As alternative lenders proliferate in the marketplace, and get more aggressive with how they lend money, you may be asked to entertain a sale and leaseback of certain properties.
A sale leaseback occurs when you sell your property to an investor who then leases the property back to you for a predetermined lease rate. Why would you want to do this? Usually, because you want cash. Here are the considerations for this type of transaction.
Tax consequences – Remember that when you sell an asset, likely at a price that is far greater than the book value on the financial statement, you cause a taxable gain on sale. Although the technique may be attractive to bring old assets up to current market value, the tax penalty may outweigh the cash benefit.
A lease payment, however, is fully deductible. In most cases, writing off the lease payment will give you a larger monthly deduction than the loan interest and depreciation when you owned the property. Be sure to check with your CPA and have him run the numbers so you know the exact tax implication.
Future value of property – By selling your property now, you lose the potential for any future cash that would be created through appreciation in the years ahead. Most investors are savvy to the potential in a particular site. If an investor seems particularly interested in your location, you may be missing a hidden opportunity.
For instance, one southeast marketer had a waterfront bulk plant. He thought his site could command a premium as a waterfront restaurant/retail location, but not as a bulkplant Most non-industry buyers he approached, however, were not overly keen on a petroleum site.
His solution was to move his operations inland, bulldoze his site and remove the tanks (which luckily were not leaking). This left a nice, clean piece of waterfront dirt which he was able to sell for many times what he would have received for his old bulk plant!
Although moving your entire operation may not be a very comfortable thought, always consider the highest and best use for each of your real estate assets. For the right price, you can always start over in a different location.
Conversely, if you are on a site that may decrease in value in the future, you may be very wise to go proceed with a sale leaseback now, while the property is at its peak. You may even want to add a “Buy-Back” provision that will allow you to acquire the property back at a future date if the price declines.
Lease length – One advantage of leasing is that leases can often be written for longer terms than traditional bank loans. This long lease term helps to lower monthly costs and is great for predictable cash flows.
The disadvantage to leasing, however, is that the lease expiration may come at an inopportune time. If you work with shorter leases, be sure that lease renewal options are clearly spelled out in your documents.
Commitment to lease – With a sale leaseback, you are committing to make payments over the entire life of the lease. If you negotiate a long lease, which of course is helpful to your cash flow, you are obligated to keep making payments regardless of the ongoing operation of your business. If your business stops, you still pay! To protect yourself, any lease should allow you the ability to sub-let.
Use of cash – What exactly can you do with the cash you gain from selling your property? For a sale leaseback to be advantageous, you must be able to parlay the proceeds into an investment or savings that exceeds the lease cost. This may mean growing your business through purchase of a competitor, expanding locations or perhaps paying off debt. It’s great to get a hunk of cash, but you must put it to good use to make the sale worthwhile.
Balance sheet issues – Consider how your balance sheet will look once the sale has occurred. What will happen is that the asset, its accumulated depreciation, and any related debt will come off your balance sheet. Depending upon your individual situation, this may or may not be a favorable change for you.
Run the numbers and then check your owner’s equity percentage (net worth divided by total assets) and debt to worth (total liabilities divided by net worth). If the equity percentage decreases, or the debt to worth increases from the sale, you will have weakened your balance sheet position by proceeding.
On the other hand, if there is a considerable amount of cash to be had by selling your property, and you use that cash to pay off debt, you will likely find a much stronger balance sheet by proceeding with your sale.
Effect on lender ratios – When you own your property, lenders treat depreciation as non-cash expense and typically add it back to your profits for the purpose of determining your borrowing capacity. When you sell your property, you trade depreciation (non-cash) for lease payments (cash). Therefore, although your bottom-line may not decrease if the lease payment is less than or equal to your present depreciation and interest payments, your cash available for debt service will be less.
To protect yourself, check to see how the lease payments would effect any loan covenants that may be in place. If you find difficulty meeting the covenants, but you are still firmly convinced you should do the sale leaseback, discuss your decision and its impacts with your lender. If the sale leaseback is advantageous to your company, the lender should be flexible enough to modify your covenants.
If the lender refuses to modify your covenants, consider paying off your debt with your sale proceeds, or bidding out your lending needs to other lenders.
Future improvements – As a tenant, you can deduct the cost of any property improvements through depreciation, exactly in the same way you would as the owner of the property. Since you may eventually walk away from the property, however, be sure your documentation is clear about the ownership rights of any improvements at the conclusion of the lease, or in the event of forfeit or non-payment of the lease.
If you decide to investigate a sale leaseback, talk to commercial real estate brokers in your marketplace as well as national lending groups. Often, local investor groups are more flexible with less onerous documentation. And, as with all transactions, be sure to have your attorney review all documents before proceeding.
