Sale-Leaseback vs Keeping Your Building

Owners sometimes frame this choice as owning versus renting, as if it were a matter of preference. It is a capital allocation decision. Your company has a sum of money invested in a building. The question is whether that is the right place for it.

Keeping the building is a legitimate answer, and for many companies it is the correct one. This guide sets out a way to reach the answer deliberately, using three tests.

Equity in a building earns what real estate earns: the rent you avoid paying, plus or minus any change in the property's value. Capital in your business earns whatever your business earns on new investment. Compare the two.

1. Estimate the net cash a sale would produce after the mortgage payoff, selling costs and tax on the gain. Under IRS Publication 544, gain is the amount realized over adjusted basis, and past depreciation lowers that basis, so have your CPA run the figure.
2. Estimate the annual rent you would pay under a leaseback, including scheduled increases, less the ownership costs you would no longer bear, such as mortgage interest.
3. Express that net annual cost as a percentage of the net cash received. This is roughly what the capital costs you.
4. Identify specifically what the cash would be used for and what return or saving it would produce.
5. Compare the two on an after-tax basis. IRS Publication 334 explains that rent on business property you do not own is deductible, and IRS Publication 946 explains that depreciation generally belongs to the owner of the property and that land cannot be depreciated. Your CPA can model the difference.

If the business can put the money to work at a return clearly above its cost, the building's equity is underused. If the cash would sit in a bank account, or fund something with an uncertain payoff, the case for selling is weak.

A sale-leaseback needs a destination for the money. Without a specific, valuable use of proceeds, you are converting an appreciating asset into a rent bill for no gain.

The figures below are invented round numbers to show the logic. They are not market data and say nothing about what your building, rent or returns would be.

• Hypothetical net cash from a sale, after payoff, costs and tax: $3,000,000
• Hypothetical first-year rent under the leaseback: $300,000
• Hypothetical ownership costs no longer paid, such as loan interest: $60,000
• Hypothetical net added annual cost: $240,000, or 8% of the cash received

In this illustration, the owner needs a use for $3,000,000 that reliably produces more than 8% a year, and more than that as the rent rises, for the trade to make sense on financial grounds alone. Retiring expensive debt or funding equipment with a strong and proven payback might clear that bar. Holding the cash in reserve would not.

The illustration also leaves something out: the value of the building at the end. That belongs to the investor after a sale and to you if you keep it. Add an estimate of it to the keep side of the comparison.

An owner decides. A tenant asks. For some businesses the difference is minor, and for others it is central.

• Alterations and expansion. If you regularly modify the building as processes change, each change will need to fit within the lease or be approved by the landlord.
• Use. An owner can change what happens in the building, subject to zoning. A lease defines permitted use.
• Exit. An owner can sell or lease the building to someone else at any time. A tenant depends on assignment and sublease rights.
• Security of tenure. An owner cannot be asked to leave. A tenant's right to stay ends with the lease and its renewal options.
• Cost certainty. An owner without a mortgage has no rent to rise. A tenant's rent typically increases on a schedule and resets at renewal.

Much of this can be protected in a well-negotiated lease: broad alteration rights, flexible assignment, multiple renewal options and defined rent increases. The protection is contractual and finite. If your operation depends on absolute freedom to change the site, or the site is irreplaceable, weigh that heavily. Owning also has a satisfaction of its own that clients describe to us.

Time changes the answer in both directions, and three horizons matter.

• At the site. A sale-leaseback suits a company that expects to stay for the lease term. If you may move within a few years, a long lease is a liability, and a sale with relocation or simply holding the building may be better.
• For the business. If you plan to sell the company, consider how a buyer will view the real estate. Some buyers want it, some do not, and a lease signed now becomes part of what they acquire.
• For the owners. Younger owners with decades ahead may value long-term appreciation and a paid-off building at retirement. Owners approaching retirement may value liquidity and diversification more.

The longer you intend to hold and the fewer competing uses you have for the capital, the stronger the case for keeping the building.

Some owners expect a sale-leaseback to make the company look lighter on paper. Under US GAAP that expectation needs correcting. When the transfer qualifies as a sale, the building comes off the balance sheet and cash goes on, and the seller also records a right-of-use asset and a lease liability for the leaseback, as described in the Journal of Accountancy's guide to ASC 842 and in KPMG's comparison of US GAAP and IFRS. KPMG notes that under US GAAP the seller recognizes a gain or loss for the full difference between the sale proceeds and the carrying amount of the asset.

What changes is the composition of the balance sheet: an illiquid asset becomes cash, mortgage debt can be retired and a lease liability appears. Whether that helps with your lenders depends on how their covenants are written. Rent also becomes an operating expense, which lowers reported operating earnings compared with owning. If you may sell the company later, that matters, because buyers often value companies on those earnings.

• ✓Do we have a specific use for the proceeds with a return above the net cost of the rent?
• ✓Is debt available to fund that use at lower cost while we keep the building?
• ✓What do we estimate the building will be worth at the end of a lease term, and how much of our return is that?
• ✓Which lease protections would we need to operate as freely as we do now, and are investors likely to grant them?
• ✓Are we confident we will occupy this site for the full term?
• ✓Could the company carry the rent, with increases, through a bad year?
• ✓How would a buyer of our company view the lease?
• ✓How much of the owners' net worth is concentrated in this property, and does that concern us?

If the first answer is no, keep the building. If the answers favor a sale, the quality of the lease will determine whether the decision ages well.

TAG's process begins with exactly these questions. We learn the company's objectives, evaluate what the property would bring and on what lease terms, and tell owners when keeping the building, refinancing or relocating looks like the better course.