Profits and Control Through a Sale Leaseback

Real estate may be an asset, but it might not always be a good investment if you are an owner/occupant. As a general rule, the value of a real estate investment is dependent on the length of a tenant’s lease, quality or credit worthiness of the tenant, location and reuse potential of the building. Long-term lease agreements with credit tenants eliminate an investor’s risk regarding the cost and expense associated with re-leasing a vacant building. A popular method of real estate investing is known as a sale leaseback, which is the sale of an owner/occupied building to an investor in exchange for a long-term lease commitment by the owner/occupant. This strategy has been used by corporations and individual owners and can provide many immediate and long-term benefits.

My Building is My Retirement Plan

Many owners/occupants feel that when they are ready to retire they can sell their real estate to generate a significant amount of cash for their golden years or pass the building on to their heirs. There are several potential problems with this concept that should be considered:

• Who will lease the building and for how long?

• What is the credit worthiness of the new tenant?

• What will the market conditions be like in 15 to 20 years?

• What will the condition of the building be like in 15 to 20 years?

• What costs will be incurred to keep the building up for the next 15 to 20 years?

• What will the surrounding area be like in 15 to 20 years?

• How much will it cost to get a new tenant?

Consider past events, such as 18 percent mortgage rates in the late 1970s, the savings and loan crisis in the1980s, the over-building in the 1990s, world events like 9/11, or today’s threat of a recession that negatively impacted the ability to sell real estate. Each of these events led to turmoil in the real estate industry, resulting in downward pressure on real estate values. Therefore, market conditions beyond your control could result in a decrease in a property’s value at a time when you are trying to maximize it.

Determining Value

A long-term lease with a strong credit tenant will generate the highest price in the market. Consider Walgreens or CVS; they are publicly traded and typically offer investors a 25-year lease term. For this investors are willing to accept lower rates of returns for the reduced risk that this type of tenant provides. While most companies are not in the same financial league as Walgreens and CVS, they can still attract a large number of investors who would be willing to accept a lease from a company that will commit to a 10- to 15-year lease term.

Investors typically capitalize the net operating income (NOI) to determine the amount they would be willing to pay for the property. This is achieved by dividing the NOI by a desired rate of return (cap rate). For example, an investor who would like an unleveraged (no loan) rate of return equal to 8 percent would divide the NOI by 8 percent. A cap rate is also a measure of risk. The longer a lease term and the credit worthiness of a tenant equates to less risk, resulting in a lower rate of return than an investor is willing to accept. The lower the cap rate the higher the price that can be achieved from the sale of a property.

Advantages of a Sale/Leaseback

When considering a sale leaseback, an owner/occupant should consult with their team of financial advisors to review how a sale would impact their personal situation. However, from a general perspective a sale leaseback will provide the following advantages:

Immediate benefits

• Unlocks capital used to acquire the property plus any sales profits

• Decreases debt

• Improves financial ratios

• 100 percent deductible rental payments

• Capital gains are currently taxed at 15 percent

• Frees up capital to purchase other investments or to expand the business

Long-range benefits

• Provides the ability to relocate if market or business conditions change, when the lease expires.

• Provides the ability to sublease space if the building is no longer needed

• Limits financial exposure for costs required to make capital improvements

• Limits financial exposure for costs required to re-let the building

• The ability to adjust rents based on market conditions

Real Estate Cycle

A sale leaseback is the final phase of the real estate cycle. Owners/occupants should evaluate the risk of staying in an investment too long. A sale leaseback will enable you to plan your future rather than being forced to react to unknown circumstances that are beyond your control. The next time you see a vacant building ask yourself, “Is this property worth more today vacant or when it had a tenant committed to a long-term lease?” 

Michael Zelnik CCIM, SIOR, is senior vice president of Equity Inc. and is responsible for client representation, site selection and investment sales. He can be reached at 877-ZEL-NICK or mike@44usa.com.

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