Real Estate Sale-Leasebacks
What's the Attraction of the Net Lease Arrangement?
To most users of real estate, the control and use of a property is all that is necessary. That said, actually owning the property isn't always necessary to achieve those goals. With leasing, users can control and use properties without actually owning them.
To that end, many property owners choose to execute sale-leaseback transactions and enter into net lease arrangements on their properties. In a sale-leaseback, sellers can convert illiquid assets into cash while still retaining use of the properties. Essentially, the user sells the property to an unrelated third party and then enters into a lease for the property for a mutually agreeable term or time period.
Many companies use net leases. One example is Pier 1 Imports, where Rick Blackwelder, vice president of real estate and development, uses net leases to finance new stores, seeking favorable lease terms, minimum red tape, flexibility in the lease, and a financially strong reliable lessor.
What Is a Net Lease?
Typically, the lessee enters into a net lease for a long period of time, often consistent with a typical mortgage loan term. This is logical, because many lessors use third-party loans to finance properties. A long-term triple net-leased property that is substantially financed with nonrecourse amortizing debt is called a leveraged lease.
In a typical net lease arrangement, the lessee pays rent—sometimes called base rent—to the lessor, and also pays all of the property's operating expenses. Thus, the landlord receives a fixed rental payment, net of all property expenses. A net lease is the opposite of a gross lease, in which the lessee makes a single rental payment and the lessor pays all of the property's operating expenses.
Net leases are sometimes referred to as single net, double net, or triple net. These variations evolve out of who pays for taxes (single net), insurance (double net, also known as net net), and maintenance (triple net), according to Stephen D. Messner in his book, Analyzing Real Estate Opportunities.
There is no standard net lease form. However, many experienced practitioners use documents that emulate the provisions that are outlined in the National Association of Insurance Commissioners (NAIC) Valuation of Securities Manual in the section on credit tenant loans. The intent is to suggest lease provisions that eliminate or substantially minimize the need to underwrite lessor (and real estate operating) risk. Thus, from a lender's perspective, rent equals net operating income (NOI).
Two primary classifications of net (or triple net) leases are acceptable: bond leases and credit leases.
The bond lease requires the lessee to perform all obligations related to the leased premises. The investment community historically has defined a bond lease as a "hell-or-high-water lease," meaning that regardless of what occurs with the leased premises, the lessee is obligated to continue to pay rent. Therefore, the focus is on the lessee's credit, not the real property characteristics of the premises. In the event of a condemnation or casualty during the last three years of the lease term, if the condemnation award or insurance proceeds are sufficient to pay the loan in full, the lessee may terminate the lease. The lessee may self-insure if it has certain creditworthiness and a minimum GAAP (generally accepted accounting practices) net worth of $100 million. The lessee must lease 100 percent of the property, and the lessee and/or a subsidiary or affiliate must actually occupy the premises. The lessee may assign and sublease but remains unconditionally liable for the performance of all lessee obligations.
A credit lease differs from a bond lease in that there may be a small set of landlord obligations or real estate risks. The lessee still is responsible for most of the obligations related to the leased premises, such as taxes, insurance, utilities, maintenance, and other operating expenses. However, the lessee may have limited rights to offset or abate rent related to casualty or condemnation or to the landlord's failure to perform roof, structural, or parking obligations. NAIC suggests mitigation of the casualty risk through rent loss insurance and mitigation of the roof, structural, and parking expenses through an increased debt service coverage ratio and an escrow arrangement.
Credit tenant loans must have an amortization equal to the lease term, and the debt service must be no greater than the lease payments. Typically, the lender would require the lessor to assign its interest in the lease, and lease payments would go directly to the lender. Bond or credit leases can provide a flexible borrowing environment.
What Is a Credit Tenant?
Although many tenants are creditworthy, a credit tenant is a lessee who has an investment-grade credit rating from a nationally recognized statistical rating organization or a NAIC rating of 1 or 2. Typically, investment-grade tenants are financed through leveraged lease arrangements, and the lenders play a key role in establishing transaction parameters. Properties leased to subinvestment- grade tenants generally are the focus of investors who can apply more equity to the transaction.
