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Sale Leaseback

Step-by-Step Guide to Understanding the Sale Leaseback Transaction Structure in Real Estate

Last Updated February 20, 2024

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Sale Leaseback

How Does a Sale Leaseback Work?

In commercial real estate (CRE), a sale leaseback occurs when the seller of a property immediately commits to a leasing agreement with the buyer.

In a sale leaseback, or “leaseback,” for short, the seller and buyer engage in a mutually beneficial transaction, in which the prior owner sells the property (“cash-out”) to the new owner, but continues to use the property after committing to a new leasing arrangement.

The structure of a sale-leaseback transaction comprises two parts.

Leaseback Stages Description
Stage 1 → Property Sale Contract
  • Once an agreement is reached between both sides with amicable terms, the property is sold and ownership is transferred after the purchase is paid in full.
  • Therefore, the new owner assumes ownership of the property as part of the investment, including the option to commit to a new leasing agreement with the seller (or former owner) right after closing.
Stage 2 → Leasing Contract
  • Shortly afterward, the new owner (now the lessor) and the prior owner agree to a new leasing agreement that permits the seller (now the lessee) to remain in the space, but as a tenant.

From the perspective of the new owner (i.e. the buyer), the ownership of the property is formally transferred to themselves upon transaction close.

  • Former Owner → Lessee Post-Closing (Tenant)
  • Buyer (Investor) → Lessor Post-Closing (Property Owner)

In sale-leaseback transactions, the buyer profile is often a real estate investor who purchased the property to generate rental income, rather than to move into and live in the property (i.e. the property is an investment, as part of the investor’s portfolio).

Notably, the real estate investor (or buyer) acquires a controlling interest in a stabilized property with a long-term tenant in place, i.e. an immediate, recurring income source.

On that note, the seller (pre-sale) is settled into the property and likely needs to continue utilizing the space.

However, there are often scenarios where a leaseback agreement is more economically sensible, such as when the prior owner’s cash reserves are running low (and they are in urgent need of cash injection).

So, what are the benefits received by the seller in a sale and leaseback?

  • Equity Injection and Capital to Reinvest in Business (e.g. Fund Working Capital Needs)
  • Discretionary Funds to Finance Growth Plans (Capital Expenditures, or “Capex”)
  • Capital to Right-Size Balance Sheet and Paydown Financial Obligations (i.e. Reduce Credit Risk)
  • Benefit from Tax Deductions (Transaction Must Quality as “Sale” under ASC 606 and “Operating Lease” under ASC 842)

Learn More → Sale and Leaseback Accounting (Source: KPMG)

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Leaseback Transaction: What are the Advantages and Disadvantages?

The benefits and drawbacks of a sale leaseback transaction to the seller (or former owner) are as follows.

Seller Pros/Cons Description
Capital Raise
  • The primary, most straightforward benefit to the former owner is the immediate inflow of the cash proceeds post-sale.
  • The liquidity (i.e. cash on hand) and discretionary cash flow of the seller increases substantially post-exit.
Favorable Market Conditions
  • The market demand could be favorable to the seller in terms of timing the exit (i.e. “seller’s market”), but a move could be untimely and disruptive to operations.
  • Therefore, a leaseback is an option to capitalize on the current state of the market, while also ensuring minimal disruption to operations.
Business Continuity
  • The seller in the leaseback usually needs to continue using the space (or prefers to remain there) because of their operational needs.
  • The maintenance of current operating performance and output can take precedence over maximizing the sale price.
Loss of Ownership (Control)
  • The former owner (post-leaseback) becomes the tenant of the property, and is now obligated to pay rent to the new owner.
  • Therefore, the seller no longer retains the rights held in the past, such as renovations to the property without the approval of the new owner.
Conditional Provisions
  • Based on the terms stated in the leasing agreement, there can be conditional provisions that the tenant (the former owner) must move out by a certain date.
  • The property was likely difficult to replace – hence the sale and leaseback – so the inclusion of certain provisions presents a material risk to the business.

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In contrast, the advantages and disadvantages of a sale leaseback transaction to the buyer (or new owner) are as follows.

Buyer Pros/Cons Description
Transfer of Ownership
  • The buyer becomes the owner of the property post-investment, fulfilling the primary objective of the investor, i.e. the transfer of ownership.
  • Upon acquiring the property, the buyer (or investor) is now in possession of a stabilized property with a reliable, long-term tenant already settled in.
Triple Net (NNN) Lease
  • Commercial real estate investors tend to positively perceive sale-leasebacks, because the lease structure is often in the form of a triple net (NNN) lease.
  • In a triple net (NNN) lease, the new tenant (former owner) bears expenses, such as property taxes, building insurance, utilities, and routine maintenance.
Alleviated Risks in Turnaround Period
  • The post-sale turnaround period is normally a “net-loss” phase in property management, as the new owner must find a new tenant(s).
  • Sale-leasebacks alleviate these monetary risks, as the former owner continues as the tenant, ensuring a seamless transition and stable rental income – without incurring routine maintenance and marketing costs.
Financial Return
  • The longer the leasing term, the higher the purchase price offered by the buyer – all else being equal.
  • Given the standard leasing term in a sale-leaseback transaction ranges from 15 to 20+ years, the rental payments represent a stable, long-term income source for the new owner.
Locked-In Interest Rate
  • Real estate investors are often incentivized to acquire properties through sale-leaseback transactions to lock in leases at favorable, low interest rates.
  • The strategy is particularly prevalent when market interest rates are expected to rise, as “cheaper” financing is readily available at purchase, contributing to more stability to the investment.
  • However, the locked-in interest rate can counteract (and benefit the seller instead) if interest rates decline.
Potential Losses
  • While leaseback transactions often fetch higher sale prices than vacant properties, they also carry risks.
  • In terms of M&A, overpaying for an asset is the most common source of missing the minimum return threshold.
  • Furthermore, the fixed lease arrangement means the buyer might not benefit from property appreciation, potentially leading to losses in the long term.
Shortage of Market Demand
  • The shifts in the real estate market and economic conditions pose risks to all real estate assets, but properties involved in sale-leaseback transactions are particularly vulnerable.
  • Why? The real estate assets carry unique characteristics – e.g. illiquidity, scarcity of comparable properties, niche market demand, and customized leasehold improvements – each contribute to risks related to market demand.

Sale Leaseback Deal Volume (2023)

2023 Sale Leaseback Outlook Source: SLB Capital Advisors)

Commercial Real Estate Sale Leaseback Example (CRE)

Suppose a commercial real estate (CRE) investment firm is interested in acquiring an office building property.

The commercial office building belongs to an owner with an established track record, strong credit profile, and significant leasehold improvements (LI).

  1. Initial Acquisition Offer → The CRE investment firm offers to acquire the building, which is subsequently declined by the current owner due to the continued need to use the office space.
  2. Sale and Leaseback Proposal → In response, the CRE firm proposes a sale-leaseback, where the firm assumes ownership of the property, while the current owner retains the right to continue using the building space as-is with minimal disruption to its day-to-day operations.
  3. Asset Sale → The current owner – or now, the seller – receives the cash proceeds post-exit, which increases their liquidity and discretionary cash flow.
  4. Leaseback (Post-Closing) → On the other hand, the CRE firm starts to earn a consistent stream of rental income right after the transaction close, without missing out on potential lost income from the process of searching for a suitable replacement or marketing spend (and with guaranteed residual value at lease-end).

In conclusion, our hypothetical scenario illustrates how the commercial real estate investor secures a long-term contractual leasing arrangement via a sale leaseback transaction, where the interests of both sides are met.

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