I’ve advised a number of my clients recently to consider selling their commercial real estate and striking a three- to 10-year lease with the investor who buys it. A few have listened.
This structure, in our parlance, is known as a sale-leaseback. Different than a straight lease and not a short-term lease that accommodates a purchase, a sale-leaseback allows an owner occupant the chance to sell at today’s high prices and remain in the building – albeit as a tenant – and avoid a move.
It’s a slick arrangement when the correct motivations are involved – equity is needed to buy a competitor or expand the business, an ownership transition is planned within the next three to five years, or a flight to quality is desired.
Today, I want to spend a moment and discuss the downside of a sale-leaseback.
The message it sends to the market: When a sale-leaseback is listed and marketed for sale, the questions from buyers range from “why is he selling?” to “is his company leaking at the gills and needs cash to survive?” Generally, there is a story. It’s critical to understand that story — why a seller is selling — and how the current financials present.
I will just pay more rent: Value is determined by taking the rent your company is willing to pay and packaging the rent as a return on investment. Simply, if your company can afford to pay $10,000 per month or $120,000 per year and the return is 5 percent, your building is worth $2.4 million. Easy, yes? Now the fun begins. Where is $10,000 per month in relation to what other comparable buildings achieve in rent? It’s either above, below or at par. Par or below — you’re golden. Above and you’re scrambling. You see, an investor looks at the worst case scenario – you spit the hook after a year, can’t pay the rent – or worse file bankruptcy – and he’s stuck with a building he can’t rent for the same amount you were paying.
You strap your operating company: If you own your building and times get tough, you can adjust the rent your company pays you, after all, you are the owner AND the tenant. Once you inject an arm’s length investor into the mix that flexibility evaporates. You are now bound to a lease. If you don’t pay, you may get evicted.
There are tax consequences: As we’ve discussed, selling appreciated commercial real estate comes with a heavy tax consequence — unless you employ a tax-deferred exchange. Yes, you free your equity but at a significant cost — in…