Looking back on my law school career, my securities class was one of the most valuable classes I took, but not for the reason you would suspect. I am not a securities lawyer, and I have never wanted to build a securities practice. I have, however, routinely used the information I learned in that class as a way to ground myself in another area of law, build on a base understanding of another concept or provide insights into a certain way of thinking on a related topic. I have used what I learned in that class exactly how the professor hoped we would – as a tool in my proverbial legal toolbox to provide value to clients by providing counsel beyond their original request and to exceed their expectations.
A sale leaseback (SLB) is a great tool in the transactional attorney’s toolbox. For a real estate practitioner or those focused on mergers and acquisitions (M&A), a SLB provides the seller of a business that has real estate holdings with an additional revenue source to justify a higher selling price. It also provides a mechanism to recapitalize a business without taking on additional investors, leveraging the business or selling the business outright. Conversely, it provides opportunities for a buyer of a company with owned real estate to capitalize on the delta between the book value of the real estate and the actual market value of a single-tenant triple net lease. Furthermore, it allows a buyer to be more aggressive in their pricing when making an offer on an opportunity, knowing that they will create value on the backend through the SLB. The remainder of this article describes the various types of net leases that may serve as the basis for a SLB, provides background on SLBs in general and evaluates the value proposition for business owners and corporations. It will also provide an example of the value that can be created through a SLB’s strategic deployment on M&A transactions.
WHAT IS A SALE LEASEBACK?
A SLB is a financial transaction where an asset owner sells that asset on the open market and leases it back from the buyer under a long-term net lease, allowing for the seller of the asset to continue to utilize the asset uninterrupted for a set period of time. While the transaction can be for any asset, historically, real estate has been the best candidate for SLBs. Through a SLB for real estate, the seller typically executes a triple net lease where the seller-turned-tenant is responsible for the majority if not all expenses relating to the property, including taxes, maintenance and/or capital improvements. Typically, the lease terms (i.e., term length, rental rate, expense structure, etc.) vary from lease to lease and, as will be discussed in more detail below, may be used as leverage to secure better pricing from the eventual purchaser of the real estate.
WHAT IS A NET LEASE?
A net lease is simply a lease where the tenant operates the building(s) and, in addition to rent, is responsible for various costs related to the operation of that building(s). There are degrees of variation in most net leases but, at the highest level, net leases can generally be broken down into two groups – no landlord responsibilities and those with some degree of landlord responsibilities.
A net lease with no landlord responsibilities is referred to as a triple net (NNN) or absolute triple net (absolute NNN) lease. In short, a NNN or absolute NNN lease provides for no landlord responsibilities with the tenant being directly responsible for all expenses, including property taxes, maintenance and capital expenses and improvements. That is, the tenant is required to coordinate and manage all maintenance, improvements and payment of all expenses associated with its operation of the building. Some professionals will make a distinction between a NNN lease and an absolute NNN lease. An absolute NNN lease is often described as “mailbox money” for the landlord because they have no responsibilities other than paying the debt service on the property, if any. Others describe this as being a simple NNN lease. Some describe a NNN lease as requiring the landlord to provide for the initial payment of the expenses and then seek reimbursement from the tenant. Under all scenarios, the tenant is ultimately responsible for the costs, but it is important to review the lease to determine the level of engagement required from the landlord and whether the expense payments are direct or reimbursed to the landlord.
Alternatively, a net lease where the landlord has levels of financial or capital repairs or improvement responsibilities is usually referred to as a double net (NN) lease. These NN leases can take on a variety of forms. For example, there are NN leases where the tenant is responsible for all expenses except specifically identified expenses, usually roof and/or structure repairs and replacement. Some NN leases require the landlord to pay for all capital expenses and improvements. Like the NNN and absolute NNN, the key is to ensure that you review the lease to determine the specific landlord obligations.
