RSM Resources

When the U.S. stock market nose-dived several years ago, many homeowners tapped into home equity as an alternative way to finance big-ticket remodeling projects. Now, more business owners are finding that sale-leaseback transactions can provide many of the same benefits.

The basic concept of a sale-leaseback arrangement is simple: A business sells a parcel of its real estate to a third party that, in turn,leases the site back to the company. The lease payments usually enable the buyer to recover its original investment, plus interest. Meanwhile,the seller can use the proceeds for capital improvements or other expansion opportunities.

For a number of reasons, sale-leaseback arrangements are becoming a popular tool for companies to unlock new sources of capital. Since the financial scandals that took place earlier this decade, so-called "synthetic leases" — those structured as a lease for accounting purposes but reported as a loan for tax purposes— draw unfavorable scrutiny from the IRS. Conversely, the IRS views a well-designed sale-leaseback transaction as a lease on both sides of the ledger.

Because of the confluence of low interest rates,attractive debt financing and a pervasive belief that real estate maybe a safer long-term investment than stocks, sale-leaseback deals have gained popularity among private and institutional investors. Industry observers note that reasonable pricing on free-standing restaurant properties — long favored by real estate investors for predictable cash flow — is becoming harder to find. That discovery is good news for owners of midsized businesses considering a sale-leaseback deal, since prospective buyers are broadening their search into new markets such as hospitality properties, shopping centers, office and industrial buildings, marinas, campgrounds, and condominiums.

Benefits

While a strong seller’s market is a good time to consider a sale-leaseback deal, experts say business leaders should look closely at the pros and cons of such an arrangement. Generally, the advantages include:

Better use of assets. A sale-leaseback arrangement converts equity in land or property to cash, allowing the seller to retain use and control of the asset. While a conventional financing package might limit a business owner’s borrowing capacity to 80 percent of the property’s appraised value, a sale-leaseback deal can usually deliver full value, less any required capital gains taxes.

Improved cash flow. A sale-leaseback deal can be an "off-the-balance sheet" way to boost cash flow without creating new mortgage or loan debt. This often reduces the company’s "book value," which can improve overall return on assets. And, the monthly payment under a sale-leaseback arrangement is often less than the cost of borrowing a comparable amount of money using conventional financing.

Potential for flexible terms. Because of the strong demand for sale-leaseback deals, sellers can negotiate favorable terms. This may include the ability to fix lease costs with little or no price adjustments for inflation, a stepped schedule that includes lower payments in the early years, and wide latitude on any required insurance or environmental provisions in the agreement. Most frequently, a sale-leaseback arrangement allows the seller to retain full operational control of the property.

Lease deductibility. Under a well-documented sale-leaseback deal, the value of the land on which the property sits can factor into a lease payment that is tax-deductible. That makes this form of financing very attractive from an after-tax viewpoint, because IRS rules do not allow companies to depreciate the value of land under other circumstances.

Drawbacks

The sale-leaseback approach is not without risk. Donald Valachi, clinical professor of real estate at California State University — Fullerton,noted these potential pitfalls in Commercial Investment Real Estate magazine:

Loss of residual property value. The major disadvantage of a sale-leaseback transaction is that the seller transfers title to the buyer, Valachi says. While owners can minimize this issue by inserting a repurchase option in the deal, that change will cause the sale-leaseback arrangement to be recorded as an asset, and therefore capitalized. For that reason, the company needs to show the obligation to make future lease payments as a liability on the balance sheet.

Possible relocation. At the end of a lease without any renewal options, the seller may need to negotiate an extension of the lease at current market rent or be forced to relocate any business operations in that facility.

Loss of flexibility. While the strength of today’s sale-leaseback market gives sellers some latitude on terms, Valachi points out that if companies don’t negotiate upfront, they can lose the flexibility associated with property ownership. This can include changing or discontinuing the use of the property or modifying a building. Long term, if the seller wants to improve the leased property, conventional financing may be difficult to obtain when a leasehold interest secures the obligation.

Higher-than-market lease payments. If the rental market softens, a company may find itself locked into a rental rate negotiated at the original date of the sale-leaseback deal. Such payments typically cannot be adjusted without the buyer’s consent.

Buyer bankruptcy. If the buyer in a sale-leaseback situation files for bankruptcy, Valachi says, companies can find themselves before the bankruptcy trustee, who may reject any agreement to renew the leaseback or the seller’s option to repurchase the property.

Is a sale-leaseback arrangement the right way foryour business to free up capital for expansion or investment? By considering these pros and cons, and by consulting with a qualified accounting or tax professional, you can make a sound decision on the best option for your company.