Legal Briefs

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 sale-leaseback.

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 portfolio.

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.

Practical Considerations

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 [email protected].

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