Utah Commercial Real Estate

Over the course of my career I have been involved in many transactions in the sale/leaseback arena of the commercial real estate investment world, and I have completed numerous transactions ranging from small single-tenant deals to very large industrial properties. There has been much written on the benefits of a sale/leaseback to the seller in a commercial real estate transaction. In this post I would like to explore the sale/leaseback investment from the point of view of the investor.

What is a Sale/Leaseback?

First, let’s define what is meant with the term “sale/leaseback.” A sale/leaseback is a financial transaction where an owner sells its property and then immediately leases it back from the buyer as part of the same transaction. The seller gets the profits from the sale while keeping possession and use of the property, while the buyer is assured immediate long-term income on the property.

Benefits

To understand this from a commercial real estate investor’s point of view, we must first examine the reasons why a seller would consider such an option. The benefits for the seller of the property would include:

• Liquidating equity into cash
• Potentially reducing operating costs
• Paying off existing debt
• Improving the balance sheet
• Strategically planning for a future sale of the business
• Retirement strategy

Of these, raising cash for the growth of the business is the most typical reason I have seen for sale/leaseback. Most companies make a much better rate of return in their business than they do in their business real estate. It is also easier and less expensive to raise cash for growth and operations by selling their property than it is to bring in investor capital, partners or bank financing. The following link contains a placemat that we use when working with sellers on sale/leasebacks, including a sampling of some recent commercial real estate transactions that we have completed:

Sale-Leaseback Placemat  (click for samples of properties sold)

With that context in mind, let’s look at this more closely from the perspective of the commercial real estate investor. Why would an investor look for a sale/leaseback strategy as opposed to a more standard real estate investment model?

1. Potential For a Higher Rate of Return: The capitalization rates for sale/leasebacks tend to be a little higher than traditional commercial real estate investments. Sale/leasebacks are often perceived as more risky and the motives of the seller are in question. Additionally, these types of commercial real estate transactions are performed more often by local and regional companies than national credit tenants, which also affects the rate of return.
2. Ability to Negotiate Lease Terms with the Tenant/Seller: In a sale/leaseback, not only are you negotiating the purchase, you are also negotiating the lease. The lease amount, rent escalations, lease term and other lease considerations are all on the table, unlike a traditional commercial real estate investment where you are buying a lease that is already in place. Therefore, a lease may be modified and tailored to better suit an investor’s specific requirements.
3. Obtaining Longer Lease Term: A critical point for the seller of the property is to maintain control of the property for as long as they are able. This means that sellers are often willing to sign much longer-term leases. Depending on the rent escalation schedule, this can be a real advantage to a commercial real estate investor.
4. Control of Expenses: The most typical structure in a sale/leaseback is an absolute NNN lease. The sellers are used to paying the expenses and want to have the ability to control those expenses in the future. Commercial real estate investors can often expect a transaction with no building maintenance or expense responsibilities.
5. Minimal Property Management: Because the operating expenses are usually paid by the seller, going forward there is really very little management for the new commercial real estate investor.

Risks

With those benefits in mind we must also consider the risks associated with this type of commercial real estate investment. Investment risks include loss in value of the real estate in a bad market and inflation on a lease with no rent escalations. The largest risk is the overall success or failure of the seller/tenant. A commercial real estate investor must have the ability to review and understand financial statements or hire that expertise in a transaction of this type to make sure that the company’s overall health is good. It is also important to look at what this new rent payment will do to their financial picture. There are a few things that I look for when evaluating a sale/leaseback transaction such as:

• What does the company plan to do with the proceeds from the sale? Are they being reinvested back into the company? If so, in what? Are the funds from the sale being used to pay off debt? Are the proceeds going to be distributed to shareholders?
• Is this building a critical component of their business? How easy would it be for the lessee to move or to close this location if things go bad?
• Is the building functional and marketable if the worst happened and the business did close?
• How does the proposed rent schedule compare to what current lease rates are in the market?
• How does the price being paid for the building compare to sales of vacant buildings in the area?

You must make sure that the company has good intentions and is not planning to take its cash with no intention to continue operations and make lease payments. I have had clients evaluate a company interested in a sale/leaseback only to determine that they are not strong enough to support the negotiated lease. In some cases, they have been able to overcome that discovery by obtaining “credit enhancements” from the sellers. These are usually in the form of personal or other financial guarantees of payment. However, on some occasions, we have been able to negotiate provisions whereby the seller provides a security deposit equal to 6 months to 18 months of rent that is released to the commercial real estate buyer in the case of a default on the lease.

The types of commercial real estate investors buying sale/leaseback properties range from large institutional buyers focused exclusively on this property type to small local investors with only one or two real estate properties in their portfolio. I hope this exercise proves helpful as you consider this type of commercial real estate investment for your portfolio.