Sale and leasebacks are a time-honoured way of raising money. The principle is simple: by selling, the vendor realises the capital tied up in his property in exchange for a stream of rental payments.
Traditionally, the purchasers have been property investors: insurance companies or pension funds who thought the building was a good buy. And, traditionally, the returns have followed the logic of the property market. That is, the price and initial rents provide the yield typical of that kind of building, with open market reviews every five years.
However, the leasing deals arranged by banks are different; they have no interest in holding the properties as long-term investments. “Fundamentally we are in it for a financing exercise,” says Peter Miles, deputy manager of Lloyds Leasing, one of the major players. “We are not like pension funds who would look to get a combination of income and capital appreciation.”
This means that the banks’ s&ls work rather like a mortgage: the rental stream is calculated to pay the bank interest and amortise the principle. “Normally, although the banks might take a view on the property, it is not taken as security,” says Alan Munro of Hambros Bank, which arranged the Queens Moat deal. “They concentrate rather on the credit risk of the lessee.” However, on some s&ls banks are prepared to take a view on the property.
Moreover — and this is critical — the banks’ s&ls are tax-driven. By claiming the various allowances available on buildings, banks can lower both their own tax bills and the cost of funds to the vendor.
The market in banking leases on property started in the mid-1980s, and took off during 1987-88. Miles estimates that, by the end of 1990, the total amount of property finance provided by the investment company subsidiaries of leasing groups was some £1.25bn. This figure includes leasing finance for new development: for example, Lloyds arranged and syndicated £240m for the Meadowhall shopping centre on this basis.
Queens Moat’s s&l illustrates how these leasing deals work. The company has sold five hotels and two office properties to a subsidiary of the Bank of Scotland for £66m. The price of the hotels is £53.9m, with QM leasing them back for £3.4m: an initial yield of 6.3%. However, the 30-year lease provides for a rental uplift of 7% pa and QM has the option to buy back the properties at five-year intervals. On the offices, the price was £12.1m and the rent £1m, so the initial yield is 8.2% and the rents are raised by 35% every five years.
Taken at face value, this looks like very cheap money for QM: the initial return of 6.7% is below the bank’s own cost of funds. But this ignores the effect of tax allowances and the buy-back options.
Under the current tax regime, plant and equipment can be written off: 25% of the cost can be claimed on a reducing balance basis. In new buildings, the heating and ventilating systems, lifts etc can tot up to a significant sum — 25% or more of the total cost. Moreover, hotels qualify for industrial building allowances, which means that 4% of the total construction cost can be written off annually for 25 years. And, in enterprise zones, industrial and commercial buildings get 100% capital allowances.
These tax breaks play a crucial role in lowering the cost of the funds to the vendor. “The allowances on fixed plant and buildings are all claimed by the landlord but in fact the benefit is passed back, impacting on the rental figure,” explains QM’s finance director, David Hersey.
And, in QM’s case, the s&l is structured so that some of the bank’s return is rolled up into the buy-back price of the properties. This is because the initial rents which QM is paying do not fully cover the cost of the bank’s money: for example, the Bank of Scotland could be earning money market rates (currently 14%) by lending the £66m out short-term to other banks.
So the difference between what QM is actually paying and the rate which the Bank of Scotland may be getting by putting its money out to earn interest is deferred and capitalised into the price which QM would pay if it exercised its options to buy back the property. During the first five years of the leaseback, QM is to pay the equivalent of a fixed rate of 11.6%.
David Hersey explains: “We had the choice of setting the interest rate. We could have a floating one, but we elected that a fixed rate of 11.6% for five years was a reasonable rate.” If QM does not buy back the buildings then, a new rate is set for the next five-year period and incorporated into the next buy-back price.
For companies who want to unlock some of the capital tied up in buildings, these s&ls have strong attractions. First, they can raise 100% of the property’s value whereas if they used the property as security for borrowing, banks will typically lend only 60% to 75% of the value. Moreover, unlike a loan, a sale-and-leaseback does not put a liability on the company’s balance sheet. And, like interest, rent is deducted from profits before tax.
Second, with an s&l, the cost of the funds — in rent etc — is fixed: the vendor knows what his outgoings will be for the next 25 or 30 years. With a traditional s&l, the costs are fixed only until the first rent review; after that they will depend on the course of the property market.
And, finally, the buy-back options give the vendor the opportunity of re-acquiring his building for the original sale price — the buy-back formulas usually do not include any appreciation in the capital value of the building.
