The sale-leaseback market has seen a boost in recent months. Current signs in 2023 suggest a surge of confidence in the sale-leaseback market due to multiple reasons that go beyond simply higher yields.
Many of the companies behind these leases demonstrate successful processes with robust business models and “stronger than you think” credit. This has garnered considerable investor interest, even in non-core markets and, even further, those properties in the industrial distribution sector.
Let’s examine why a sale-leaseback should be considered for businesses that own their real estate.
Alternative to Conventional Financing. Businesses (“Tenant/s”) can structure the initial lease term for a period that meets its needs without the burden of balloon payments, call provisions, refinancing, or the other issues of conventional financing. Moreover, the tenant can avoid the substantial costs of conventional financing such as points, appraisal fees, and some legal fees. A sale-leaseback also usually provides the tenant with renewal options, while conventional mortgage financing has no guarantee for refinancing.
Improves Balance Sheet and Credit Standing. In a sale-leaseback, the tenant replaces a fixed asset (the real estate) with a current asset (the cash proceeds from the sale). If the lease is classified as an operating lease, the tenant’s rent obligation usually is disclosed in a footnote to the balance sheet rather than as a liability. This results in an increase in the tenant’s current ratio, or the ratio of current assets to current liabilities – which often serves as an indicator of a tenant’s ability to service its short-term debt obligations. Thus, an increased current ratio improves the tenant’s position for borrowing future additional funds.
However, if the lease is classified as a capital lease, the advantages of the sale-leaseback arrangement from an accounting perspective are altered considerably. Statement of Financial Accounting Standards No. 13 on accounting for leases requires that a capital lease be recorded as an asset and capitalized and requires the obligation to make future lease payments to be shown as a liability.
Avoid Debt Restrictions. Tenants restricted from incurring additional debt by prior loan or bond agreements may be able to circumvent these limits by using a sale-leaseback. Rent payments under a sale-leaseback usually are not considered indebtedness for such purposes, thus a tenant can meet its cash needs through the sale-leaseback without violating any previous agreements.
Use Capital for Growth. Sale-leasebacks have grown to be a primary tool to release cash for growth initiatives, particularly for companies with limited access to traditional forms of financing. Proceeds from sale-leasebacks can be routed to new investments in equipment, technology, personnel, or additional facilities. The finest element is that a sale-leaseback enables the business to raise capital without losing control of the property.
Use Capital to Consider Mergers & Acquisitions. If you’re considering acquiring a complementary business, you may need to raise additional capital to fund the purchase of the target company—or to pay down debt following an acquisition—which may be the case for companies and private equity firms alike. Usually, the cost of capital for commercial real estate investors is quite competitive as a real estate investor will acquire your property at market rate, creating an immediate arbitrage between the real estate multiple and the acquired business EBITDA multiple.
A tenant’s decision to raise funds through a sale-leaseback frequently is based on substantial income-tax advantages. These savings are an additional source of cash that the seller may use.
Deduction of Rental Payments. The main tax advantage of a valid sale-leaseback is that rental payments under the lease are fully deductible. With conventional mortgage financing, a borrower deducts interest and depreciation only. The rental deduction may exceed the depreciation in three cases: if the property consists primarily of a non-depreciable asset, such as land (although land is not depreciable, rental payments for the lease of land may be deducted); if the property has appreciated in value (while depreciation deductions are limited by the cost of the property, rental deductions may equal the fair market value of the property); or if the property has been fully depreciated.
Timing Gain and Loss Recognition. A tenant can use a sale-leaseback to time the recognition of gains or losses while retaining the use of a property. A business may want to recognize gains to use business credits or net operating loss carryovers. If the business owns appreciated property, a sale of assets will produce a gain that could be offset by the credits or net operating loss carryovers. However, if the adjusted basis of the assets exceeds its fair market value, a recognized loss will reduce tax liability.
Capital Gain-Ordinary Loss Treatment. Because the property involved in a sale-leaseback generally is held for use in the tenant’s trade or business, it qualifies for capital gain-ordinary loss treatment. Under Section 1231 of the Internal Revenue Code, if the property is held for the long-term holding period, gain on the sale, with some exceptions, will be taxable as long-term capital gain to the extent that the gain exceeds the losses in the same year from the sale of other Section 1231 property. However, the gain will be taxable as ordinary income to the extent of recapture income. But in the case that the sale results in a loss, it will be deductible in full as an ordinary loss to the extent the loss exceeds Section 1231 gains from the sale of other property in the same year. This can be a substantial advantage to the tenant/business in a sale-leaseback transaction.
Great Rivers Realty Capital, LLC can help you capitalize on current real estate market opportunities. We specialize in representing owners of net lease property, as well as companies considering a sale-leaseback of their property. Additionally, we have demonstrated notable success in sourcing direct, off-market commercial real estate investments for family offices, institutional investors and private 1031 clients, as well as the clients of wealth advisors, registered reps and CPAs. Contact us today to unlock exclusive real estate investments for you and your clients.