Sale-Leaseback Examples: Three Worked Scenarios

Every number below is hypothetical, for illustration. We chose round figures so the arithmetic is easy to follow. They are not market rents, prices or cap rates, and the cost and tax amounts are placeholders. Your actual figures will come from your property, your credit, your CPA and your lawyer.

One relationship runs through all three. Investors commonly express the price through a capitalization rate, or cap rate: annual net rent divided by the purchase price. So $60,000 of annual net rent on a $1,000,000 price is a 6.0% cap rate. Read in reverse, price equals rent divided by cap rate. The cap rates in these examples are invented inputs chosen to make that relationship visible.

A manufacturer owns its only plant and has a $2,000,000 mortgage. It also has a $1,500,000 equipment loan. Together, the two loans cost $660,000 a year in payments: $260,000 on the mortgage and $400,000 on the equipment loan. An investor offers $6,000,000 with a first-year rent of $480,000, which works out to an 8.0% cap rate.

• Sale price: $6,000,000
• Less mortgage payoff: $2,000,000
• Less assumed transaction costs: $180,000
• Less assumed income tax on the gain: $500,000
• Net cash after those items: $3,320,000
• Less equipment loan payoff: $1,500,000
• Cash left in the business: $1,820,000

Now the annual picture. Payments of $660,000 go away and rent of $480,000 begins, so fixed payments fall by $180,000 in year one. But the loans would eventually have been paid off, while rent continues and rises. If rent increases 2% a year, it reaches about $585,000 in year 11. The company has also given up the building's future appreciation and now needs a landlord's consent for some changes.

This example also shows the rent trap. If the company agreed to $540,000 in rent at the same 8.0% cap rate, the price would rise to $6,750,000. That is $750,000 more cash today in exchange for $60,000 more rent every year, before increases, and rent that sits above what another tenant would pay can cause problems later.

Two dentists own a small office building through a real estate company they own equally. Their practice rents from that company for $90,000 a year, and the real estate company has a $600,000 mortgage. One dentist plans to retire and wants to be paid out; the other wants to stay in the location. An investor offers $1,500,000 with a rent of $112,500, a 7.5% cap rate.

• Sale price: $1,500,000
• Less mortgage payoff: $600,000
• Less assumed transaction costs: $60,000
• Less assumed tax on the gain: $150,000
• Net cash to the real estate company: $690,000
• Share to each dentist if divided equally: $345,000

The practice's rent rises from $90,000 to $112,500, an increase of $22,500 a year, and the mortgage is gone. The retiring dentist has cash without selling a building interest to a partner. The remaining dentist no longer owns the real estate and carries a practice whose lease now belongs to an outside landlord.

The questions here are mostly about the lease and the people. Who signs, and does the investor want personal guaranties? Does the guaranty of the retiring dentist end? Can the lease be assigned if the practice is sold to a group later? Because this is a health care business, have counsel with health care experience review the transaction as well.

A family-owned distributor operates from a building held in a separate family company with no debt. The founder is retiring. One child runs the distributor; the other works elsewhere. The distributor currently pays the family company $200,000 a year in rent. An investor offers $4,000,000 with a rent of $300,000, a 7.5% cap rate.

• Sale price: $4,000,000
• Less assumed transaction costs: $120,000
• Less assumed tax on the gain: $600,000
• Net cash to the family company: $3,280,000

Compare that with keeping the building. Holding on gives the family $200,000 a year in rent before expenses and tax, plus any future appreciation. Selling gives $3,280,000 now, which is about 16.4 years of the current rent, ignoring investment returns and any increases. Selling also gives the child outside the business a way to receive value without owning part of the company.

The operating company bears the cost. Its rent rises by $100,000 a year, from $200,000 to $300,000, and the child running it now has an outside landlord. Keeping rent at $300,000 but pricing at an 8.0% cap rate would produce a $3,750,000 price, or $250,000 less, so the cap rate matters even when rent is fixed. An honest conversation among family members about who gets the cash and who carries the rent belongs at the start.

• Income tax on the rent. We show cash payments before tax. The treatment of the sale and the rent is a question for your CPA.
• Financial reporting. Under ASC 842, a transaction that qualifies as a sale puts a right-of-use asset and a lease liability on the seller's balance sheet. So the mortgage leaves, but a lease obligation arrives. Features such as most repurchase options or a finance lease classification can cause it to be treated as a financing.
• Who pays for property expenses. In a net lease, the tenant typically pays taxes, insurance and maintenance on top of rent, as an owner-occupant already does, but the roof and structure allocation varies.
• Prepayment penalties on any loan you pay off early, and transfer taxes that vary by location.
• What the business earns on the cash. A sale-leaseback looks very different if the money retires expensive debt rather than sitting in a bank account.

1. Estimate a rent the business can carry in a weak year, not only in a good one.
2. Ask a qualified advisor what range of value the building and your credit might support.
3. Subtract debt payoff, including any prepayment penalty, plus estimated costs and transfer taxes.
4. Ask your CPA to estimate the tax on the gain.
5. Compare the new rent with the loan payments and ownership costs it replaces, in year one and again in later years after increases.
6. Decide in advance what the net cash will do. If there is no clear answer, that is useful information.

When we work with an owner at TAG, this is an early step in evaluating whether the deal makes sense: we look at price and rent together, using real figures, before anyone goes to market.