Sales and leasebacks of real estate remain an often used mechanism to raise capital, improve operational cash flow, and, all being well, returns on investment. They range from a simply structured transaction involving a straight sale and leaseback, often through auctions, to the most complex structures involving large multimillion-pound portfolios with complex arrangements for the substitution and re-purchase of the property by the original seller company, backed up by bond issues.
With the property market where it is, is this a time to even contemplate a sale and leaseback? If so, what should companies be thinking about before embarking on such an exercise?
A sale and leaseback at its simplest is a finance-driven transaction that involves the sale by a company of its property to a third-party investor who leases it back to the company for a term at an agreed rent. The rent may be an open market rack rent, an index-linked rent (or a combination of the two), or a different amount that is related to the price paid by the buyer. It can involve a single property or a portfolio of properties, or it can involve funding arranged by the seller (either itself or through an arrangement made by it with a financier (commonly referred to as stapled finance)). Depending on the value and nature of the transaction considerable thought would be given to the structure with forward planning to mitigate possibly adverse tax implications.
A sale and leaseback can enable a company to release cash tied up within the real estate, strengthen its balance sheet and improve operational cash to allow investment in business, whether that is to pay down debt (to improve its banking covenant), invest further in its core activities or make strategic investments. The cost of funds raised is likely to be significantly cheaper than borrowing in the current market.
Private equity is always looking to buy out inefficient companies and make its capital work. Debenhams is a good example of a retailer that was taken private and became more efficient by putting sale and leasebacks to good use. Some private equity players will also look to invest in a company simply to access its real estate capital base. So a leaseback can be defensive too.
Sale and leaseback transactions may help to realise tax benefits, such as the ability to deduct rent under the lease as an operating cost.
The sale will transfer the property value risk to a third party, while giving the company the operational flexibility of either remaining in the premises over the longer term or moving to newer and better suited premises, depending on how its business performs. Obviously there will need to be a commitment to stay in the building for 10-15 years if an appropriate value is to be realised for the property.
The main perceived disadvantage of sale and leaseback is that the company may be giving up the ‘family silver’. It may, also, through the negotiation of the lease, be giving up the flexibility that the company enjoys in the way it deals with the buildings at the property (although it may be possible to build some operational flexibility into the lease). Many pub companies sold out their real estate on sale and leaseback transactions, and are now facing financial difficulty. Woolworths is another example of a company that sold a large proportion of its real estate and leased it back. Some may point to these examples as evidence that sale and leasebacks are not as successful as they are made out to be.
It could also be argued that those companies that did carry out sale and leaseback transactions in the past, such as Woolworths, may have suffered much earlier than they did, were it not for the sale and leaseback transactions carried out. Alternatively, it could be argued that the strategic investments made as a result of those transactions or, in the case of pubs, the rental growth projections turned out to be the wrong decisions.
WHY CARRY OUT A SALE AND LEASEBACK IN THE CURRENT MARKET?
Notwithstanding the downturn, prior to which the number of sale and leasebacks had increased quite considerably, several companies are still carrying out such transactions. According to CB Richard Ellis, in the first half of 2009, 17% of all property disposals were sale and leasebacks. HSBC has carried out sale and leaseback transactions on several international head offices, including the building at Canary Wharf. Retailers like Tesco are also carrying out such deals. Traditional manufacturing has not carried out such a large number of such deals historically, but there is evidence that this is changing.
Evidence from the surveying world suggests that the shortage of good quality real estate products is pushing prices up and there is currently talk of ‘a window of opportunity’, where relatively high prices can be achieved for prime covenants.
The lack of financing or the availability of only very expensive funding from many of the lending banks is forcing companies to look at other sources of finance, which if companies could raise quickly, may pay substantial rewards as the recovery gathers pace.
Where a company is thinking of raising a substantial amount through a sale and leaseback transaction, whether of a single property asset or a portfolio of assets, there are numerous issues that should be considered in advance to ensure a structure is workable and mitigates any tax liability.
A possible structure is shown in the diagram below.
The most significant financial issue (apart from the price and rent) will be the possible tax leakage in carrying out the transaction. The sale of the property to the investor will attract stamp duty land tax (SDLT) at 4% (if the value is more than £500,000). The leaseback will not attract any SDLT provided it is in consideration of the sale. There is little that can be done to mitigate the SDLT consequences of the transaction, although if planned sufficiently in advance some reduction might be achieved.
A further disadvantage could be VAT leakage. This can happen in two ways. First, if the company has opted to tax the property for VAT, then the investor will have to pay VAT on the sale consideration. The VAT element will attract SDLT at 4% (thereby increasing the SDLT cost to the investor by an additional 0.7%). The investor may look to the company to share this cost. With some forward planning, the position can be mitigated through arranging a sale to a group company (outside of the company’s VAT group) and a pre-packaged leaseback. The sale of the property could then be treated as a transfer of an investment letting business as a going concern (which attracts no VAT), mitigating the additional 0.7% in SDLT on the VAT element of the transaction.
