Risk vs. Reward
Find the right balance for sale-leaseback transactions.
Today’s economic climate has forced both public and private
sectors to think outside the proverbial box to come up with innovative
financing strategies. One strategy that has recently gained popularity is the
The mechanics of a sale-leaseback are fairly straightforward. The
sale component allows the seller to shift the risks and benefits of ownership
to a third party and generate immediate profit from the sale. It also allows
the investor to purchase the asset at a fair market rate. The leaseback
component allows the seller to benefit from its continued use of the asset,
while allowing the investor to derive income generated from the long-term
rental of the property — typically 20 years to 50 years.
Sale-leasebacks have been a staple of private real estate
investors for years. Warehouses, offices, hotels, movie theatres, stores,
restaurants, and even schools have been included in sale-leaseback
transactions, which can range in size from a single property to a large
Limited financial resources have prompted some state governments
to use sale-leaseback transactions to tap into their property’s equity and use
the proceeds to solve budgetary constraints. Last year Arizona sold 14 state
buildings for $735 million. Public-sector sale-leaseback transactions such as these are similar to bond sales, where
investors purchase certificates of participation instead of outright ownership.
Sale-leaseback benefits are counterbalanced with risks, mainly
whether the influx of the sales profit outweighs the costlier rental payments
made over the term of the lease. California’s planned sale-leaseback of 11
buildings for $1.2 billion was held up by legal challenges in late December and
finally canceled by newly elected Gov. Jerry Brown. It was estimated that the
state would have paid $6 billion more than state ownership over the course of
the 35-year lease, according to the California Legislative Analyst’s Office.
While most private-sector sale-leaseback transactions lack the
political rhetoric of public offerings, buyers and sellers still must balance
risk/reward factors when making such decisions. In a sale-leaseback, the
seller’s risk is the investor’s profit. In today’s market the investor often is
acquiring the asset at a reduced market value. But depending upon the structure
of the leaseback component, the investor is likely to recoup its investment at
a premium. Leases are usually triple net, so that rent and all operational
costs related to the use and upkeep of the asset will be net to the investor.
However, below are significant risks associated with structuring the deal that
can be minimized with seeking the appropriate legal advice.
Verify seller’s commitment. The crux of making the transaction
work for both parties is the seller’s long-term commitment to use and occupy
the property for its initially intended use. Ten- and 20-year leases are quite
common in sale-leaseback transactions. For example, Inland Public Properties
Development, a subsidiary of Inland American Real Estate Investment Trust,
purchased seven public charter schools for $61 million and is leasing them back
to Imagine Schools for 20-year triple net leases, at an annual lease rate of
$4.6 million, according to Inland.
Clarify intent. As with any investment, a thorough review of the
creditworthiness of the seller/tenant is critical. In these transactions, the
seller’s credit, or lack of it, may signal an ulterior motive, such as an
intent to hide assets or avoid tax liability, which would have significant
legal implications in the event that the seller were ever audited or were to
seek bankruptcy protection. For example, if the investor/landlord were ever
forced to terminate the leasehold interest and repossess the property, the
seller/tenant may argue that the underlying intent of the transaction was to
create a mortgagor/mortagee financing arrangement, thereby allowing the
seller/tenant to seek a right of redemption. To avoid later speculation,
document each party’s intent clearly in the lease.
Know the property. The sale-leaseback transaction differs from
most other lease transactions in that the seller/tenant has more personal
knowledge about the condition of the property than the investor/landlord. To
address that issue, the lease should contain specific acknowledgements from the
seller/tenant that it is extensively familiar with the condition of the
property, there are no existing conditions affecting its use, and that it
continues to occupy the property in as-is condition.
Right of first refusal. Considering the seller/tenant’s connection
to the property, the seller/tenant may negotiate a right of first refusal to
buy back the property if the investor receives a bona fide offer from a third
party. Additionally, the tenant may negotiate a right to buy back the property
during the lease term at a fair market price. If this is the case, the investor
will want to negotiate a price with a pre-determined escalator to guarantee a
set return on the investment.
Before considering a sale-leaseback arrangement, investors should know
all of the risks and benefits associated with the structure of both the sale
and leaseback components of the deal in order to safely determine whether this
is the right strategy for both parties.
Renee Shprecher is a real
estate associate with Buchalter Nemer in Scottsdale, Ariz. Contact her at