Sale-and-leaseback arrangements have become a popular mechanism for the release of cash which is otherwise tied up in business premises.
In times of financial uncertainty or difficult market conditions, sale-and-leaseback real estate transactions may present an attractive proposition for commercial entities seeking to raise finance.
This is particularly the case in a challenged market, where lending costs are high or the availability of funding is tenuous.
There can be few more trying business challenges than operating during a global pandemic, which may explain why, according to research from Savills, European sale-and-leaseback transactions reached a total of €8.4bn (£7.2bn) in 2020, 8.5% higher than the five-year average, with predictions of this trend continuing through 2021.
Why sale and leaseback?
The primary reason for pursuing a sale-and-leaseback strategy is usually the release of capital. From a seller’s perspective, the sale of its (usually freehold or long leasehold) property interest to a buyer, followed by an immediate leaseback of that property, has the benefit of allowing the seller to remain in occupation while freeing up capital for other purposes, such as investment in its business operation.
Logistics properties in particular have been frequent, recent participants in the sale-and-leaseback market. Increased automation of warehousing processes requires cash investment. A relative shortage of warehouse facilities in the face of an exponential increase in e-commerce has resulted in hefty price tags for logistics sites, and their elevated valuations have presented an opportunity for owners to release cash for business investment through a sale of their reversion and the taking of a lease.
The sale-and-leaseback model may also provide alternative sources of finance at more modest rates, with the agreed rent likely to be lower than the interest costs associated with traditional borrowing arrangements.
Sellers who do not require funds for operational investment within the business may find themselves able to invest the sale proceeds elsewhere to generate higher returns which exceed the rent payable under the lease. Furthermore, a company with enhanced liquidity (achieved through the sale of its headline real estate interest) may also find itself able to improve its leverage through the repayment of existing debt.
The potential benefits of the sale-and-leaseback strategy can run both ways. The buyer, most commonly an institutional investor, often acting through a special purpose vehicle, will be interested in both the asset itself and the income that is derived from it.
A seller wishing to enter a sale-and-leaseback transaction may be prepared to sell at a slight discount or pay a slightly elevated rent in order to release funds quickly, and the grant of a relatively long lease back to the seller will ensure that the property remains a saleable – and fundable – commodity in the investment property market. In addition, the income from the property can be employed to match longer-term liabilities that the buyer-landlord may have under other financing arrangements.
Obviously, the sale-and-leaseback structure is not a one-size-fits-all. The seller’s covenant strength is at the core of a successful arrangement, particularly where the income stream is paramount to the investment purchaser. The desirability and adaptability of the property is also key to the buyer’s ability to relet the property beyond the initial corporate covenant.
How are transactions structured?
The sale-and-leaseback structure is what it says – a sale of the property, with a simultaneous lease back to the seller. However, the leasing side of the arrangements does not necessarily follow a standard formula. Historically, such leases have fallen into one of two categories, namely:
- An operating lease, with ownership of the asset retained by the buyer at the end of the lease term; or
- A financing lease, where a transfer of ownership of the property back to the seller may be required at the expiry of the lease, such as through exercise of an option. A finance lease may also arise where the lease term represents the major part of the asset’s economic life. This type of leasing arrangement will almost certainly involve a higher rent during the term and/or a premium payment from the seller at the term end.
Accounting considerations may affect leasing structure. Previously, operating leases were considered as off-balance sheet assets, only recognising “in-year” costs on the profit and loss account, while finance leases were treated as a liability on the balance sheet. The introduction in 2019 of International Financial Reporting Standard 16, which sets out the principles for the recognition, measurement, presentation and disclosure of leases, removed that distinction, requiring both structures to be shown on the balance sheet, though there remains a difference in terms of how the resulting expenses are classified on each party’s income statement – and, in the case of sale and leaseback arrangements, there are “top-up” accounting requirements if the purchase price is not fair value.
In terms of transaction documentation, this is very much what you would expect – a sale agreement coupled with (typically) a full repairing and insuring “triple net” lease, usually of whole. The sale premium (on which stamp duty land tax will be payable) will provide the capital which the buyer wishes to obtain from the transaction.
