Alon Domb Head of Corporate
Raising capital from real estate: sale and leasebacks as an alternative to debt financing
This article compares sale and leasebacks and debt financing from the perspective of a corporate occupier seeking to raise capital from their real estate assets.
What is a sale and leaseback?
A sale and leaseback of real estate involves the owner of a property selling the property to a third party investor for a lump sum payment, after which the investor then immediately leases the property back to the corporate occupier for a term at an agreed rent. The result is that the corporate occupier ceases to own the property but can continue to occupy it, and the investor acquires an investment property with a tenant (i.e. the corporate occupier) already in place.
Sale and leasebacks have been a popular choice for corporate occupiers seeking to raise capital from their real estate assets for many years. A perceived advantage of sale and leasebacks over debt financing had been the off balance sheet accounting treatment of the leaseback; however, with the introduction of the new lease accounting standard IFRS 16, corporate occupiers will now be required to report liabilities for the leaseback on their balance sheet for annual periods commencing on or after 1 January 2019.
Raising more capital
The amount that can be raised through debt financing will typically be constrained to a percentage of the value of the property, which at present is generally set at 60-70%. This can be contrasted with a sale and leaseback, where a corporate occupier would receive all of the proceeds from the sale of the property (i.e. 100% of the value of the property), less the costs of sale and any applicable taxes. A sale and leaseback may therefore allow a corporate occupier to raise more capital than they could achieve through debt finance.
Raising capital without incurring debt
A corporate occupier may be restricted from incurring debt by its constitution, by contractual arrangements or by the terms of existing financing arrangements. They may accordingly turn to a sale and leaseback as a way of raising capital when the option of debt finance is for whatever reason unavailable.
Deductibility of rental payments
With a sale and leaseback, a corporate occupier is entitled to deduct the full amount of the rental payments under the leaseback as an operating cost of the business, whereas if they opted for debt financing they would only be able to deduct interest payments (and not principal repayments). A sale and leaseback may accordingly offer corporate occupiers a tax advantage over debt finance.
Balance sheet benefits
The introduction of IFRS 16 means that liabilities under a leaseback now need to be reported on the balance sheet. However, as it is only the present value of the rental payments under the leaseback that must be reported, a sale and leaseback may still have less of a balance sheet impact than debt financing, which requires the entire principal amount of the debt to be reported.
A corporate occupier may have less operational flexibility (e.g. with regards to alterations, permitted use and sharing occupation) if they opt to become a tenant under a sale and leaseback than if they instead raise capital through debt finance and remain the owner of the property. This will however depend on what can be negotiated. With a sale and leaseback, a corporate occupier may be able to negotiate some flexibility into the leaseback so as to facilitate their expected future operational requirements. With debt finance, whilst the corporate occupier remains the owner of the property, they will cease to have an unfettered discretion in their use and operation of the property as the finance documents will typically include covenants governing what they can and cannot do, so again operational flexibility will depend upon what can be negotiated.
Although the leaseback will typically be made on a full repairing and insuring basis, a corporate occupier may be able to pass certain ownership risks (e.g. the risk of uninsured damage and the risk of defects in newly constructed buildings) to an investor, which clearly the corporate occupier would remain liable for if they instead opted to remain the owner of the property and raise capital through debt financing.
Property cycle risk
Corporate occupiers have often been able to time sale and leasebacks to coincide with booms in the cycle, allowing them to realise gains and/or reduce exposure to losses from later slumps. However, as rental values will typically be high when capital values are high, corporate occupiers may later find themselves obliged to make rental payments that are higher than prevailing market rental values, particularly as leasebacks will typically feature upward only rent reviews. The corporate occupier would also forego entitlement to any future capital growth, which would accrue to the investor as the owner of the property. Corporate occupiers will need to consider all of these factors when determining whether a sale and leaseback (with an obligation to pay rent, but no residual value risk) or debt financing (with no obligation to pay rent, but continued residual value risk) is preferred.
Historically sale and leasebacks were negatively perceived as businesses prioritising their short term cashflow and profitability over their long term security and stability. However, as it has become more common for businesses in the UK to lease rather than own their premises, and as blue chips (including, in recent years, DHL, Goldman Sachs and Tesco) have opted for sale and leasebacks of their UK property, sale and leasebacks are increasingly seen as a sensible option for corporate occupiers to consider as part of their real estate strategy, and may even be perceived more positively than increasing leverage through debt finance would.
Does a sale and leaseback remain a viable alternative to debt finance?
IFRS 16 may have reduced the appeal of sale and leasebacks to certain corporate occupiers; however, they may still offer advantages to corporate occupiers over alternative methods of raising capital from real estate assets, typically being debt finance. Corporate occupiers will need to consider all of the above factors (amongst others) in the context of their business and obtain professional advice (from accountants and lawyers, amongst others) to determine the best option and (if relevant) to ensure that any sale and leaseback is appropriately structured.
Ince Gordon Dadds has advised on sale and leasebacks, debt financing and other forms of transactions where the aim is to raise capital from real estate assets.
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