covenants?

This guide assumes the company reports under US GAAP and that the transfer qualifies as a sale. It is a description for planning purposes. Your CPA should prepare the actual pro forma.

• Cash increases by the net proceeds.
• The land and building are derecognized at their carrying amount, which for a long-held property may be far below market value.
• The difference between the sale proceeds and the carrying amount is recognized as a gain or loss. Under US GAAP the seller-lessee recognizes it in full at the sale date, adjusted for any off-market terms.
• If proceeds are used to repay the mortgage, that debt is removed.
• A right-of-use asset and a lease liability are recorded for the leaseback, because ASC 842 requires a lessee to recognize both for its leases.

So the transaction converts an illiquid asset into cash and can retire mortgage debt, and it adds a lease obligation to the balance sheet. It does not make the cost of occupying the building disappear from your statements. Anyone who tells you otherwise is describing rules that no longer apply.

After closing, an operating leaseback produces lease expense recognized on a straight-line basis. Depreciation on the building and interest on the mortgage stop.

This is the question most covenant outcomes turn on, and it has two answers.

The accounting answer: Deloitte's leases guide notes that ASC 842 characterizes operating lease liabilities as operating liabilities, not debt, and that the FASB intended them to sit outside of debt. On that basis they may not affect ratios that are built on debt.

The lender's answer: the same guide points out that the FASB cannot dictate how banks and other lenders view those amounts. A Baker Tilly article on lease accounting and loan covenants adds that rating agencies and analysts often estimate operating lease obligations and include them in their debt calculations, so a lender may treat them as debt for its own purposes whatever the standard says.

A finance lease is different. An industry article on the sale-leaseback model observes that finance obligations are typically included in leverage calculations. And if the transfer fails to qualify as a sale at all, the cash received is itself recorded as a financial liability while the building stays on the books. Lease classification and sale qualification are therefore covenant questions, not only accounting ones.

The Baker Tilly article lists covenant ratios that lease accounting can affect: fixed-charge coverage, current ratio, debt service coverage, debt to net worth, and funded debt to EBITDA. For a sale-leaseback, work through each with the definitions in your own agreements.

• Leverage (funded debt to EBITDA). Repaying the mortgage reduces funded debt. But rent is usually an operating expense that reduces EBITDA, while the depreciation and interest it replaces are usually added back. Whether the ratio improves depends on how much debt is repaid, how large the rent is and how your agreement defines both terms.
• Fixed-charge and debt service coverage. Many definitions count rent as a fixed charge. You are replacing mortgage payments with rent payments, so compare the two amounts under the actual definition.
• Current ratio. Cash rises at closing, but ask your CPA how the lease liability will be split between current and long-term. If proceeds are spent on long-term uses, the net effect can go either way.
• Net worth and debt to net worth. A gain on sale increases equity and a loss reduces it. The lease liability may or may not count as debt in the ratio.
• Negative covenants. Many loan agreements restrict asset sales, sale-leaseback transactions, new lease obligations or the use of sale proceeds, and may require proceeds to prepay the loan.

The agreement's accounting clause matters too. Baker Tilly notes that a significant portion of agreements contain frozen GAAP or semi-frozen GAAP clauses. Under those clauses, a ratio change caused solely by a change in GAAP either does not cause a default or requires the parties to renegotiate in good faith. Have your attorney confirm whether your agreements contain one and how it applies to a new lease before modeling anything.

There are three separate reasons to involve lenders early, and the first is not optional.

1. The mortgage lender has to be paid off or consent. Ask for a payoff figure early, including any prepayment charge, because it comes straight out of proceeds.
2. Any lender with a lien on the real estate or a covenant restricting asset sales or sale-leasebacks has to release or waive. That often includes the bank behind your line of credit, even if the building is not its primary collateral.
3. Every lender who tests financial covenants should see the pro forma. Ask them directly how they will treat the lease liability and the rent, and get the answer in writing, by amendment if needed.

Lenders generally react better to a transaction presented as a plan, with a pro forma and a stated use of proceeds, than to one they learn about from a title company's payoff request. If the proceeds will reduce their exposure, say so. If the proceeds are going into growth, show the return.

Build the covenant pro forma at the term-sheet stage and rerun it whenever price, rent, term or escalations move. Each of those changes the gain, the lease liability or the rent expense.

• ✓What is the carrying amount of the land and building, and what gain or loss results at the proposed price?
• ✓Will the leaseback be an operating lease, and will the transfer qualify as a sale? Have the auditors agreed?
• ✓What lease liability and right-of-use asset will be recorded, and at what discount rate?
• ✓What is the mortgage payoff, including prepayment charges?
• ✓How does each loan agreement define indebtedness, EBITDA and fixed charges, and does it use frozen GAAP?
• ✓Does any agreement restrict sale-leasebacks or direct how sale proceeds must be used?
• ✓What do the covenant ratios look like on day one and in each of the next several years as rent escalates?
• ✓How do bonding companies, key vendors or customers who review our statements read the change?
• ✓Have we modeled the downside case, where revenue falls and rent does not?

Lenders can be allies in these transactions when they are brought in early. Our role is to supply the real estate inputs for the pro forma, price, market rent, escalations and term, and then to negotiate them with the covenant result in mind.