Secondly, if the company has carried out any works to the building in the previous ten years where it has reclaimed VAT (the Capital Goods Scheme) and its VATable business is less than 80% of its total sales, then the sale and leaseback could have the effect of disapplying its option to tax. A balancing charge of a proportion of the VAT recovered by the company in relation to works carried out to the building would then be due to HM Revenue & Customs (HMRC). The proportion would be the number of years remaining. For example, if works were carried out six years previously, then 40% (representing the balance of the ten years) of the VAT recovered could be repayable. This is a real possibility for banks and financial institutions whose VATable supplies may be lower than say manufacturing or retail businesses.
The price and rent will clearly be material. Some sale and leaseback transactions are structured on the basis of a rent offered by the company. The rent could be fixed and reviewed annually or five yearly at a fixed-percentage increase or linked to the retail prices index (RPI), or with a mixture of the two, subject to a cap (say 6%) and collar (say 2%), or be subject to open market (five yearly upward only) review. The market will then bid a price by reference to those rental arrangements.
An alternative would be to fix a price and then invite the market to suggest the rent that would be sought.
The state of repair of the building and what liability to repair the company will seek will be material. A sale and leaseback provides more flexibility to negotiate on such issues than a traditional lease negotiation. In the case of a fairly new building, a full repairing liability would be acceptable. An old building may, on the other hand, demand a schedule of condition or if it is likely to be redeveloped at the end of the lease term, a complete release of liability from dilapidations.
Over time the company will have carried out numerous works to the building as part of its occupation. Clarity is required on what reinstatement liability will apply at the end of the lease. Ideally there should be no reinstatement liability. Some transactions may demand that the building is reinstated to a particular specification (for example open plan offices).
Operational flexibility needs to be considered at the outset and each company will be different. For example, a supermarket retailer may want the ability to extend stores by, say, up to 10% of the floor space without landlord’s consent or to allow sub-letting to businesses, which they subsequently decide are complementary to their business (eg walk-in surgeries).
Insurance issues are often forgotten until lawyers get involved. Thought should be given to whether the obligation to insure the building and against loss of rent should remain with the company (as tenant) or be passed on to the investor (as landlord). Investors prefer that the landlord insures, but that may be more expensive for the company. The company will also have less control over the terms of the insurance and how its interest will be protected under the relevant policy. Equally, in modern leases it is possible to negotiate out the risk of uninsured damage (for example if terrorism or flooding become uninsurable) where the capital risk can be passed to the landlord and only a small proportion of the rental risk might remain with the company.
One way in which the company can achieve certainty on the price and terms (avoiding a price chip when costs have been incurred and the company is down the line with a particular prospective buyer) is to prepare a vendor due diligence package on which the buyer can rely. This would include legal reports on the title to the property, building and environmental condition surveys, as well as a package of any relevant construction documentation and warranties (if any major works have been carried out to the building over the previous 12 years). While there is an upfront cost incurred by the company in producing this information, a purchaser would be able to bid having received full disclosure of the issues. This arrangement should also make the timetable for the transaction much stricter so that if a purchaser wobbles, at least an under bidder might be ready to step in fairly quickly.
Planning the sale can be further improved if the company is linked to a financial institution that might be able to provide lending to the buyer, or if the company is able to arrange a facility with its own bank. Provision of such stapled finance may remove the investor’s funding risk, increasing the range of buyers who may be approached with the proposal.
Depending on the nature of the property and its possible future redevelopment, the company may wish to seek some kind of planning-based overage arrangement so that it can share in any additional value that might be created in relation to the properties (for example a change of use from manufacturing to residential) at the end of the lease term.
In some cases the seller may want to continue to participate in the value that might be generated by the property and may only wish to raise a proportion of the value of the property through the transaction. This can be achieved through a joint venture, either through a company, limited partnership or a trust arrangement, giving the company a percentage share in the relevant entity. A limited partnership structure will reduce the SDLT cost on the transaction as the company’s share would be exempt.
Equally, if the property is one that the company may wish to re-acquire (particularly applicable to retail operators) the company may seek a buy-back option from the investor at either a fixed or an open market price at the end of the lease term.
Where a portfolio of properties is included, the arrangement could extend to include provisions for the substitution and removal of certain properties from the transaction. These arrangements will be much more complex and will give rise to SDLT issues in particular, and the transaction documents would need to legislate for these.
IS IT A GIVEAWAY?
The current market, with lending still restricted, provides favourable circumstances for strong companies to achieve supreme returns on equity, and represents an opportunity to use sale and leaseback transactions to raise relatively cheap funding. With prime product much in demand, and prices having increased significantly since last year (certain predictions suggest a 6% change in the past quarter alone), this might be a perfect time for a business to use a sale and leaseback to catapult itself forward.