Sale-Leaseback vs a Bank Loan or Line of Credit

The most common mistake in this comparison is treating all capital as interchangeable. A seasonal inventory build, a new production line, the purchase of a competitor and a shareholder buyout are different needs with different lives. Each source of capital is designed around one of them.

• Line of credit. A revolving facility you draw and repay as cash needs rise and fall. It is typically secured by receivables and inventory and renewed periodically.
• Term loan. A fixed amount borrowed for a set period and repaid on a schedule, often used for equipment, an acquisition or a building improvement.
• Sale-leaseback. A sale of the building for its value with a long lease back. There is no principal to repay. The cost is rent for as long as you occupy the property.

A useful rule from corporate finance is to match the life of the funding to the life of the need. Short-term needs financed with permanent capital leave you paying for money you no longer use. Long-term needs financed with short-term debt leave you exposed every time the facility comes up for renewal.

Bank debt has an end. A line of credit comes up for renewal, and the bank can decline to renew, reduce it or change its terms. A term loan amortizes and matures. Even when the relationship is good, the company must plan around those dates, and a renewal that falls in a weak year can be difficult.

A sale-leaseback has no maturity. The proceeds are yours and are never repaid. The obligation that replaces repayment is rent, which continues through the lease term and any renewals you exercise. That permanence is the feature and the cost. You cannot pay the capital back when the need has passed, and you cannot get the building back unless the owner agrees to sell.

If you could repay the money within a few years from operating cash flow, permanent capital is probably the wrong tool. If you could not, short-term debt probably is.

Bank credit facilities usually come with financial covenants: tests of leverage, cash flow coverage or net worth, measured on a schedule. A line of credit may also be limited by a borrowing base, so the amount available shrinks when receivables and inventory fall, which tends to be when cash is tightest. The bank typically takes a lien on business assets and, for a closely held company, may ask the owners for personal guaranties. A covenant breach gives the bank the right to act even if every payment has been made.

Sale-leaseback leases generally carry fewer financial tests. The advisory firm Stout describes a sale-leaseback as having no financing covenants, and the law firm Torys describes these leases as imposing limited, if any, financial reporting requirements. Investors differ, though, and a lease may still require financial statements, a guaranty or a security deposit. The main obligation is simple: pay the rent and perform the lease.

What the lease controls is the building. As tenant you will need to follow its terms on alterations, use, assignment and subletting. A bank with a lien on your receivables has little interest in whether you add a mezzanine. A landlord does.

Loans often specify what the proceeds may be used for. An equipment loan funds equipment. An acquisition facility funds the acquisition. Credit agreements commonly limit distributions to owners, additional debt, investments and asset sales while the loan is outstanding.

Sale proceeds are generally yours to use as you choose. The buyer is purchasing a building and a lease, not directing your spending. Two cautions apply. First, your existing lenders may have a claim on the proceeds or the right to approve the sale; read your credit agreement, since many restrict asset sales and sale-leaseback transactions specifically. Second, an investor deciding how much to pay will ask what you plan to do with the money, because it affects the financial strength of its future tenant.

An established banking relationship can often move quickly. The bank already knows your business, and a line increase or a term loan may need only updated financials and credit approval. If the need is urgent and modest, the bank is usually the first call.

A sale-leaseback involves selling real estate: valuation, marketing to investors, a letter of intent, environmental and title review, and negotiation of a purchase agreement and a long lease. It generally takes longer and has more points at which a buyer can ask to change terms. On the other hand, it does not depend on your bank's credit appetite, which can change for reasons unrelated to your company.

If you expect to need capital, begin evaluating a sale-leaseback before the need becomes urgent. A seller with time has more buyers to choose from and more leverage on the lease.

Interest on bank debt is usually the least expensive capital a healthy company can obtain, and the cost stops when the loan is repaid. Rent under a leaseback continues and typically rises over the term. Stout characterizes sale-leaseback capital as generally somewhat more expensive than senior debt and less expensive than mezzanine financing, which is a general observation and not a quote for your company.

On the tax side, IRS Publication 334 explains that rent for property used in your business that you do not own is deductible. A sale-leaseback is a sale of the property and may produce a gain, which IRS Publication 544 explains how to measure; a loan involves no sale. Ask your CPA to compare both routes after tax.

On the balance sheet, a loan adds debt. A sale-leaseback that qualifies as a sale removes the building and adds cash, and under ASC 842 the seller records a right-of-use asset and a lease liability for the leaseback, as the Journal of Accountancy's guide explains. The commitment is visible either way. Check how your loan covenants define debt and whether lease liabilities are counted.

The choice is seldom all or nothing. Companies frequently combine these tools: a sale-leaseback retires the mortgage and term debt and funds a long-term investment, while a line of credit remains in place for working capital. With real estate debt gone, the remaining bank relationship may be simpler.

The bank will still have views. It may count rent in its coverage tests, and it loses the building as collateral. Talk to your lender before going to market, not after.

• ✓Is the need short-term, medium-term or permanent?
• ✓Could we repay the amount from cash flow within a few years?
• ✓How much do we need, and will a bank lend that much on acceptable terms?
• ✓What covenants and guaranties come with the bank's proposal, and could we meet them in a weak year?
• ✓Do we intend to operate from this building for the full term of a lease?
• ✓Does our current credit agreement allow a sale-leaseback, and where must the proceeds go?
• ✓How quickly do we need the funds?
• ✓After tax and costs, what does each option net, and what does each cost per year?

TAG can provide the real estate side of this comparison: what the building would likely bring, what rent and lease terms would accompany that price, and how long the process would take, so you and your banker can weigh the options with complete information.