Is Leaseback of Commercial Property a Good Idea?
**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**
Leasebacks have become so common in commercial real estate that basically every week I answer my clients’ questions about them. My recommendations on whether or not a leaseback is the right choice for a property owner always depends on his overall goals.
This guide will dive into discussing the pros and cons of leasebacks for both sellers and buyers as well as what they are in the first place.
What Is a Sale and Leaseback in Commercial Real Estate?
A sale and leaseback of commercial property is exactly what it sounds like. Sometimes the owner of a business also owns the property where it is located. When they sell the property and lease it back from the new owner it’s called a sale and leaseback.
This can be done with any kind of business:
The business continues uninterrupted in the space during and after the transaction.
How Does a Sale and Leaseback of Commercial Property Work?
Commercial properties are sold all the time with a tenant already in place. The major difference with a sale and leaseback of commercial real estate is that the sale involves negotiating a new lease.
Otherwise, it’s the sale of a commercial property, and the leasing of that commercial property.
#1. Property Sale
Properties with a tenant in place are income-generating properties. The buyer is buying the real estate and the income stream.
Commercial property purchase agreements contain an inspection period. This gives the buyer time to inspect the property before being obligated to complete the purchase.
The seller is required to turn over any documents that will help with the property inspection. This includes surveys, title insurance policies, and environmental studies.
With an income-generating property, the buyer is also inspecting the tenant and their financial strength. Diligence documents will include the tenant’s financial statements and tax returns.
If the buyer hasn’t terminated the contract by the end of the inspection period, the sale proceeds to the closing.
For property owners wanting to learn more about how a commercial property sale works and what it involves, here is a detailed guide on Selling Your Own Commercial Real Estate Property.
#2. Property Lease
The purchase agreement for an arm’s length sale of income-generating property will transfer any existing leases to the new owner. The lease terms, including rent, remain the same.
In the case of a sale leaseback, the agreement will specify that a new lease will be completed as a condition of closing. The amount of rent to be paid is negotiable along with other terms.
Lease negotiations usually start after the end of the inspection period. Neither party wants to pile up legal bills from lease negotiations until they know that the buyer is committed to the purchase.
A completed lease is a condition to close. This means that if the buyer and the tenant aren’t able to agree on a lease, the deal is terminated.
Sale and Leaseback Advantages and Disadvantages for Sellers (Tenants)
Most of the pros and cons of leasebacks for the seller/tenant come down to owning vs. leasing a commercial property. I have discussed this topic in detail in a guide on my Car Wash Advisory website by using car washes as an example. But let’s look at the full list specific to the situations that involve a sale transaction.
Generally, it makes sense for a business owner to own the premises. Why pay rent to someone else when you can keep the money? At some point before doing a leaseback you will stop and ask yourself “is leaseback a good idea?” Let’s go over some leaseback pros and cons.
4 Sale and Leaseback Benefits for Sellers (Tenants)
#1. Receive Capital and Liquidity
The obvious benefit of selling an investment property is the capital that the seller receives from the sale.
The added liquidity can allow the seller to:
- Take advantage of a strong real estate market to sell high
- Take advantage of a stronger investment opportunity
- Diversify their investment portfolio
- Access cash that is needed to strengthen or grow their business
#2. Reduce Risk Concentration
By owning both the property and the business, the seller has concentrated a lot of their financial risk around one asset.
If their business has problems, it will impact their real estate investment.
It would also be good to have the option of moving the business at the end of the lease term. With a sale leaseback they can avoid having a vacant property on their hands later.
Selling the property and reinvesting the proceeds elsewhere will reduce their risk concentration.
#3. Continue Ownership of Business / Operation
The seller can reallocate their assets without disturbing their operating business. By making the completion of the sale contingent on a suitable lease, they can:
- Ensure that the business is protected in the new lease
- Pick an experienced landlord
#4. Tax Benefit
When a business owner is also the landlord, there are restrictions on identifying rental income profits as passive income. This means that profits can’t be offset by other passive losses at tax time.
This may not be a problem since depreciation and other legitimate expenses often reduce their taxable rental income below profitability.
If they buy another property that is not leased by their company, they can avoid this issue.
5 Sale and Leaseback Drawbacks for Sellers (Tenants)
#1. Increased Operating Costs
Business owner landlords often give their business a sweetheart rent deal. They charge just enough to offset their expenses. They are content with growing the asset and aren’t concerned with rental income.
A new owner will expect to receive rental income and asset growth. They will charge rent that is at least equal to market level rents. This could increase the tenant’s operating costs.