Regardless of the structure, a NNN or NN lease provides value to both the landlord and the tenant. For the landlord, a net lease property provides a very stable, nearly guaranteed long-term tenant and rental income stream with any rent escalations increasing the net operating income (NOI), since the tenant is required to pay some or all of the expenses. The net lease structure also provides limited downside risk for the landlord as there is limited exposure to the expenses and costs associated with vacancy of the property. Finally, as noted above, while there can be varying degrees of engagement required from the landlord (i.e., less for NNN and more for NN), this level of engagement is often significantly less than the time and effort required to manage a multitenant, multifamily or single-family rental asset. Similarly, tenants also prefer the net lease structure. Tenants like the stability that comes from a long-term lease as well as the ability to control many of the expenses related to the operation of the asset. Many times, there are also favorable tax treatments of operating leases versus owning the asset.
SALE LEASEBACKS FOR BUSINESS OWNERS AND CORPORATIONS
SLBs, and the resulting net lease structure, provide a variety of benefits to current business owners who own their real estate and may act as a way for owners to convert the owned real estate into capital. Business owners are often looking for ways to extract some of the equity in their businesses, but to do this, many owners wrongly believe that the only way to “cash out” is to sell some or all of the company. A SLB, however, provides a way to monetize the underlying real estate asset while providing the owner of the business with a long-term net lease to operate under. The owner can essentially “cash out” the equity in the underlying real estate while retaining ownership and operation of the overall business. In addition, the SLB provides the business owner with access to additional capital outside of the traditional financing options through the proceeds of the SLB. Financing for small businesses can be burdensome to apply for and difficult to obtain, but a SLB serves as a substitute to traditional financing. These proceeds can then be reinvested in the business through the purchase of new equipment, expanding to new lines of business, opening new operation centers or stores, hiring additional employees or acquiring other businesses.
Similarly, benefits abound for large corporations who utilize SLBs. Like the small business owner, a larger corporation can reinvest the proceeds back into its business by expanding the business, buying new equipment or investing more heavily in its employees. In addition, the proceeds can be used to pay down debt and improve the financial strength of the company. Importantly, for public companies, there is a positive correlation between market returns and those companies that utilize SLB proceeds to reinvest in the business rather than paying down debt.1
SALE LEASEBACKS IN M&A TRANSACTIONS
While SLBs create value for businesses regardless of when they occur, utilizing SLBs at the time of acquiring a new company can exponentially expand those benefits. SLBs, when used in the M&A transaction setting, capitalize on the value arbitrage as a result of the divergence between valuation multiples of the operating company and the company-owned real estate. That is, the multiple that is paid for the business (i.e., six times EBITDA, nine times EBITDA, etc.) is often much lower than the multiple that can be put on the owned real estate after the SLB transaction.
As an example, the owner of a business is selling her widget company, WidgetCo, to a private equity group, PEGroup. WidgetCo has 2018 earnings before interest, tax, depreciation and amortization (EBITDA) of $5 million and is being acquired at a six multiple (i.e., $30 million). WidgetCo has three owned locations in major markets that total 100,000 square feet with an average industrial rental rate of $8 per square foot across all three properties. PEGroup is acquiring WidgetCo with an equal debt-to-equity split.
Based on this scenario, the seller of WidgetCo is bound by the market rate multiple for her type of business. That is, while there are some small variances that can be achieved to the overall market rate, the typical sales price is limited to what the overall market is willing to pay for a widget company. In this case, there is no other way for the WidgetCo owner to extract additional value from the sale of the business beyond the market rate of a six multiple. If, however, the owner of WidgetCo proposes that PEGroup executes a SLB at the time of acquisition on the three owned properties – or if the owner executes a SLB prior to offering the business for sale – the owner can extract additional value from the real estate resulting in a sale price that could be substantially more than book value or of the six multiple that she would be getting on the business.
Here’s how this works.2 2018 EBITDA is $5 million. There is no rental expense currently because the three properties are owned. As a result, earnings before interest, tax, depreciation, amortization and rent (EBITDAR) remains at $5 million and the resulting value of the business is $30 million (i.e., $5 million multiplied by six). If, however, a SLB is executed, the overall evaluation of the business improves to $36.6 million. 2018 EBITDA remains at $5 million while EBITDAR is reduced to $4.2 million, since the business will have a new rental obligation of $800,000 per year at the conclusion of the SLB ($8 per square foot multiplied by the total square footage of the three facilities totaling 100,000 square feet). As a result, at the same six multiple, the value of the business drops to $25.2 million, a reduction of $4.8 million. If the sale of the real estate is factored in at a 7% cap rate3 with a net operating income of $800,000 through a triple net lease, the real estate is valued at $11.4 million, bringing the total value of the asset to $36.6 million – an arbitrage of $6.6 million or a 22% increase in the value of the overall business. In other words, through a SLB, the buyer bought the entire business, including the real estate, at a six multiple and then sold the real estate at a 14.3 multiple, resulting in a value creation of $6.6 million.
