Sale-Leaseback Risks and How to Reduce Them

A sale-leaseback is a permanent sale combined with a long contract. If the business later wishes it still owned the building, the only route back is to buy it at whatever price the owner will accept at that time, unless a purchase right was negotiated. Ask your CPA to quantify the tax effect of the sale before you commit, because it cannot be revisited after closing.

That irreversibility is the reason to look hard at risk before going to market. The points below are the ones we see matter most to occupiers, with the lease terms that address each. None of the mitigations is free. Investors price flexibility, so each protection is a trade against price, and the work is deciding which ones are worth it for your business.

As a tenant you need permission for things you used to decide alone: structural changes, new uses, subleasing, signage, sometimes even rooftop equipment. You also lose the ability to refinance, sell or redevelop the property on your own timetable.

• Broad use clause: permit your current use and any lawful related use, so a change in what you make or do does not require consent.
• Alteration rights: freedom for non-structural and equipment work, and a reasonable, timed consent process for the rest.
• Transfer rights: the ability to assign to a buyer of the business and to sublet surplus space.
• Operating autonomy: under a net lease you should control maintenance vendors, scheduling and standards, since you are paying for them.
• Limits on landlord entry and on landlord changes to the site, such as adding buildings or granting easements that interfere with your operations.

A mortgage can sometimes be restructured, extended or refinanced. Rent under a long lease is a fixed obligation that usually rises each year whether or not your revenue does. In a strong year the difference is academic. In a weak one, rent that was comfortable at signing can become the largest fixed cost you cannot adjust. And unlike an owner, a tenant who falls behind has no equity in the building to fall back on.

• Set initial rent at a level the business can cover in a poor year, not only an average one.
• Keep escalations predictable and moderate. If increases are tied to an inflation index, negotiate a cap.
• Hold back part of the proceeds as a reserve instead of deploying all of it.
• Negotiate default terms with real notice and cure periods, so a late payment during a tight month does not put the lease at risk.
• Avoid financial covenants in the lease that could create a default while rent is being paid.
• Preserve sublease rights so unused space can produce income.

Run the rent schedule against your worst year of the past decade. If the business could not have paid it then, the rent or the structure needs to change.

You may choose a buyer carefully, and that buyer may sell the building a few years later. Leased buildings are traded regularly, and your lease goes with the property. The new owner inherits the landlord's obligations but not necessarily the relationship or the attitude. The landlord may also place a mortgage on the building, which introduces a lender whose rights can affect yours.

• Put everything in the lease. Understandings with the original buyer that are not written down do not bind a successor.
• Require a subordination, non-disturbance and attornment agreement from any landlord lender, so that a foreclosure does not end your lease as long as you are not in default.
• Record a memorandum of lease where appropriate, so your rights, including options, are a matter of public record. Ask your attorney whether and how to do this.
• Require that any security deposit be transferred to a new owner, with written confirmation.
• Consider a right of first offer if the landlord decides to sell, and discuss the accounting implications of any purchase right with your CPA first.
• Limit estoppel certificate requests to a reasonable form and frequency, since each sale or financing will generate one.

Investors pay more for long, uninterrupted terms, so leasebacks are often longer and less flexible than a lease you would sign as an ordinary tenant. A business can change a great deal over that time. It can outgrow the building, shrink, be acquired, or move production elsewhere, and the lease stays the same.

• Match the initial term to how long you are confident the site will work, and use renewal options for the period beyond that.
• Negotiate expansion rights if the site has room and growth is plausible.
• Ask about a termination right, with a fee, at a defined point. Many investors will refuse or price it heavily, but the answer tells you what flexibility costs.
• Some investors with multiple properties will consider a substitution right, allowing you to replace the building with another of comparable value. It is uncommon and needs careful drafting.
• Make sure assignment and sublease rights are broad enough to serve as your exit if the business moves.

Under a net lease, the tenant typically pays property taxes, insurance and maintenance, much as you did as owner. Two things can still surprise you. First, capital items: if the lease makes you responsible for replacing the roof, parking lot or mechanical systems, you carry an owner's capital burden without an owner's equity. Second, property taxes: a sale can prompt the assessor to revisit the property's value, and under a net lease any increase is yours. Ask your property tax advisor how a sale at the proposed price might affect the assessment before you agree to it.

Casualty and condemnation clauses also deserve a careful read. They determine whether you must rebuild, whether rent continues while the building is unusable, and who receives insurance proceeds and awards.

A related risk sits on the other side of the ledger: proceeds that do not earn their keep.

The lease is a long-term cost. The proceeds need to produce a benefit that outweighs it, whether by retiring more expensive debt, funding growth that earns more than the rent costs, or providing liquidity that owners genuinely need. If the cash covers operating losses without fixing their cause, the company ends up with the same problem, plus rent, minus its building.

• ✓Can we cover rent, with escalations, in a poor year?
• ✓Are we confident we will want this site for the full initial term?
• ✓Can we alter, expand, sublet and assign without depending on the landlord's goodwill?
• ✓If the landlord sells or its lender forecloses, are our lease and options protected?
• ✓Do we know who pays for the roof, structure and major systems, now and near the end of the term?
• ✓Have we asked how the sale could affect our property tax assessment?
• ✓Has our CPA reviewed the tax and accounting treatment?
• ✓Has our lender confirmed how the lease affects our loan covenants?
• ✓Is there a specific, costed plan for the proceeds?

Our role as the occupier's representative is to raise these points while several buyers are still bidding, because that is when lease protections can be obtained at a reasonable cost. After a buyer is selected, the same requests are harder and more expensive.