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Advantages & Disadvantages of a Sale and Leaseback transaction

Advantages & Disadvantages of a Sale and Leaseback transaction

After a tumultuous start to 2020, the sale and leaseback market has been one of the most active sectors of the Commercial Real Estate market. The Pandemic has created uncertainty that has wide-ranging implications. For some businesses, it has constituted a temporary decline in activity and associated liquidity problems. For others, it has accelerated demand (especially those with an online presence).

What are Sale and Leaseback Transactions?

A sale and leaseback is a transaction in which a party sells a real estate asset with an agreement to lease the property back at an agreed rental rate and term. As the selling entity has freedom in the establishment of the lease, they can create terms that provide appropriate flexibility for the future. For the purchaser, the leased property will often represent an attractive, stable, long-term investment.

While sale and leasebacks are often utilised by companies looking to recycle capital back into their core business, other factors must be considered when weighing a lease versus own decision.

Opportunity Cost of Capital

The primary consideration for a company investigating a sale and leaseback is the "opportunity cost of capital"; companies have limited capital reserves so should aim to allocate them most efficiently. Ideally, businesses will prioritise, generating a higher return from their core business rather than the return from a commercial property.

For example, if a company is generating a 15% return from capital invested in the core business, it is inefficient to retain a property with a market yield of 5%. In this scenario, the company would generate an additional 10% annually by reallocating the property investment back into the business.

While this is an oversimplified example (capital growth has been ignored in both cases), the opportunity cost of capital is a vital consideration in allocating company resources efficiently.

Opportunity cost also applies to the rent component of owning and occupying. When a business owns and tenants a building, they are not obligated to pay an annual rent. Due to this, some owners perceive themselves as occupying the space for free. However, the company is effectively paying rent by sacrificing the income that they could receive if they were to tenant the property to another company.

Advantages of a Sale and Leaseback

The benefits to businesses considering a sale and leaseback are varied but include:

  • Operational flexibility – cash out now, allowing a business to stay or move premises in the future as the company expands/contracts
  • Restore finances – bolster the firm's balance sheet by reducing debt and improving free cash flow
  • Secure attractive prices and terms – long term leased investments with committed tenants appeal to both purchasers and sellers; especially in low-interest-rate environments. A company that has occupied a premise over a long period may choose to crystallise capital gains while ensuring tenure security by writing a long-term lease
  • Reduce risk – A business which owns its real estate is exposed to both real estate market risk (the risk that property prices move adversely) and company-specific risk (the risk that the economics of the underlying firm negatively affect profitability). By selling the underlying property, a firm can reduce exposure to real estate risk and in effect, partially reduce total risk to the company.

Flexibility of Terms

A company must evaluate its future needs and the consequences of exiting a property asset when engaging in a sale and leaseback arrangement. It's essential to establish the length of tenure and renewal provisions in a contract if the intention is to remain at the property for an extended period.

As the lease is often created to start on the settlement, there exists an opportunity to formulate collaborative lease terms that suit both vendor and purchaser requirements.

Disadvantages of a Sale and Leaseback

As this arrangement often creates a long-term financial commitment, every company will have different operating objectives and mandates to consider; some of which may not be in favour of selling the real estate.

Retaining ownership of a property can be viewed as diversification away from the core business. As the property is considered a defensive asset class, it may be more enduring for some companies to retain the asset as a store of capital to balance the risk of the core business.

Additionally, forfeiting operational control can be challenging for an owner-occupier as they will often be used to self-managing the property. Selling the asset also means relinquishing control over the premises to another party, which may be unpalatable. Special consideration should be made in scenarios where a company has a highly specialised fit-out, as future relocation can be cost-prohibitive. This can reduce their ability to negotiate future rent reviews and may make it unwise to sell.

Key Takeaways

Efficient capital allocation is an imperative consideration for all business owners. Sale and leaseback transactions are worthwhile considerations for companies looking to pull-back or reallocate capital. In uncertain times, ensuring the balance sheet is conservatively positioned, or having the capital flexibility to seize growth opportunities can only be advantageous.

It provides the ability to reposition a company through debt reduction and/or increasing capital reserves to take advantage of future opportunities.

The Jasper platform is designed to make the sale and leaseback process simple for prospective vendors. Jasper's platform is developed to allow for fractional ownership. This opens up the possibility of selling down a percentage of an asset rather than the whole property. Scenarios where this may be particularly useful include where only one partner wishes to exit, or where a company needs to release a specific amount of capital but still wants to retain operational control.

Business needs are always changing; our platform has been developed to enhance flexibility for decision-makers. If your business is considering a sale and leaseback, we will welcome the opportunity to speak with you about it.

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Vernon Sequeira - Jasper

Vernon Sequeira

Investment Manager

Posted on 3 Jan 2021

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