With continued demand from real estate investment trusts (REITs) and other institutional real estate investors for high yield real estate assets (particularly in the industrial space), we are seeing, as we often do in peak times and in times of high cost of debt, growing interest by landowners looking to take advantage of sale and leaseback arrangements as a way to free up capital while remaining in their premises for operational reasons.
In a real estate market where industrial and commercial properties are in high demand and financing costs are rising, landowners are leaning towards sale and leaseback arrangements to allow them to unlock and re-invest capital within their businesses and operations. In this article we will explore what a sale and leaseback transaction is, and the advantages and disadvantages for both the seller/tenant and buyer/landlord.
What is a sale and leaseback transaction?
A sale and leaseback transaction occurs when a landowning occupier sells their property to a third-party investor and simultaneously takes a lease back of all or a portion of the property for all, or part of, the property’s remaining economic life. In effect, the seller transfers legal ownership of the property to the buyer in exchange for consideration and then enters into a lease with the new buyer to retain the use of the property as a tenant. This process is popular amongst landowners who have multiple premises or one-off, fit-for-purpose properties, within which they wish to remain.
Advantages of a sale and leaseback
An appropriately structured sale and leaseback arrangement can reap rewards for both the seller and buyer of the property.
For the seller and eventual tenant
- The seller/tenant can take advantage of rising or peak real estate asset values and use the capital to pay off existing debt or redeploy the capital into other aspects of their business.
- A sale and leaseback transaction can be an alternative to conventional debt raising, particularly in the current uncertain economic climate with rising interest rates and inflation. The seller/tenant can raise more cash with a sale leaseback than through conventional mortgage financing. For example, a typical mortgage financing funds no more than 70-80% of the property’s value while a sale and leaseback allows the seller to realise 100% of the property’s market value (minus any capital gains tax).
- The seller/tenant can pre-negotiate the proposed lease terms, according to its best interests and bargaining power. This can translate to the seller/tenant structuring the lease based on its desired terms without the burden of call provisions, refinancing and arbitrary fitout works.
- A sale and leaseback transaction can offer corporate tax incentives to the seller/tenant given rental payments under the leaseback are fully deductible as an operating cost of the business. In contrast, the borrower of conventional financing is only entitled to deduct the interest and depreciation elements of the mortgage repayments.
For the buyer and eventual landlord
- The buyer/landlord will acquire the property with a tenant producing an immediate and guaranteed rental income for the medium to long term.
- The buyer/landlord will not have to incur expensive marketing and leasing fees in order to secure a tenant.
- Despite bearing the risk of any decline in the property value, the buyer/landlord will benefit from a steady rental income and any appreciation in the value of the property.
- The general long-term nature of a sale and leaseback transaction enables the buyer/landlord to better estimate the expected future rate of return of the property.
And why a sale and leaseback isn’t for everyone
There are of course disadvantages to sale leaseback transactions for both the seller/tenant and buyer/landlord.
For the seller and eventual tenant
- The most obvious downside to the seller/tenant is that it forgoes any future capital growth in the property from the time it sells the property, however, this is not an issue if selling at the top of the market.
- The long-term nature of a typical leaseback can remove flexibility for a tenant that may require agility.
- There may be some uncertainty at the end of a leaseback if the lease expires and the tenant is unable to renegotiate a renewal based on the initial favourable terms. This can be particularly problematic if the tenant uses the property for long-term purposes such as for its headquarters or main distribution centre.
For the buyer and eventual landlord
- Despite the arrangement being no different to giving a conventional lease to a tenant, the landlord runs the risk of the tenant defaulting on the lease and leaving the property vacant for a short while. This is relevant in the current economic climate given the rise of inflation and pressures on the bottom line for tenants.
- Although not a disadvantage per se, we strongly recommend that the buyer/landlord undertake exhaustive due diligence to ensure the creditworthiness of the tenant and to be aware of any potential environmental liabilities or ongoing contracts with third-party contractors which the buyer/landlord will acquire as part of the sale of the property.