Why Do Companies Do Sale-Leasebacks?

A company that owns its building has money in two places. Some is in the business itself: inventory, equipment, people, customers. Some is in real estate. The real estate is useful, because the company needs somewhere to operate, but the company only needs to occupy the building. It does not need to own it in order to use it.

A sale-leaseback separates those two things. The right to use the building is kept through a lease. The capital that was sitting in the walls is released as cash. The reasons companies do this come down to what they believe that cash can do elsewhere, and to events that make the question urgent.

The most common reasons are about where the money goes.

• Paying down debt. Proceeds retire the mortgage on the building and may also pay down a line of credit or term loan, which reduces interest cost and can ease pressure from lenders.
• Funding growth. New equipment, added capacity, another location, new hires or new product lines that the company would otherwise fund with borrowing or outside equity.
• Making an acquisition. Cash from real estate can help buy a competitor or a complementary business.
• Providing liquidity to owners. Buying out a retiring partner, redeeming a shareholder or paying a distribution without selling the operating company.
• Building a cash reserve. A cushion for a cyclical business or one facing a period of uncertainty.

Net lease investors and their advisors describe the same list: expansion, equipment and technology, debt repayment, shareholder buyouts and strengthening the company's financial position. One feature sets a sale-leaseback apart from borrowing against the building. A lender advances only part of a property's appraised value. A sale converts the property's market value into cash, before the mortgage payoff, closing costs and tax on the sale are deducted.

The amount you keep is not the sale price. It is the price less the mortgage payoff, closing costs and tax on the gain. Ask your CPA for an after-tax estimate before judging whether the proceeds are worth the rent.

Some owners decide they would prefer to concentrate on the business they know. Owning a building means carrying a large, undiversified investment in a single property in a single location, usually alongside the business that depends on it. If the company struggles, the owners are exposed twice: once through the business and again through a building whose main tenant is that same business.

There is also the matter of return. If a dollar invested in the operating business earns more than a dollar left in the real estate, moving capital from one to the other can make sense. That is a judgment about your own company, and it deserves an honest answer. Plenty of owner-occupied buildings have been good investments in their own right, and the stability of owning has real value.

A sale-leaseback also changes what the company holds if it is later sold. Many buyers of operating businesses want the operations and not the property, so separating the two in advance can simplify that later sale. The lease you sign now is the lease that buyer inherits, which is a strong reason to negotiate assignment rights carefully.

Often the idea has been in the background for years and an event brings it forward.

• A loan is maturing and refinancing terms are less attractive than they were.
• A partner or family member wants to retire and the company cannot fund the buyout from cash flow.
• An acquisition opportunity appears and needs to be funded quickly.
• The owners are preparing to sell the operating company and want to deal with the real estate first.
• The company is under financial pressure and the building is its largest source of untapped value.
• Conventional credit is limited or carries covenants the company wants to avoid.

The last two deserve a plain statement. Sale-leasebacks are used by healthy companies as an ordinary financing choice, and they are also used by companies under strain. In the second case the transaction can stabilize a business, but the investor will be underwriting the tenant's ability to pay rent, so the financial story has to be told carefully and truthfully.

A balanced view includes the motives that should make you hesitate.

Doing it to make debt vanish from the financial statements is a mistake. Under ASC 842, the US accounting standard for leases, a company that sells and leases back its building records a right-of-use asset and a lease liability. A mortgage may be gone, but a lease obligation takes a place on the balance sheet. How the totals compare depends on the facts, and that is a question for your CPA.

Doing it to cover recurring operating losses is also weak. The cash is received once. The rent is owed every month for the full term. If the proceeds are spent without fixing what caused the losses, the company ends up with no building and a fixed obligation.

Doing it without a firm view on how long you will stay invites trouble. A long lease on a site you may outgrow in a few years is expensive to exit.

Before anything else, put your motive through these questions.

• ✓Can we state in one sentence what the proceeds will be used for?
• ✓What return or saving do we expect from that use, and how does it compare with the rent we would pay?
• ✓Would a loan or refinance accomplish the same thing at lower long-run cost?
• ✓Do all owners agree on giving up the building and any future appreciation?
• ✓Will the business need this location for at least as long as the lease term a buyer is likely to require?
• ✓Is the reason still sound if the next two years are weaker than expected?

When we first meet an owner considering a sale-leaseback, this is where we begin, because the objective determines which price, rent and lease terms are worth negotiating for.