Sale-Leaseback: Selling the Building and Leasing It Back

How it works

The owner sells the property to an investor, often a private buyer, a real estate fund, or a net lease REIT, at a price based on the rent the property will produce. At closing, the owner's business signs a lease with the new owner, usually ten to twenty years, triple net, with fixed rent escalations. Nothing changes operationally. The business is in the same location with the same people. The owner has the sale proceeds and a rent obligation.

The price the investor pays is driven by the rent and the cap rate. If the lease is $200,000 a year and investors in that market and property type are buying at a 7 percent cap rate, the property sells for roughly $2.85 million. A lower cap rate means a higher price. Cap rates depend on the tenant's credit, the lease term, the location, and the property type.

Why an owner does it

To take the real estate equity out before selling the business. A business buyer may not be able to afford the building, and the owner may not want to be a landlord. Selling the building to an investor first, then selling the business with a lease in place, separates the two and gives the business buyer exactly what their lender wants: a long-term lease at a known rent.

To fund the business before a sale. The proceeds can pay down debt, fund expansion, or clean up the balance sheet in the year or two before listing, all of which can raise the business's value.

To diversify. An owner with most of their net worth in one building in one town may prefer cash.

To set the rent. The owner, as both seller and tenant, negotiates the lease. Setting it at market, with reasonable escalations, produces a clean rent expense for the business's financials and a fair price for the property.

What it does to the business sale

The business now carries market rent as an expense, which lowers its earnings if it previously paid no rent or below-market rent. That is correct, since a buyer would have that expense anyway, and it is better for the business to show the rent for a year or two before the sale than for the buyer's accountant to impose it.

The lease has to work for the next owner. A buyer's lender will want the term to cover the loan, usually ten years including options. The lease should allow assignment to a buyer of the business without unreasonable landlord consent, and the buyer should be able to step into it at closing. A lease that is personally guaranteed by the current owner needs a plan for releasing that guarantee at the business sale, which the landlord may or may not agree to. Negotiate that up front.

The business's value is now on its earnings alone, and the buyer pool is wider because the purchase price is lower.

What to watch

Rent set too high produces a higher sale price for the building and a lower one for the business, and can leave the business with an occupancy cost that squeezes it in a soft year. Rent set too low does the reverse. Market rent, supported by comparable leases, is the answer.

Escalations compound. A 3 percent annual increase over fifteen years is about a 56 percent increase in rent. Fixed dollar or CPI-linked escalations with caps are more common and easier for a future buyer to underwrite.

The tax is due. A sale-leaseback triggers capital gain and depreciation recapture on the building. A 1031 exchange into other property can defer it. An owner who wants the cash pays the tax. Run both numbers with a CPA before committing.

The investor's diligence takes time. Appraisal, environmental report, survey, title, lease review. Sixty to ninety days is normal. If the plan is to sell the business afterward, sequence the two so the lease is signed and the property closed before the business goes to market.

Losing control. The owner no longer decides what happens to the building. If the lease has renewal options at market, the tenant is protected. If it does not, the business could face a large increase or a relocation at the end of the term, which a future buyer will price in.

A worked example

An owner holds a distribution business with $500,000 in SDE and the 20,000 square foot warehouse it operates from, appraised at $3 million. The business has been paying no rent. The owner plans to sell the business within two years and does not want to be a landlord afterward.

Market rent for the warehouse is $216,000 a year, triple net. At a 7.5 percent cap rate, an investor would pay about $2.88 million. The owner sells to a net lease investor, signs a fifteen year lease with two five year options and 2.5 percent annual escalations, and pays the tax on the building or exchanges into a passive property.

The business's SDE, adjusted for the new rent, is $284,000. At 3 times, the business is worth about $850,000. Eighteen months later the owner sells the business to an individual buyer with an SBA loan, who steps into the lease. The buyer's lender is satisfied because the lease runs longer than the loan.

The owner has received about $2.88 million for the building and $850,000 for the business, for roughly $3.73 million, and is out entirely. Selling both to a single buyer would have required a buyer able to finance $3.85 million, which is a much shorter list, and would have taken longer.

When not to do it

When the owner wants rental income in retirement. Leasing directly to the business buyer produces the same income with the owner in control of the asset.

When the building is worth more for another use. A developer or an owner-user pays more than a net lease investor.

When the business could not afford market rent. If market rent would push the business's earnings to a level that does not support a sale, the building and the business have a problem that a sale-leaseback exposes rather than solves.

When the tax on the building is large and the owner has no plan for it. Recapture and capital gain on a building held for twenty years can be a substantial share of the proceeds. Run it first.

When it fits

A sale-leaseback fits an owner who has significant equity in the building, plans to sell the business within a few years, does not want to remain a landlord after the business is sold, and can accept the tax outcome or defer it through an exchange. It fits less well for an owner who wants the building as retirement income, where leasing directly to the business buyer is usually better, or for a property whose value is in an alternative use, where a sale to a developer is the better path.

We model the three paths side by side: sell both to the business buyer, lease to the business buyer and keep the building, or sale-leaseback to an investor and then sell the business. The right answer depends on the owner's cash needs, tax position, and appetite for owning property after the exit, and it is a decision to make before the business goes on the market.