Sale Leaseback Misnomers
In just two words, “sale leaseback” describes the entire transaction. This brevity is useful in some ways, but unhelpful in others. What gets left out are the many facets of the sale leaseback transaction that are important to their outcome. For instance, sale leasebacks are often perceived to be pure real estate transactions. Real estate is involved, but sale leasebacks are more accurately a corporate finance transaction and a capital allocation tool. Misnomers proliferate, and what follows are some of the most common, along with clarification.
Misnomer #1: I am relinquishing control over a mission-critical asset in a sale leaseback transaction.
A prominent concern that many senior executives and strategic owners have when considering a sale leaseback is the idea of giving up control of their facility. There is a misconception that when a company sells their property, the new owner will call the shots, or worse, wrestle operational control of the building away from them.
In reality, several levers can be pulled to ensure the seller retains effective control over the property and any buildings thereon.
The first lever that comes to mind is the type of lease itself. Most sale leasebacks are absolute net leases, under which the owner-operator sells the property but continues operating as if nothing has happened. Of note, the sale leaseback investor is passive in nature — simply looking to collect a rent check — and does not have any desire to interfere in operations.
A second lever is the term of the lease. Many sale leasebacks are negotiated with a long base term that is typically 15 to 20 years. On top of this, the tenant commonly secures renewal options for up to an additional 20+ years. This takes lease renewal risk off the table, by giving the tenant 40 or more years of control over their facility.
A third lever is alteration provisions. These provisions, which are part of a long-term lease, give the tenant the flexibility to put in new manufacturing lines, upgrade HVAC equipment, or make whatever changes are needed to support the tenant’s needs.
Misnomer #2: My cost of capital with a sale leaseback is higher than the prevailing interest rate on a loan.
Another common misconception is to compare cap rates on a sale leaseback to the interest rate that can be obtained by way of a corporate debt or mortgage financing. This is comparing apples to oranges and distorts the cost of capital from sale leasebacks.
Sale leasebacks monetize the entirety of the value of a real asset. Consider a business with a $20 million property that has the ability to execute a sale leaseback at an 8% cap rate. The 8% will be on the property’s total value, i.e., $20 million, and the proceeds from the transaction will be $20 million.
By contrast, if the business arranges a debt financing, that leverage is only part of the company’s capital stack. To get the comparison right, company owners need to consider the weighted average cost of capital of the entire business. Many companies’ weighted average cost of capital is in the low to mid-teens. In the above-described situation, the sale leaseback-generated 8% cap rate will be well below the WACC, and is going to be highly accretive from a cost of capital standpoint.
Misnomer #3: A sale leaseback will interfere with my ability to sell the business.
Debunking this misnomer relies on a closer examination of the buyer/investor and their objectives. It is true that, in a sale leaseback, investors are acquiring title to the real property. Yet the investor’s motivations go well beyond real estate attributes. The investor is in fact signing up for a long-term rental stream. Accordingly, investors prize the credit-worthiness of the tenant underlying the lease, i.e., the owner-operator from which they purchase the building.
As a result, the investor is particularly interested in the identity of the tenant, the company’s financial strength, its business model, trajectory and staying power. Buyers are loath to see the tenant’s credit strength deteriorate and want to guard against future business owners negatively impacting the credit, for example by way of increasing the amount of leverage on the company. For this reason, landlords often want a say in a change of control scenario, and many commercial real estate leases contain a clause granting the landlord a consent right for the tenant to assign the lease to the acquirer of the business.
Looking at this issue from a tenant’s standpoint, it is important in sale leasebacks to limit the landlord’s ability to block an eventual exit. Thankfully, there are ways to mitigate the issue from the company’s standpoint by giving the tenant an ability to enact a change of control without landlord consent, provided there is no material erosion in the credit profile of the succeeding business. Here investors focus on metrics such as EBITDA levels, leverage ratios or fixed charge coverage. Each situation is unique, and we utilize our deep experience in the sale leaseback arena to create a suitable outcome for our clients.
Misnomer #4: With a sale leaseback, I will miss out on the appreciation of the real estate I own.
While it is true that real estate assets tend to appreciate over time, the more important question boils down to capital allocation. The comparison that needs to be made is the return generated by owned real estate to the return that could be generated by reinvesting proceeds in a higher growth area. These options could include new or expanded product lines, manufacturing expansion, add-on acquisitions, and entering promising new geographies.
Remember, a business is reliably valued at a multiple of its EBITDA, and embedded in that is an expectation of meaningful earnings growth. By comparison, real estate is a relatively low-yielding asset with low growth rates that are largely driven by modest annual rent growth.
Further, owned real estate on a corporation’s balance sheet does not throw off cash, and from that aspect can be viewed as ‘dead weight’ in that it is not serving any other purpose than a store of value. The possibility of owned real estate appreciating may be comforting to business owners, but the fact of the matter is owned properties are relatively illiquid, slow-growing, low-yielding, and non-core to company’s actual business operations.
Misnomer #5: A sale leaseback is no different than any other commercial real estate transaction.
The two have similarities, but a sale leaseback is a corporate finance transaction to raise capital for deployment elsewhere in the business. Sale leasebacks are highly nuanced transactions, especially with respect to the key terms of the lease and structuring the deal.
Further, a pure real estate transaction is driven solely by real estate attributes like strength of location and building age and quality, while a sale leaseback is driven by the credit profile of the underlying business that is guarantying the lease. As a result, the seller’s balance sheet and cashflow come into play, factors which are absent in a regular-way commercial real estate transaction.
Most traditional real estate leases tend to be shorter in duration — think somewhere in the range of three, five, or seven years. Sale leasebacks, on the other hand, tend to be much longer in duration (15 to 20 years), with renewals that can extend out to 40 years.
As discussed above, sale leasebacks are also structured with triple net leases versus traditional real estate transactions, where the landlord bears some level of cost when it comes to improvements, maintenance, or tax obligations. Because sale leasebacks are both passive for the property investor and long-term in nature, investors are willing to pay a premium to acquire facilities with a properly structured sale leaseback.
Concluding Thoughts:
A high percentage of companies own the underlying properties in which they operate the business. At the same time, we are in a market environment where the sale leaseback continues to be particularly attractive among an array of capital raising alternatives. For those operating businesses that in fact have owned real estate, we at SLB are at-the-ready to help explore the pros and cons of such a transaction, and to address how any of the above-described misnomers may or may not apply to your particular situation.