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By Joseph A. Fisher | Summer 2020
With the commercial real estate industry facing significant instability for the foreseeable future, businesses may need access to cash to keep the lights on. This need extends from the biggest of big-box stores to the smallest mom-and-pop storefronts; COVID-19 isn’t too discriminating when it comes to its impact on businesses. The sale-leaseback is a transaction that has long been a common tool available to CRE professionals. But these days, it might prove especially valuable to help a cash-strapped company survive an unprecedented time.
Basically, the sale-leaseback is an avenue for a business to improve its cash position by selling owned real estate while retaining the right to use the property through a long-term lease. Potential investors, meanwhile, are looking for quality income-producing real estate with a tenant (or tenants) who is willing to sign a long-term lease. Sounds like a win-win, right? The tenant receives an influx of cash that will improve its ability to operate in the immediate future; the buyer makes a long-term investment while managing risk with an established tenant. Both sides of a deal address their priorities.
Sale-leaseback transactions come in all shapes and sizes, which shows the wide appeal of the potential benefits. Recently, as the coronavirus pandemic continues to wreak havoc on the global economy, discount retailer Big Lots completed sale-leasebacks on four distribution centers, collecting roughly $550 million after taxes and expenses. But many much smaller businesses can also benefit, such as law firms and medical practices that own their real estate.
The lease commitment in a sale-leaseback is usually 10 to 15 years. Use of the sale-leaseback allows the seller to convert owned real estate to cash at long-term rates and allows them to realize 100 percent of the asset’s available value – compared to, say, accessing 70 percent of an asset’s value through bank debt. By using the available cash from the real estate, the seller preserves its borrowing limit access to the debt market for the future. With the long-term lease, the business also retains the ability to maintain control of the facility’s operation, maintenance, and potential alterations.
Nothing is too good to be true, and, accordingly, sale-leasebacks come with risks. By disposing of its real estate asset, the selling business gives up the right to any appreciation of the asset that might be realized in the future. Additionally, the long-term lease removes the flexibility to benefit if rental rates move downward. The disposition also means that the seller/lessee may be subject to relocation at the end of the primary lease period. By negotiating options to renew the lease, the business protects itself against relocation as well as upward movements in the rent cost of the space.
For the investor, the sale-leaseback represents an opportunity to acquire an attractive real estate investment with a long-term income stream from a selling tenant with good credit. The investor can then earn a reasonable yield with a reasonable risk profile. But the investor still carries some risk should the commercial real estate market decline or the tenant becomes unable to fulfill the lease. If a sale-leaseback transaction took place in December 2019, for example, the investor could be facing difficulty related to the impact of COVID-19.
There is one particular market that’s ripe for the sale-leaseback transaction. With U.S. corporations owning nearly $2.5 trillion of real estate, that capital might be of better use to the companies if that real estate were sold and leased back. The returns that are available from real estate are typically less than returns for a corporation’s core business, creating positive leverage by converting the value of real estate to cash for the business. Additionally, individuals or group ownership entities that own the real estate they occupy for their business would find this transaction beneficial. Medical and other professional practices are two good examples of types of companies that should consider sale-leaseback.
A Hypothetical Sale-Leaseback
The Orthopedic Clinic purchased a second-generation 6,000-square-foot office building 10 years ago for its private medical practice. The corporation paid all cash for the building, with the following terms of the purchase:
- Purchase price: $775,000
- Acquisition costs: $7,750
- Improvement/land allocation: 80/20
The appraised value today is $937,500. The Orthopedic Clinic has an offer from an investor to purchase the building for the appraised value and would lease the building back to the Orthopedic Clinic with an absolute net lease for 10 years. The net lease payments would be $75,000 per year for the first five years, with a 10 percent increase for years 6 through 10. For analysis purposes, assume the lease payments would be payable annually at the end of the year. The cost for The Orthopedic Clinic to sell the building today would be 5 percent. The Orthopedic Clinic’s after-tax weighted average cost of capital is 6 percent, and their tax rate for all income is 21 percent. The Orthopedic Clinic’s incremental borrowing rate is 5.75 percent.
The projected annual growth in value of the property is 3 percent per year and the projected cost of sale at the end of the projected occupancy period is 5 percent. The Orthopedic Clinic has retained your firm to perform an after-tax sale-leaseback analysis and help them determine whether they should continue to own their building or accept the offer to sell and leaseback to occupy the building for the next 10 years.
- What are the net present values of continued ownership versus sell and leaseback? The NPV of both positions calculated at the user’s cost of capital provides the economic benefit of both positions over the projected analysis period in present value money – the larger value indicating the better decision between the alternatives.
- What sale price at the end of the holding period of the continue to own option would equalize the net present values of the two alternatives? The continue-to-own value is the present value of the annual ownership cash flows and the sales proceeds discounted to EOY 0. For the sale-leaseback, this value is the present value of the cash received at sale reduced by the present value of the lease cash outflows over the analysis period.
- What is the after-tax cost of the capital raised in the sale-leaseback? 8.5 percent.
- How does the before- and after-tax amount and cost of funds raised from the sale-leaseback compare to the before- and after-tax amount and cost of funds raised from conventional financing?
The before-tax sale proceeds from the sale-leaseback are typically greater than the before-tax proceeds from a conventional finance or refinance of the property, and the before-tax cost of the funds raised from the sale-leaseback is usually greater than the before-tax cost of the funds raised from the finance or refinance. The after-tax sale proceeds from the sale-leaseback may be more or less than the after-tax proceeds from conventional financing, and the after-tax cost of the funds raised from the sale-leaseback may be more or less than the after-tax cost of conventional financing.
While commercial real estate reacts to a quickly changing world, the sale-leaseback could be a solution that matches businesses looking for cash with investors looking for
Joseph A. Fisher, CCIM, is the president of Fisher Investment Real Estate in Indianapolis. Fisher has been a CCIM Institute instructor since 1980 and was CCIM Institute president in 2007. Contact him at firstname.lastname@example.org.