The Above-Market Rent Trap in Sale-Leasebacks

Investors value a leased building by dividing its annual rent by the return they require, known as the capitalization rate. In a normal sale, the rent is whatever the existing tenants pay. In a sale-leaseback, the seller and the tenant are the same party, so the rent is a number you help choose. Choose a higher number and the price rises with it.

Hypothetical, for illustration only: suppose an investor is willing to buy at a rate of 8 percent. At annual rent of $500,000, the price would be $6,250,000. At annual rent of $600,000, the price would be $7,500,000. An extra $100,000 a year in rent appears to create $1,250,000 at closing. These are round numbers chosen to show the arithmetic, not market data.

That extra money is not free. In the example, the company has committed to pay the additional $100,000 every year of the lease, usually with annual increases as well. Over a long term, the added rent can far exceed the added proceeds. In substance, the company has borrowed against its own future through the lease, at a cost that is easy to overlook because it is never stated as an interest rate.

It helps to be clear about who gains from a higher rent and price, because the suggestion often comes from someone with a reason to make it.

• An owner who needs a specific amount at closing, for example to repay a lender or fund a buyout, gets there without finding another source of capital.
• A seller's intermediary paid on the sale price earns more on a larger price. That is a reason to ask how your advisor is compensated and whom they represent.
• An investor comfortable with the tenant's credit holds a lease paying more than the building could earn from anyone else, for as long as the tenant keeps paying.
• Owners who plan to exit before the long-term cost is felt may capture the proceeds and leave the rent to their successors.

The party that does not benefit is the operating company over the life of the lease. If you will still own that company in ten years, you are on both sides of this trade.

The costs of above-market rent arrive at different times, which is part of why they are underestimated at signing.

• Every year: higher occupancy cost reduces operating earnings and cash flow compared with a market-rate lease.
• In a downturn: rent is fixed and usually escalating. A rent level that was tight in a good year becomes a real threat in a poor one.
• When you sell the business: buyers value companies on earnings. Rent above market reduces earnings, and a buyer may reduce the price by more than the proceeds the higher rent originally created. Buyers also treat a long, above-market lease as a liability they are inheriting.
• At renewal: if the renewal option is at fair market rent, the rent may reset downward, but many leases set a floor at the prior rent, which locks in the premium. If there is no option, you negotiate from an inflated starting point.
• If you need to sublet or assign: a subtenant will pay only market rent, so you cover the difference for the rest of the term.
• If the landlord sells: the building will be marketed on your rent, and the new owner will have paid for it. That owner has little room to give relief if you need it.

There is also a credit effect. Investors measure how comfortably a tenant's earnings cover rent. Higher rent makes that coverage thinner, and a careful investor may respond with a higher required return or more security, which gives back part of the price gain.

Off-market terms are not invisible to accountants. Under US GAAP, the lease accounting standard requires a company to determine whether a sale and leaseback transaction is at fair value. It can do so by comparing the sale price with the fair value of the asset, or the present value of the lease payments with the present value of market rental payments, whichever is more readily determinable.

If the transaction is not at fair value, it is adjusted. According to PwC's lease accounting guide, when the sale proceeds are higher than the fair value of the asset, the excess should be considered additional borrowing. Deloitte's guide describes the same adjustment as additional financing provided by the buyer to the seller, with part of each leaseback payment allocated to that financing. The practical result is that the portion of the price created by above-market rent is reported as a financing obligation, not as sale proceeds, and the seller's gain or loss is measured against the asset's fair value instead of the inflated price.

Deloitte also notes that any adjustment of lease payments resulting from off-market terms must be considered when the leaseback is classified, which is a separate analysis your accountants will perform. This is detailed, fact-specific work. Have your CPA review the proposed price and rent against fair value before you commit, not after closing. Tax treatment is a separate question to raise with your CPA at the same time.

If your accountant would need an appraisal to support the price, get the appraisal before you sign the letter of intent. It is also the quickest way to see how far rent has drifted from market.

1. Establish market rent independently. Look at what comparable buildings in your area lease for, on a comparable net basis, before anyone proposes a price.
2. Establish the building's value as real estate, separate from your lease, through broker analysis or an appraisal.
3. Compare the offer to both. If the proposed price is well above what the building would bring on market rent, the difference is coming from your credit and your future rent payments.
4. Test affordability. Model the rent with its escalations over the full term against a conservative forecast, including a poor year.
5. Ask every bidder for pricing at market rent as well as at any higher rent you are considering, so the cost of the extra proceeds is visible.
6. Compare that cost with other sources of the same capital, such as bank debt.

Rent is not required to match market exactly, and market rent is a range, not a single figure. A company may sensibly decide to accept rent toward the upper end of that range in exchange for proceeds it can put to work at a return that exceeds the cost. Rent can also reasonably reflect features of your building that a generic comparable lacks.

The trap is not paying a premium. It is paying one without knowing its size, its cost over the term, or its effect on a future sale of the business. If you choose a premium deliberately, protect yourself in the lease.

• ✓Is the renewal rent set at fair market value without a floor at the prior rent?
• ✓Are the annual escalations modest enough that the gap to market does not widen every year?
• ✓Could we sublet or assign without covering a large shortfall?
• ✓Have we shown the lease to our CPA and, if a company sale is likely, to our M&A advisor?
• ✓Would we make the same decision if the extra proceeds were offered as a loan on these terms?

Because we represent the occupier and stay involved in the lease, not only the sale, we show clients both numbers side by side: what the building is worth at market rent, and what each additional dollar of rent costs over the term.