Why would a creditworthy company choose to lease? First, a net lease can provide a company with the ability to match a long-term real estate asset with a long-term liability. In essence, the company gets long-term financing through lease terms that typically range from 15 to 25 years, plus renewal options equal to the initial term. This is important for less mature companies (those without an investment-grade credit rating) and companies that are expanding and rapidly opening new stores. For example, a retail company that is opening 50 new stores with real estate costs of $5 million per store could need as much as $250 million in additional capital just to finance the real estate. Net leasing each location would satisfy that financing need with long-term capital.
Second, a net lease is treated as an off-balance-sheet financing transaction if it is structured as an operating lease in accordance with the Financial Accounting Standards Board's (FASB) 13 rules for operating leases and capital leases. A lessee classifies a lease as either a capital lease (reported on the balance sheet) or an operating lease. If a lease meets any one of the following criteria, it is a capital lease:
- the lease transfers ownership of the property to the lessee by the end of the lease term;
- the lease contains an option to purchase the property at a bargain price;
- the lease term is at least 75 percent of the estimated economic life of the leased property; or
- the present value of the lease payments is at least 90 percent of the fair market value of the leased property.
A lease that does not meet any of these criteria is an operating lease. The operating lease obligation is reported in the financial statement notes as a contingent liability, as opposed to being reflected on the balance sheet. The company thus achieves a lower debt-to-equity ratio, which may favorably affect its cost of debt and equity for its core business.
Third, and most important, a net lease allows a company to use its capital for more profitable investments. Typically, a company would expect to pay (net lease) rent equivalent to 10 percent to 12 percent of the cost of the property. Normal return on investment targets for growth companies range from 15 percent to 20 percent. Thus, a net lease should allow a company to net a 5 percent to 10 percent gain on the capital that is now available for more profitable investments, such as the company's core business. In fact, a net lease encourages a company to concentrate on its core business by minimizing the potential long-term distraction that real estate ownership creates. Moreover, academic research has concluded that sale-leaseback transactions can enhance the value of stockholders' equity, reducing risk through more equity and less debt, according to Wade R. Ragas in his book, Real Estate Sale/Leaseback.
Finally, a company considering a sale-leaseback also should perform a sensitivity analysis, using after-tax cash flows, for leasing versus owning. A residual value (the value of the property at the end of the lease term) should be assumed, and the company should use its weighted average cost of capital (also known as weighted average required return) as its discount rate.
Advantages to the Lessor
Lessors of net-leased properties appreciate the value of having a credible, stable, long-term tenant. Because the net lease provides for the lessee to pay all operating expenses, rental increases flow directly to the bottom line, increasing NOI. Although other lease structures may provide for larger incremental (gross) rental increases, after subtracting correspondingly increasing operating costs, often NOI growth is no greater than a net lease. Considering the increased risk through exposure to increased vacancy and potentially uncontrolled operating expenses—especially real estate taxes and insurance—a net lease is a safer choice. In addition, a net lease offers reduced property management responsibilities. The best net lease lessors focus on managing relationships with lessees instead of managing properties.
Lessors often believe that the residual value of the property is greater than the estimate of the lessee.
Lessees prefer lessors who have long holding-period expectations and favorable tax treatment (tax-free earnings) such as pension funds and real estate investment trusts (REITs). Typically such entities have lower capital costs than taxable entities, including the lessor.
Finally, the lessor often can obtain more favorable financing for the property than the lessee, because the lessor can pledge the lease income stream toward repayment of the debt.
Benefits for Both Sides
A sale-leaseback with a net lease can work for both buyers and sellers. A net lease provides the lessee (a sale-leaseback's seller) long-term control and property use without a balance sheet impact.
A net lease provides a lessor (a sale-leaseback's buyer) a stable income stream—reduced vacancy risk and no operating expense variations—and a potentially appreciating real estate asset.