A sale-leaseback transaction can raise needed cash for a seller who owns commercial real property, while at the same time, enable the seller to remain and operate the property as buyer’s tenant effective upon closing the sale. This article reviews certain benefits and pitfalls associated with a sale-leaseback transaction. The key is to qualify the transaction as a sale with an operating lease (not a finance lease).
Typical Benefits and Risks:
A “sale-leaseback” is essentially two transactions bundled together, wherein the seller agrees to sell the property, and simultaneously, the buyer agrees to lease the property back to seller effective upon closing. If the seller has significant equity in the property, the sale can generate substantial cash which the seller may need to fund current operations, or use for expansion, a new venture, or alternative investment. A sale can be less expensive than conventional refinancing to raise capital, and the seller’s balance sheet is improved if existing mortgage debt is satisfied by the sale proceeds. The buyer acquires the risk of property ownership, but with the right to control its occupancy, the tax benefits arising from depreciation, and any appreciation in value. In addition, the lease customarily provides a long-term source of rental income to the buyer (as landlord), with the seller (as tenant) being obligated to pay insurance, maintenance, real estate taxes, and operating expenses applicable to the property for the duration of the lease.
Will Your Transaction Qualify as a Sale?
Structuring the transaction requires attention to accounting standards. The transaction needs to first qualify as a “sale.” Ideally, there should be: (a) the existence of a written sales contract with a seller who holds legal title and control over the property, with (b) a transfer of title and control to the buyer upon exchange of consideration. Transfer of control is reviewed primarily from the buyer’s perspective. To establish control, the buyer must possess substantially all of the benefits associated with the property’s ownership. A key control indicator, of course, is the seller’s delivery of a deed at closing which transfers legal title to the buyer.
Will Your Lease Qualify as an Operating Lease?
The lease between the seller and buyer needs to qualify as an “operating lease.” A different classification of the lease can disqualify the transaction as a sale-leaseback and affect the amount and timing of recording the lease income and expense on the books of seller and buyer. To be classified as an operating lease, the parties should exclude the following provisions from the lease:
- a transfer of ownership to the tenant at lease expiration,
- the inclusion of an option to repurchase the leased property that the tenant is reasonably certain to exercise,
- a lease term which covers a “major part” of the remaining economic life of the property,
- total consideration paid to the landlord which represents “substantially all” of the property’s fair value, and
- a situation where the tenant’s use of the property is so specialized that the property has no alternative use to the landlord at the end of the lease term.
The Sale-Leaseback Agreement:
A written purchase and sale agreement is essential to memorialize the rights and obligations of each party, with no ambiguity as to the agreed terms. The agreement should affirm that it is the mutual intent of the parties that: (a) the transaction will result in a complete transfer of legal and equitable title to the buyer at closing; (b) upon such closing the buyer shall have control over the Property with the authority to lease the property to the seller; (c) each party shall report the lease as a true operating lease and not a finance lease (or other financing arrangement); and (d) no agreement between the parties shall be construed to create a joint venture or partnership. A lease which contains construction commitments, variable rent payments (such as percentage rent), a seller repurchase option or right of first refusal, or a buyer put option will each require additional scrutiny.
While a sale-leaseback can offer may benefits, the structuring can be complex. The proposed sale-leaseback agreement and the lease should both be examined in consultation with professionals. Failure to do so can result in the transaction being treated as a finance lease – which will have unintended financial consequences.