Importantly, as noted above, numerous factors can impact the overall value of the real estate in the context of a SLB. A longer lease term will drive higher pricing as compared to a shorter lease term. If the tenant or guarantor of the lease has investment grade credit, this will significantly impact the capitalization rate that the owner can demand for the real estate. The amount of rent charged back to the owner-turned-lessee will also impact the overall value of the SLB transaction. For example, for the WidgetCo illustration, a 50-basis-point improvement in cap rate results in an additional $900,000 in proceeds, even with the rent held constant. Lease term also has a dramatic impact on value. If the tenant agrees to a 20-year lease rather than a 10-year lease, they can expect to extract an additional $2.3 million in proceeds.
The implications of the dramatic increase in value are obvious. For a seller, they can achieve a higher value for their business through a higher multiple. More importantly, this kind of SLB analysis, at a minimum, provides a seller with the data and information they need to support an aggressive asking price, even if the price does not fully account for the full arbitrage in value created through the SLB. In the example above, this allows a seller to ask for a six and a half or seven multiple on the business rather than the market rate of six with the data to back up the increase in value that they can present to a buyer. In short, this analysis provided the seller with the most powerful weapon in a negotiation – information.
For a buyer, the value that is created through a SLB allows them to identify opportunities where the value of the real estate is significantly undervalued and allows them to be more aggressive in their pricing if they know the underlying value and economics of the real estate. In addition, a SLB provides a buyer with better financing options and, likely, the ability to bring less equity to the closing table. As illustrated above, if our example buyer, PEGroup, was going to purchase WidgetCo without a SLB, they would be required to bring $15 million in cash/equity as well as secure debt service for $15 million. In the scenario above, if PEGroup anticipated purchasing WidgetCo for $30 million but planned on doing a SLB at closing, rather than bringing the full $30 million in debt and equity at closing, they would only need to bring $19.6 million (i.e., $30 million purchase price minus the $11.4 million in proceeds from the SLB), significantly reducing their equity and debt service need.
We started this article with the premise that it is important for all attorneys, regardless of practice area, to constantly add tools to their proverbial toolboxes to enable them to provide additional value to clients beyond the client’s original request. The information you have gleaned from this article has, hopefully, provided you with another tool in your toolbox for the next time a client calls you asking about SLBs, business valuations or commercial real estate. How much value can you add to a client who is selling a business if you ask if they have considered a SLB to provide more aggressive pricing on their deal? How much value can you provide to a private equity firm acquiring a business if you ask if they have run a SLB analysis to see if there is an arbitrage that can be realized through the sale and leaseback of the owned real estate? Many times, in the practice of law, simply asking the question is just as valuable as having the answer.
1. “[W]e find abnormal market returns are positively correlated with the price-earning (P/E) ratio and negatively correlated with debt structure,” write Wells and Whitby. In short, they conclude that “the market perceives sale-and-leaseback funds likely to be used for growth as value enhancing while firms likely to use funds to meet debt obligations experience lower event returns.” Wells, Kyle and Ryan Whitby, 2012, “Evidence of Motives and Market Reactions to Sale and Leasebacks,” Journal of Applied Finance, Vol. 22, No. 1, 2012.
2. This is a very simplistic example. In practice, we would run a cash flow analysis, a real estate financing and valuation model, debt schedule, new debt amortization schedule and a new real estate debt amortization table to ensure that all necessary debt coverage rates remained intact and that no covenants from the acquiring group were breached. With that said, very rarely do we find that a SLB does not improve the financials of the overall transaction.
3. The cap rate is simply a measure of value at a moment in time. Several factors would go into this determination, including, but not limited to, length and structure of the lease, credit of the tenant and guarantor and quality of the underlying real estate.