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      November 2008
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Financing alternatives

By Donald Kason
Illustration: Gary Clement

In today’s credit environment a sale-leaseback transaction can be a creative change to traditional corporate financing

The turmoil in US financial markets has led to a credit crunch that has spilled over into Canada and other parts of the world. Today corporate lending in Canada is more restrictive for many companies than it has been in the early part of this decade. Lenders want increased collateral, more restrictive covenants and debt service coverage ratios, yet interest rate spreads on loans are higher than we have seen in some time. All this is happening in an environment where parts of the Canadian economy are growing and other parts are experiencing slower economic output, particularly the manufacturing sector in Eastern Canada.

In today’s credit market, a sale-leaseback transaction may represent an attractive financing alternative to traditional corporate financing. Despite the current compression in the debt capital markets, certain real estate assets are still a preferred long-term asset class for many institutional investors, and that creates an alternative financing market for companies with the right kind of real estate. Companies carrying on operating businesses may want to monetize the real estate assets they own and use by way of a sale-leaseback transaction. By selling its real estate to investors, a company can raise cash while retaining the useful operational benefits of its existing premises (location, leaseholds, equipment setup, etc.) through a long-term lease.

The company may not want to carry its real estate on its books or may want an alternative source of funds without necessarily showing a debt obligation on its books. Selling its office or industrial premises can be an ideal way to achieve this. Of course, certain lease structures may result in capital lease treatment, but generally, conventional real estate leases would be off-balance obligations. Government agencies may also look to sale-leaseback transactions as a means to transfer the risk of management and ownership of government real estate to third parties more suitable to take on this risk.

For the vending company, the sale-leaseback transaction generates cash, which can be used to repay debt or free up equity to be used in a more effective, advantageous way. In addition to generating cash, there are other possible benefits that may motivate a sale-leaseback transaction:

One potential disadvantage of a sale-leaseback is the owner will trigger a current tax liability on the sale of the property to a landlord at fair market value if the property has appreciated in value. However, if the property has not appreciated significantly, or if the owner has tax loss carry forwards, any inherent taxable gains from the sale of the property may be minimized or eliminated.

A typical example would be a company that has, over the years, acquired a number of locations across Canada where it manufactures its products. The company has acquired those sites over time and has either constructed or retrofitted the buildings to make them suitable for its manufacturing processes. Such locations were acquired to meet the needs of its operating business and to be close to its customer base where it could obtain the raw materials and skilled workers for its manufacturing process. The company acquired these locations using a combination of the profits from the business (shareholders’ equity) and loans to the company. Being in those locations helped the business grow successfully; it is now a strong company with assets, a profitable business and good support from its customers. However, the company is not a professional real estate investor or land developer. Its expertise is in manufacturing, sales and client service. Therefore, the company has decided to sell some of or all its locations to a financier and lease them back under a long-term lease.

The lease terms, including the net rent payable, the term of the lease, renewal options and the treatment of real estate capital maintenance costs will impact the price paid for the real estate. The challenge in drafting the documents in a sale-leaseback transaction is to strike a balance between the goal of the buyer to have the most marketable product possible and the goal of the vendor to ensure that it has adequate protection of its business interests in the future. Finding that balance makes these transactions interesting.

Similar transactions
The situation described is a typical sale and leaseback transaction, but each transaction will have its individual characteristics. Other vendors/tenants in sale and leaseback transactions may have different goals. For example, a company may decide to consolidate its locations into a single location serving all of Canada, with a goal of freeing up capital and taking advantage of the existing market conditions. It could carry out a sale and leaseback transaction with much shorter leases, with a goal of continuing to provide the operating company with the use of the real estate assets only until the longer term organizational goal is realized. With that variation, the negotiation on the sale side and lease side is much closer to a traditional property sale and short-term lease negotiation. While that kind of transaction is technically also a sale-leaseback transaction, it has different goals and does not fit as closely with the typical structure dealt with here.

Another approach is to use a sale-leaseback transaction more as a financing technique, much more akin to a build-to-suit arrangement. In this situation, the company owns a site that it wants to develop and arranges for a contractor/developer to buy the land from the company, develop and construct the manufacturing facility and lease it back over a long-term lease that will provide the developer/contractor with sufficient funds to pay off its mortgage financing and to obtain a reasonable profit from the construction of the building. In such circumstances, the lease is more of a capital nature than an operating nature and, at the end of the term, the tenant usually has the right to purchase the property on a nominal or reduced-cost basis (referred to as a bargain purchase option). Again, while technically a sale and leaseback, this transaction is more of a financing technique; a more elaborate discussion on this topic is beyond the scope of this article.

Yet another beneficial use of a sale-leaseback transaction can be for asset securitization, where a special purpose entity (often referred to as a bankruptcy remote entity) holds the property to reduce or even eliminate commercial risk. Asset securitization involves the segregation of an income-producing pool of assets and the transfer of ownership to investors through a financial instrument that is secured by the assets. In general, asset securitization involves a vendor, a special purpose vehicle (typically a trust, partnership or corporation) and/or a group of investors. Investors are typically large institutional investors, the retail market (mortgages) and pension plans. The company sells the assets to the special purpose vehicle for cash, which the special purpose vehicle raises from investors. The company then leases back the property pursuant to a long-term lease. This transaction is more a financing technique and is noted here for the reader’s interest.

