A sale-leaseback is a transaction in which a company sells its real estate and leases it back from the purchaser. In this post I will describe what the sale-leaseback is and how it is generally structured, the benefits to both parties involved in the transaction, and key factors for those considering such a transaction.
A sale-leaseback is when a property owner sells the property to an investor but continues to operate out of the building by simultaneously leasing it back.
A sale-leaseback is considered a form of finance. I previously worked for a publicly traded REIT who’s core competency is the sale leaseback. It’s interesting to note, that even though the company invested in real property, it was originally considered a specialty finance company, rather than a real estate company. That speaks to the fact that this type of transaction is really just a creative form of finance that happens to be centered around the real property. This form of financing is an alternative to traditional bank, mezzanine, and mortgage financing.
The graphic below outlines the typical sale-leaseback transaction structure. As you can see, there are two parties involved in the transaction. The seller is a business that owns the property and operates their core business from the property. The buyer is the investor who would like to buy the real estate. Note that the seller of the property becomes the tenant and the buyer becomes the landlord. This is because the two parties enter into a lease agreement simultaneous to the close of the property sale.
First and foremost, a company can only consider doing a sale-leaseback if it owns the real estate from which it operates its core business. In general, a company should consider a SLB when the profit margins of their core business exceed the returns generated from the real estate. The primary benefit of the transaction is financial, as it allows the operating business the utilize the capital from the real estate to finance their core business endeavors. They can use the net sale proceeds to pay for an expansion, pay down debt, make a cash distribution, or pay for operations.
Businesses in many industries do SLB’s. Their real estate can be retail, industrial, office, medical office or even specialty real estate. I’ve seen SLB transactions in the following sectors: restaurant, convenience store, grocery store, apparel, pharmacy, office, medical facilities, distribution and logistics, dollar stores, gyms, movie theaters, etc.
Many of the most active buyers are REITs, but there are individual and non-public entities and family offices. Right now, public companies are most active due to their low cost of capital.
However, once the property is sold, the seller loses control over the real estate. They may have trouble vacating the property. They may have to relocate after the initial term and options expire if the landlord is unwilling to extend the lease. Additionally, the interest rate in a sale-leaseback arrangement is generally higher than on a conventional mortgage (but lower than mezzanine capital).
The biggest risk and potential challenge for buyers is the risk of tenant default. If the tenant defaults, it could be very difficult to re-lease the building and achieve the same rental rate. This is particularly challenging when the asset type is very specialized and/or if the property is located in a secondary or tertiary market.
Buyer Due Diligence
For groups that are looking to be on the other side of the exchange, the buyers/landlords, there are several key factors you ought to consider when evaluating this type of transaction. The three primary areas buyers need to evaluate are the tenant credit, the quality of the real estate, and the industry outlook. I’ll break down each of these below.
Tenant Credit and Guarantor
It is fair to compare the sale-leaseback transaction with the purchase of a bond. You are essentially buying a bond plus the residual value of the underlying real estate. When evaluating the purchase of a bond, you consider the coupon (annual interest rate), the term (i.e. the maturity date) and the likelihood of default (credit risk). You need to make sure the tenant has strong credit because it will likely be very difficult to replace the SLB rent if the tenant were to vacate during the term. Make sure they have a strong balance sheet and EBITDA.
Quality of Real Estate
In addition to the rental stream that you as the purchaser are buying, you are also buying the underlying real estate. Make sure that the real estate is well-located and could be re-leased in the event that the tenant vacates early. It’s often difficult to predict what the location will be like in 20 years when the original tenant vacates, but you should try to evaluate whether it is in the path of growth or if the area is in decline. The location of the real estate is particularly important for retail, convenience store, and restaurant operators because the quality of the real estate will be directly correlated with the success or failure of that business. The better the real estate, the better the likelihood that the tenant will be successful and make their monthly rent payments.
SLB’s generally involve a lease term of 10+ lease. Therefore, you should be comfortable that the industry will continue to be in demand for at least the initial term of the lease. Obviously, it is difficult to predict which industries will be successful 20 years from now, but if you stay on top of trends and have decent judgement, you should be able to make a reasonable decision. For example, I wouldn’t have recommended doing a SLB with Blockbuster 15 years ago, and I wouldn’t recommend entering into an SLB with a high-end apparel, accessories retailer, or department store right now.
Just because you have a contractual lease agreement with the tenant, does not mean that you are guaranteed to get paid as outlined in the lease. If the industry takes a turn, the market takes a turn, or if the tenant gets into financial trouble, or their tenant health ratio (rent as a percentage of revenue) becomes unsustainable, the tenant could be unable to make the rent payments, or worse, file for bankruptcy and reject the lease. It is never a guaranteed income stream, so be diligent in your underwriting and make sure that you consider the potential downside scenarios of the transaction. Make sure that you are confident in the assumptions that make the deal pencil.
Sale-leasebacks almost always result in a triple-net lease (NNN). Often times the leases are absolute NNN in which the landlord has zero responsibilities. Sometimes, however, the lease is NNN or NN. Under this type of lease, the landlord might be responsible for the structure or the roof or even the parking lot. The term is generally 10-20 years or more with another 10 years or more of option periods. The structure on the lease payments is negotiable. For example, they can be structured with low rent payments during the early years and higher rent payments during later years.
For all of you non real estate folks, a cap rate is effectively the inverse of a company’s earnings multiple (see my blog post on cap rates for more details). To determine the multiple of a particular investment, divide 1 by the cap rate. For example, if a property’s cap rate is 7%, the earnings multiple would be 14.3x (1/7% = 14.3x). The cap rate is determined by taking the NOI of the property and dividing it by the purchase price (Cap Rate = NOI/Purchase Price). There is generally a market cap rate for each transaction type at any given period of time. Note that these market cap rates change.
More general facilities, that can be re-leased to another tenant in better locations, pose less risk to the investor, and are therefore, less costly to the tenant in terms of rent. More specialized properties will require a higher cap rate, all other things being equal, due to the increased risk.
Its tempting for property owners to want to sell at a high price. Since the property will sell on a multiple of the rental amount. The higher the price, the higher the rental amount. Companies that are on the sell side of the transaction need to be careful not to set the rent too high as it could make it difficult for the company’s operations to remain successful. It is important for both sides of the transaction, that the rent-to-sales ratio be healthy.
As buyers, you also need to be cognizant of the fact that the rent paid by tenants under the sale-leaseback is generally above market. Keep that in mind because if the tenant were to struggle or fail, it will be tough to replace that income stream.
There is no right or wrong with a sale-leaseback. It is a financing structure that may be a great option for one company, but less than ideal for another. Generally, companies that are hoping to grow and expand, who own the real estate from which they operate, will benefit from a sale-leaseback. On the other hand, companies like McDonalds and Chif-fil-A, who own the majority of the real estate from which the operate their restaurants, benefit from owning. This is because they have access to huge pools of equity, and because they have made real estate one of their core competencies. Sale-leaseback transactions can be a very powerful financing tool for the right company; it is worth considering if you own your real estate and need a capital injection.