In England and Wales, as a transaction by way of an “exchange”, both parts of the sale-and-leaseback transaction are chargeable on the greater of either the market value of the interests transferred or the consideration given (section 47 of the Finance Act 2003). However, where all the conditions of section 57A(3) of the 2003 Act are met, the leaseback element will be exempt. SDLT relief may be available on the leaseback element of the transaction if:
- the sale is entered into wholly or partially in consideration of the leaseback;
- the interest leased back is created out of the original interest;
- other consideration (if any) comprises only cash and/or the assumption, satisfaction or release of debt;
- the sale is not a transfer of rights under section 45 or section 45A of the 2003 Act; and
- where the seller and buyer are both corporate bodies, they are not members of the same SDLT group.
Existing capital allowances may be available on the sale, and the parties will need to decide at an early stage whether the benefit of those allowances will remain with the seller/tenant or pass to the buyer.
Different tax rules apply in different jurisdictions, meaning that commercial terms and structuring on cross-border portfolios may be more involved.
No standard lease
The letting document itself is likely to be a heavily negotiated version of a standard institutional FRI “triple-net” lease, reflecting the diverse concerns of the respective parties. The seller will inevitably want to subject itself to the minimum of operational restrictions, to reflect both the length of the lease (usually between 20-35 years) and its prior ownership.
Conversely, the buyer will seek more robust terms to protect against tenant default, and to ensure that the lease remains a fundable “pure income-play” asset. The seller will, however, lose the benefit of ongoing capital allowances.
Lawyers seeking a “standard” lease for use in a sale and leaseback transaction will be lucky to find one. The negotiation of bespoke leasing arrangements, which enable the seller to continue to use premises as flexibly as it did as owner while protecting the buyer’s investment concerns, may be more arduous than agreement of the sale terms.
However, the due diligence involved in the property sale and the negotiation of transaction documents is likely to be no more protracted than that required by an institutional lending transaction.
The cash injection for sellers, coupled with uninterrupted occupation, should ensure that sale and leaseback arrangements are not merely for times of trouble but remain a viable and attractive alternative to traditional financing sources.
Examples of lease provisions
The quirks of a sale-and-leaseback transaction may see, among others, the negotiation of the following types of (non-typical FRI) provisions:
- Fixed annual or stepped rent increases, providing operational and investment certainty for both parties.
- Retail price index or consumer price index increases, often with a cap and collar. A determining consideration may be that RPI rent increases over the first five years don’t need to be estimated for SDLT purposes, which is not the case for CPI-based rent reviews (though the proposed alignment of CPIH – CPI including owner occupiers’ housing costs – and RPI between 2025 and 2030 may affect this distinction in the coming years).
- Greater operational control for the seller/tenant, such as reduced repair obligations both during the term and for yielding up purposes, or a greater allowance for fair wear and tear. The landlord may be less concerned about state and condition where the lease term is relatively commensurate with the building life, and redevelopment would be expected at the end of the fixed term.
- Greater tenant flexibility on alterations and, occasionally, user, to more closely reflect the ability it would have had to adapt the premises to the needs of its business if it had retained the ownership of the property.
- Financial reporting covenants. The investor-buyer will be keen to ensure the continuation of its income stream over the length of the long leaseback, particularly where the rent is not in step with the market rent. It may, therefore, be critical to the buyer to have visibility of the tenant’s business operation through financial reporting, in a similar way to the oversight of tenant’s accounting records under turnover rent arrangements.
- Provisions aimed at maintaining the tenant’s corporate covenant strength, such as through the provision of guarantors and/or relatively strict change of control provisions, especially during the early part of the term when the investment value is stabilising. Intra-group assignments may cause concern to investors, for example if the group assignee has lesser covenant strength or if potential Good Harvest Partnership LLP v Centaur Services Ltd [2010]1 EGLR 29 issues may arise in relation to existing guarantors. Assessment of the corporate strength of the tenant is a key concern for investors both at the outset and throughout the life of the sale-and-leaseback arrangement, and a tenant’s disposal of its proprietary interest may need to be more tightly controlled.
- Business maintenance covenants, similar to the principle of keep-open arrangements, requiring the seller to maintain its occupation of the facility.
- Competitor “black list” restrictions, imposed by tenants, restricting reversionary sales to entities in competition with the tenant.
- Robust provisions for re-entry in line with the usual requirements of lending institutions.
- Lease cross-default termination rights where there is a portfolio of assets being sold.
- Tenant options to renew the lease or acquire the freehold, particularly where the property is an operationally important location for the tenant.
Justin Salkeld is a real estate partner and head of the real estate department, and Jo Shakespeare is a real estate knowledge lawyer at Baker McKenzie
