When Is a Sale-Leaseback the Wrong Move?

A sale-leaseback is difficult to reverse. Once the building is sold, getting it back depends on the new owner's willingness to sell and on a price you do not control. The lease that replaces ownership is a long fixed commitment. Because the decision is close to permanent, it deserves a deliberate search for reasons to say no.

We represent occupiers, and part of that job is telling an owner when the transaction does not suit the business. The red flags below are the ones we look for in the first conversations. One of them does not always end the discussion, but each should change the structure or send you to an alternative.

Investors pay for a long, dependable stream of rent. To get an attractive price you will be asked to commit to the building for many years. If the company might outgrow the space, consolidate into another facility, move closer to customers or be sold to a buyer that does not need the site, that commitment becomes a liability.

Leaving early means subletting, negotiating a buyout with the landlord, or paying rent on an empty building. A shorter lease reduces that exposure but usually reduces the price too, and it narrows the pool of interested investors.

• ✓Are we confident we will operate from this building for the full initial term?
• ✓Does the building have room for the growth in our plan?
• ✓Could a change in customers, technology or regulation make this location unsuitable?
• ✓If the company were sold, would a buyer want this facility?

If the honest answers are uncertain, selling the building outright and relocating, or a short leaseback while you move, may fit better than a long one.

A sale-leaseback turns an illiquid asset into cash. That helps only if the cash does something the building could not. If the proceeds would sit in a bank account, or be spent on operating shortfalls with no plan to end them, the company gives up the building and takes on rent without improving its position.

Before going further, write down what the money is for and what it is expected to earn or save each year. Then compare that with the annual rent. If the benefit does not clearly exceed the cost, there is no financial case.

A sale-leaseback can relieve pressure for a company in difficulty, and sometimes that is the right call. It works when the cash funds a real fix. It fails when it only postpones the same problem with a new fixed cost attached.

As an owner with little or no mortgage, your occupancy cost is low and largely within your control. After the sale you pay rent every month, it rises on a schedule, and under a net lease you still pay taxes, insurance and maintenance. Rent does not flex when revenue falls.

Test the rent against a bad year, not an average one. Take the weakest year in your recent history, or a plausible downturn, and add the proposed rent with its escalations. If the result is uncomfortable, the rent is too high for the business whatever price it supports.

Be especially careful when a buyer offers a higher price in return for rent above what the building would lease for on the open market. The extra proceeds are a form of borrowing that you repay through the lease, and the above-market rent stays with the company, including when a future buyer of the business evaluates its obligations.

If the goal is simply to raise a moderate amount of capital, compare a sale-leaseback with borrowing. A mortgage refinance or a loan secured by the building lets you keep ownership, any future appreciation and control over the property. When the loan is repaid, the building is still yours.

A sale-leaseback generally raises more cash than a loan against the same building, since it converts the whole value instead of a portion. That advantage matters only if you need the larger amount. Ask your banker what is available and on what terms, then compare the after-tax cost of each route with your CPA.

Do not choose a sale-leaseback in the belief that it keeps obligations off your financial statements. Under US GAAP a seller-lessee applies lessee accounting to the leaseback, which means recognizing a right-of-use asset and a lease liability. The transaction can retire mortgage debt and add cash, but the lease commitment is recorded.

Two further issues can undo the economics.

• A large tax bill on the sale. The IRS explains that when depreciable property is disposed of at a gain, all or part of the gain may have to be treated as ordinary income. A building held and depreciated for many years may have a low tax basis, and the tax can take a meaningful share of the proceeds. Have your CPA estimate it before you decide.
• Unresolved property problems. Environmental contamination, title defects, deferred maintenance or zoning nonconformities will surface in a buyer's due diligence. They can lower the price, lead to holdbacks, or end the deal after you have spent time and money. Some can be fixed first, and that is often the better order.

A third situation is worth naming: restrictions in loan or ownership agreements that prevent the sale or dictate where the proceeds go. If a lender must receive the cash, the transaction may not achieve what you intended.

1. Name the flag precisely and decide whether it can be fixed, such as by cleaning up a title issue, or is a fact about the business, such as an uncertain future at the site.
2. For fixable issues, resolve them before going to market.
3. For structural issues, reshape the deal: a shorter term, lower rent with a lower price, or the sale of only part of the property.
4. Price the alternatives with your banker and CPA: refinancing, a secured loan, selling and relocating, or keeping the building.
5. If no version passes the tests above, do not proceed. Keeping the building is a legitimate outcome.

We would sooner advise a client to wait than help with a transaction that weakens the company. If you are unsure which side of these tests you fall on, the first step of our process is designed to answer exactly that.