Often, purchasers may include pension fund (or life insurance) investors, which typically do not pay income tax on the income from the property, if properly structured. Further, as pension fund entities typically do not pay capital taxes, a sale-leaseback may eliminate this cost. These tax advantages make institutional investors with long-term investment horizons formidable bidders for quality real estate assets and help maintain competitive tension that can result in a premium being paid for quality real estate assets that provide a stable and reliable income flow from tenants with solid covenants. Where the landlord is a taxable entity, it should seek tax advice to carefully evaluate the impact of the rental property restrictions on its income tax situation.

Some matters are dealt with differently in a sale-leaseback transaction than in a normal leasing transaction, for example:

Rental rates Typically the rent in a straight leasing transaction is set at market rental rates. In a sale-leaseback transaction, it is possible for the seller/tenant with a good financial rating to be able to sell the asset for more than its fair market value by increasing the lease rate beyond fair market rates. This strategy can transform the lease to a form of financing whereby the landlord accepts the risks of early termination and/or insolvency of the tenant, provided it can satisfy itself that the covenant of that tenant is strong enough to support the lease rates agreed upon.

Term duration Usually the term of a lease under a sale-leaseback transaction is longer than under normal leasing circumstances — often 20 years with extensive renewal rights.

Condition of the property at lease commencement As the tenant is both the seller and the occupant, it cannot expect the landlord to stand behind the building or its environmental condition. Accordingly, in a sale-leaseback transaction, the lease often provides that the tenant is fully responsible for the premises and that the landlord can look to the tenant for all maintenance and capital expenses, whether arising from normal wear and tear or from an insured or uninsured casualty.

Signage, expansion and alteration As the usual sale-leaseback transaction involves a single user, the rights to signage, expansion and alteration are usually in favour of the tenant, subject to the landlord’s concerns that alterations are done in a manner that enhances the value of the building. Obviously, special purpose alterations not of value to any other user would be something to be avoided by the landlord. The capital costs of expansion rights can be difficult for a landlord to budget for unless taken into account when the landlord arranges for its financing.

Option to purchase An option to purchase, other than at fair market value, needs careful consideration by tax advisers to both the tenant and the landlord. If the option to purchase at the end of the lease term is at a price less than the fair market value, the lease payments may not be fully deductible from the tenant’s income as a business expense on the basis that they are unreasonably high or a portion of amounts paid as rent for the property will be recaptured when the property is eventually sold at a profit.

Sale restrictions If the tenant is in a highly competitive business, it may wish to include provisions in the lease that the landlord may not transfer the asset to a competitor of the tenant, as such a transfer may have unacceptable ramifications to the tenant. Though at first blush such a restriction may seem acceptable, it may result in the landlord not being able to find a lender, as the most likely buyer for certain manufacturing facilities are companies that are direct competitors of the tenant. Restricting the ability of the landlord to transfer may result in restrictions on the lender’s ability to enforce its security, as the likely buyers in an enforcement scenario are not permitted transferees under the lease. Sometimes, a restriction on transfer can be avoided by providing to the tenant a right of first refusal and/or offer so that if the tenant has an issue with the proposed new transferee/landlord, it can buy the landlord’s interest rather than have its landlord be replaced by a competitor.

Hell or high water Generally, the lease will be most financeable if it contains no provisions allowing the tenant to terminate the lease or set off any obligations owed by the tenant against those owed to the tenant by the landlord. Accordingly, leases typically are structured so as to obligate the tenant to always make payments irrespective of the state of the property (i.e., whether the entire building is destroyed or not), as well as not allowing the tenant any early termination rights (except possibly toward the end of the lease term). Typically these risks are mitigated by appropriate insurance obtained by the tenant.

Conclusion
In today’s challenging credit market, the traditional sale-leaseback may provide substantial benefits, particularly as interest rate spreads increase and real estate markets remain relatively strong. Given that real estate rates of return are still relatively low, the overall after-tax cost of capital under a sale-leaseback, coupled with the benefits outlined, may prove to be a significant advantage. Moreover, leases do not typically contain an obligation to repay principal, which is inherent in a debt obligation, alleviating cash flow concerns in difficult economic times. A sale-leaseback can be a good way for a company to utilize real estate to free up debt and equity capital and improve the return on assets employed. To complete sale-leaseback transactions effectively there are significant marketing, tax and legal issues to consider. Accordingly, it is important for a company to seek experienced advisers to maximize value and ensure that its operational interests are adequately protected over the term of the lease.

This article is intended as a summary only and should not be relied upon as advice to any specific client or specific situation.

Donald J. Kason, MBA, CA, is president of NAI Commercial in Toronto. He can be reached at dkason@naicommercial.ca. 

Gregory Harris, LLB, Harris + Harris LLP (gregharris@harrisandharris.com). 

Susan Farina, MBA, CPA, CA, tax partner of Goldfarb Shulman Patel & Co. LLP, assisted with the article

Technical editor: Peter Hatges, CA, CBV,CF, partner with KPMG LLP in Toronto and the national leader of corporate finance in Canada. He is also a member of the CICA’s Corporate Finance Working Group