#2. Reduced Flexibility
When the business owner is the landlord, unexpected business interruptions can be more easily dealt with by the tenant. The owner can accept reduced rent, or even grant a short-term rent holiday if necessary.
With a landlord that is arm’s length from the tenant, that is not likely to happen.
#3. Decreased Downside Risk Protection
Diversifying a portfolio to protect against a worst-case scenario is called downside risk protection. Real estate is considered an excellent asset for risk protection.
If a seller uses the proceeds from a sale and leaseback to bolster their business, or otherwise doesn’t re-invest those funds in real estate, it could reduce their downside risk protection.
#4. Capital Gains Tax
Unless a 1031 exchange process is used, Capital Gains Tax will be owed on any profits from the sale. The seller could also owe Depreciation Recapture at the time of the sale.
For a comprehensive discussion of the tax consequences from a commercial property sale, read the following articles by PropertyCashin:
- Tax Implications of Selling a Commercial Investment Property in the US
- 9 Ways to Avoid or Minimize Capital Gains Tax (CGT) on Commercial Investment Property
#5. Closing Costs
In a commercial real estate sale, each party is usually responsible for their closing costs. Depending on the nature of the property, and the complexity of the lease, the costs can vary widely from one transaction to the next.
To better understand the impact of closing costs on your net proceeds, read the following article: Commercial Real Estate Closing Costs for Sellers.
Dos and Don’ts of a Leaseback for the Seller (Tenant)
There are several essential dos and don’ts in sale and leaseback transactions that sellers should keep in mind.
4 Do’s for Sale and Leaseback Sellers (Tenants)
#1. DO Carefully Weigh the Upsides and Downsides
In a sale-leaseback, the seller has to be careful to balance their interests with those of their business.
For example, obligating their business to pay more rent may get them a higher price for the property, but it could hurt the business.
A strategy that meets the long term goals of both the seller and their business is needed for a successful sale-leaseback transaction.
#2. DO Use a Qualified and Specialized Attorney
The purchase contract will be familiar to most commercial attorneys. A lease, however, can be very different depending on the type of business involved.
An office lease is very different from a retail lease. A medical practice lease is different from both. Your attorney should be familiar with your type of business and your needs as a tenant.
To find a real estate lawyer for your needs, browse our directory of top-rated local commercial real estate attorneys.
#3. DO Analyze the Market Rent Dynamics
The buyer will try to negotiate the longest lease term possible. Long-term consistent returns are very desirable for commercial real estate investing professionals. They also avoid the costs of replacing a tenant for as long as possible which allows them to build up reserves.
Long lease terms are not necessarily bad for tenants. If market rents are increasing in your area, having a locked-in rental rate with reasonable periodic increases could keep your rent below market.
Many tenants prefer to have shorter lease terms with the option to extend the lease multiple times. Pre-determined rent increases per extension will protect them if market rents increase. If rents have gone down in the market, options might give the tenant an opportunity to renegotiate their rent.
The tenant may have to qualify for each extension by showing that their financial condition hasn’t declined.
#4. DO Get Standard Payment and Forgiveness Terms
The seller should negotiate the lease the same as any other lease. If the tenant has their own lease form, the sale contract should specify that it will be used.
Language concerning rent payments and the tenant’s ability to cure rent defaults should be reasonable.
3 Don’ts for Sale and Leaseback Sellers (Tenants)
#1. DON’T Agree for a Too High Rent
The seller has to be careful not to accept rents that will hurt their business. Their sales may support a higher rent now, but it could cause a problem during periodic economic downturns.
If the seller/tenant decides to sell the business later, high occupancy costs will hurt the value of the business.
#2. DON’T Think All Landlords Are Equal
The ability of the landlord to meet their obligations is an important consideration when reviewing sale-leaseback offers. An experienced landlord who understands that their investment depends on your success will greatly benefit your business.
This should be weighed along with the price when considering a sale of the property that will continue to house your business.
#3. DON’T Agree to Terms that Forbid Selling Your Lease
Everyone expects to succeed in business. But, sometimes things happen that are outside of the tenant’s control. Leases should be written in a way that gives them the ability to deal with unforeseen circumstances.
The lease should allow for the replacement of the tenant. The landlord will want to have some approval of the replacement. They may want the original tenant to continue to be responsible for rent payments.
If that happens, the tenant should at least attempt to include a “burn off” of their responsibilities. If the replacement tenant has performed as agreed for a specified period of time, the original tenant would be released from their obligations.
Where Do I Find a Buyer for My Property Who’ll Let Me Lease It Back?
