In this week’s edition of the frequently asked question blog series, we will address the question, “what is a sale and leaseback?”. A sale and leaseback is a financial transaction whereby an owner sells their property to an investor and then immediately signs a long-term lease for the space. This means that you become the tenant to the investor to whom you sold the real estate.
Now, you may be thinking, “why in the world would I want to do that? It doesn't seem like there would be much benefit to me as the business owner.” Although you may have doubts, there are several reasons why executing a sale and leaseback can be an effective strategy for your business. Below I’ve provided a list of some of the pros and cons:
Pros
Sellers receive a large capital infusion
Probably the biggest pro associated with executing a sale-leaseback is the capital infusion you receive from the sale of your property. Owning real estate is extremely capital intensive. Therefore, unless you have a lot of money to purchase additional properties, it may inhibit your ability to expand your operations. Additionally, capital deployed within your business typically has a higher return on equity than real estate. On average, capital invested in real estate will achieve anywhere between 4% -12% + risk-adjusted return. However, depending on your industry, capital deployed within your business, can have much higher returns over time.
Tenants enjoy additional tax benefits
Once you sign a long-term lease, your lease payments become tax-deductible as a cost of business operations. Your lease payments can be deducted over the life of the lease. Additionally, improvements you make to your space during your tenancy can be depreciated over the life of your lease agreement. To verify and learn about other deductions you may claim as a tenant, speak with a licensed CPA.
Clears up your balance sheet
If you own property with a mortgage on it, your debt-to-equity ratio may be skewed. Your Debt-To-Equity ratio is one of the metrics that banks use to assess your viability as a borrower. If you carry too much debt, you may be deemed a risk and may not qualify for additional financing. When you sell the property outright, you remove your real estate loan from your balance sheet. This modification can make you more attractive to banks and you will likely qualify for better loan terms when seeking financing for other business-related endeavors.
Cons
Lose out on benefits of real estate ownership
Probably the biggest con associated with a sale and leaseback is that you lose out on the benefits of real estate ownership. Some of these benefits include:
1) Amortization - every month that you pay your mortgage, a portion goes towards paying down your loan. Over time, your equity in the property grows which helps you build long-term wealth.
2) Tax Savings - Real Estate related expenses such as mortgage interest, repairs & maintenance, utilities, etc. are tax-deductible. Additionally, if you rent out space within your building, you may be able to capitalize on real estate depreciation, further lowering your tax bill.
3) Appreciation - Historically, average real estate values have increased by 2-3% per year. Although appreciation is not guaranteed, it can be a nice addition to your overall return if you hold the property for an extended period.
Tax implications of a sale
Another significant con is the taxes associated with the sale of a commercial property. As of 2021, The long-term capital gain tax rate is 20% and the recapture tax rate goes up to 25%. Depending on your property’s basis, you may find yourself having to pay a sizable tax bill at the end of the year. To determine your potential tax obligation and discuss tax-saving strategies to avoid some or all of the final amount, I highly encourage you to speak with a licensed CPA.
Lose control of the property
Finally, another con of executing a sale and leaseback is that, unless you structure it into your lease agreement, you may lose control of the property after your term has expired. Since you no longer own the property, you have no control over what the landlord decides to do after your lease expires. They may raise your rent, reduce your footprint, or kick you out in favor of another tenant.
Sale-and-leasebacks are complicated transactions that require experienced professionals to perform. Because of this, I highly recommend that you seek the services of a competent commercial real estate lawyer and commercial real estate agent to help you navigate the process. If you’re located in the Louisville or Southern Indiana area and you’re interested in pursuing this strategy, our brokerage has a significant amount of experiencing helping our clients do so.
Pro-tip: If you would like to better understand the process of leasing commercial real estate, I highly recommend securing a copy of my latest book "Before You Sign That Lease: The Small Business Owner's Guide To Leasing Commercial Space". Click the following link to grab your copy today: https://amzn.to/3mmg4fU