Unlock Trapped Equity and Working Capital – Identify equity in your real estate using the sale-leaseback strategy

By Joseph Larkin, CCIM, MCR, SIOR, SLCR

Where possible, many companies are currently capitalizing on their real estate equity. One of the most powerful ways a company can create value is by employing the strategic and sophisticated use of the sale-leaseback transition.

The sale-leaseback strategy was originally used as a financing transaction when the real estate market lacked adequate access to capital at reasonable rates. It provides the opportunity for a company to cash out the equity in its real estate and convert it to cash to finance its core business activities, reduce debt, and/or expand operations.

Companies that purchased real estate for their business many years ago may have a large amount of equity in their real estate holdings. Converting the equity into cash may provide a company the opportunity to reinvest the equity back into the business, reduce debt, or acquire a competitor through a leverage buyout or a merger and acquisition.

With a typical sale-leaseback structure, a company sells its operational real estate to an unrelated private investor or an institutional investor. Simultaneously with the sale, the company leases back the property from the investor, typically for 10 to 20 years.

The company usually receives more cash with a sale leaseback than through conventional mortgage financing. For example, if the transaction includes both land and improvements, the seller receives 100% of the property’s market value (minus any capital gains tax). In comparison, conventional mortgage financing normally funds no more than 65 to 75% of a property’s value.

Typically, the initial lease term can be structured for a period that meets the company’s needs without the burden of balloon payments, call provisions, refinancing, or the other issues of conventional financing. Moreover, the seller avoids the substantial costs of conventional financing such as points, appraisal fees, and some legal fees. Options to renew the lease also may be negotiated, extending the occupancy period.

From the perspective of the company, converting the equity in the real estate into cash and deploying the cash into operations could generate a higher return than keeping the equity in its real estate. The elimination of any mortgage debt on the real estate also can improve the company’s financial statements.

From an accounting standpoint, depending on the book value, the true market value of real estate is not reflected on the balance sheet. The sale-leaseback transaction places the cash received from the sale on the books as a short-term asset and removes the real estate as long-term capital asset at the book value (typically below market value) from the balance sheet. This conversion of the equity into cash would reflect the true value of the asset, now cash. This could have a dramatic impact on the balance sheet and, more importantly, the company’s financial ratios.

From a tax standpoint, when converting the company from an owner to a tenant, you’re allowed to effectively depreciate the land as lease payments to cover the use of the land and the building. If you own the property, you can’t depreciate the land. Those lease payments are fully tax deductible.

There are some drawbacks to this strategy: the sale of real property may trigger a capital gains tax and, under GAAP, the lease will be “booked” as a long-term liability. Based on the lease structure, the lease payments may be straight-lined or amortized.

The company’s decision to complete a sale-leaseback transaction may be based on a variety of after-tax analysis. For instance, comparing the return on the deployment of capital in the business, using an after-tax weighted average cost of capital, to the return on the equity if the company continues to own its real estate.

This strategy may provide a business with an exit strategy to sell the going concern (the business) and the real estate separately. By partitioning the real estate from the business, the parts may be worth more than the whole, allowing for the sale of the business individually and capitalizing on the individual values.

The investor benefits from having a financially bankable tenant who already occupies the space then enjoying the security of a stable, long-term income stream. The lease is structured as an absolute net, which provides the benefit of eliminating most of the property management responsibilities and capital investments. The type of lease and terms are negotiated at the outset.

The investor’s evaluation of the sale-leaseback transaction starts with the tenant’s credit. Moreover, investors use a variety of performance measurements such as capitalization rate; internal rate of return, both before- and after-tax; capital accumulation modeling and financial management rate of return.

The sale-leaseback strategy provides an alternative to ownership, which is leasing. “You don’t need to own your real estate but control it” through a well-structured lease. The evaluation of the sale-leaseback transaction has many integral parts for both the company and the investor. When properly structured, it is a win-win situation for both.

Of course, it is important to have an experienced and knowledgeable commercial real estate team working with you as you consider this option.