Depending on the type of your commercial property and local real estate market conditions, finding a buyer may be daunting. Moreover, not all buyers are looking for real estate to lease it back to the previous owner.
There are companies specializing in leasebacks as an investment strategy. As professionals in this niche, they provide convenient cash transactions and lease terms to sellers.
As a leading national platform for commercial real estate investors, we at PropertyCashin maintain relationships with reputable leaseback companies throughout the country.
To get a no-obligation cash offer from a reputable sale and leaseback firm serving your location, fill out our simple online form.
Sale and Leaseback Advantages and Disadvantages for Buyers (Landlords)
4 Sale and Leaseback Benefits for Buyers (Landlords)
Investors are looking for income-generating properties that are occupied. Here are some of the benefits to buyers-landlords of using a sale-leaseback to buy commercial properties.
#1. Passive Income
The term “passive income” means different things to different people. The popular meaning is that you don’t do much to earn income.
Although net leases put most of the maintenance responsibilities on the tenant, the landlord will have some obligations in the lease that they have to meet.
For tax and investment purposes, passive income includes rental income. This enables investors who buy and sell commercial properties to use a 1031 exchange strategy to manage their tax liability.
#2. Purchase of Real Property
The purchase of real property has advantages over other types of investment. This includes the tax benefits of depreciation of the property’s improvements, and the ability to re-purpose the property if necessary.
#3. Already Secured Income Source
Investors look for income-generating properties. These are properties that have tenants in place, not vacant properties. The existing tenant’s lease will allow for a change in property ownership, but not for re-negotiation of the lease terms.
#4. Customized Terms
In sale-leaseback transactions, offering a new lease makes the property more desirable to buyers. The more time that’s left on the tenant’s lease, the more valuable the property is to an investor.
This gives the buyer the chance to customize the lease terms to fit their needs.
3 Sale and Leaseback Drawbacks for Buyers (Landlords)
#1. Dependence on the Tenant Quality
As we mentioned, the financial quality and stability of the tenant is a vital part of the value of the property.
Buyer/landlords should require several years of financial statements from prospective tenants. If they are not trained to review a company’s financials, they should have their CPA look over the records and give an opinion.
They should also specify bank and vendor references in the list of required diligence documents that are part of the purchase contract.
#2. Risk of Overpaying
The buyer should base their offer on the value of the real property and the income that can be reasonably expected from that property from a normal tenant.
They should research the market rents being paid for similar properties in the area. The price of the property should not be based on rents that are higher than the market will support.
Even a strong tenant who is willing to pay higher than market rent does not justify overpaying for a property. If that tenant should go out of business, the landlord will not be able to rent that space to another tenant for that amount.
#3. Purchase-Associated Expenses
A sale-leaseback transaction will have due diligence expenses and closing costs to consider. Legal costs will be slightly higher due to the creation and negotiation of the lease.
Dos and Don’ts of a Leaseback for the Buyer (Landlord)
2 Dos for Sale and Leaseback for Buyers / Landlords
#1. DO Appropriate Diligence of the Tenant
The importance of a buyer’s due diligence of the tenant cannot be understated. The buyer’s investment return calculations include having time to set aside reserves for the future cost of re-leasing the space.
Although the tenant can be replaced, if they don’t stay long enough for those reserves to be collected, the difference will have to come out of the investor’s pocket. This reduces the return on their investment.
Single-tenant properties present a greater diligence challenge since the landlord’s risk isn’t spread across multiple tenants.
#2. DO Scrutinize the Terms of Multi-Site Operator Tenants
A tenant with multiple locations can provide a landlord with more security if their lease is guaranteed by the entire company.
If the tenant’s other units are organized as separate companies, such as LLCs, the landlord should require that the lease be cross guaranteed by all the other companies.
The buyer should be aware that if the other units are underperforming, it could create a financial drain on their tenant.
Annual financial reporting by the tenant should be required as part of the lease.
Don’ts for Sale and Leaseback for Buyers / Landlords
#1. DON’T Base the Price on the Seller’s Cash Flow Only
The value of commercial properties is determined by using comparable sales of similar properties and the income approach. The value of the real property is affected by the income that it generates.
However, the future appreciation of the asset will be determined by its location, size, visibility, and accessibility. The value of the real property itself should not be overshadowed by the current tenant.
#2. DON’T Think All Sellers/Tenants Are Equal
A prudent buyer will need to be sure that the initial tenant can pay as agreed for the term of the lease. Even if the property can easily be re-leased, it can take 6 months before a new tenant starts paying rent.
Loss of rent early in an investor’s ownership of a property will severely damage their returns.