How to negotiate a sale-leaseback so that both parties benefit

There has been a steady flow of sale-leasebacks in Cleveland as local, regional and national investors find themselves flush with cash, but with limited properties to buy.

“There’s a lot of activity from outsiders looking in,” says Joseph V. Barna, SIOR, a principal at Cushman & Wakefield/CRESCO Real Estate.

The reason, he says, is because it’s so competitive in the major markets.

“If a property becomes available in Los Angeles, Dallas or Houston, there could be 30 investors chasing it who are all capable of writing a check. That’s led investors to look to secondary markets, such as Cleveland, where they’re able to transact at higher capitalization rates with less competition. Cleveland has become a sweet spot because there’s a good mix of opportunity and competition.”

Smart Business spoke with Barna about how sale-leasebacks are being used to satisfy investors’ appetites while offering sellers significant benefits.

What are the conditions that create an ideal situation for a sale-leaseback?
In a sale-leaseback, owners sell their property to an investor while retaining the benefits of using the property, typically on a long-term lease of 10-20 years. The structure is increasingly popular because it allows owners to use the real estate without tying up debt and equity capital.

Companies best positioned to consider a sale-leaseback are those that have a lot of equity in the property and can benefit from freeing that up — for instance, to make an acquisition, pay down debt or as part of an exit strategy.

How do investors determine if a sale-leaseback is a good deal?
For investors, a sale-leaseback is primarily a financial transaction based on cash flow. However, there have been times when a building owner has a 100,000-square-foot property that it leased back for $6.50 per square foot in a market that’s seeing $4.50 per square foot as average.

Investors see that rate and buy at an 8 percent capitalization rate, looking only at the cash flow and failing to take into account the intrinsic value of the real estate. The building owner gets an above market cash influx from the deal, then eventually files for bankruptcy and goes out of business. The investor is now sitting on an empty building and will inevitably take a major financial hit because it takes time to re-tenant at a fair market rate.

Sometimes investors are so eager to push their money out the door that they’ll actually gamble a little on the risk side, increase the capitalization rate and still get burned. Even when the lease is up, tenants often leave and they can’t replace that cash flow because the market is down and the rate was well above market.

Ultimately, the investor needs to understand the intrinsic value of the property, as well as local market conditions before investing.

What should get close attention as the parties structure a sale-leaseback?
A seller will be asked to maximize the property’s value by signing a 10- to 20-year lease. Before doing that, it’s important that they understand their company’s future growth potential, which will determine whether the property will meet the business’s needs for that duration.

Companies that are expecting to grow should plan for an expansion of the physical space. In that case, before making the deal, determine a formula for rent that accounts for the addition. If there is a realistic chance that the business is likely to contract, look into the rights to sublease, or include a cancellation clause as part of lease structure.

Who should companies work with to execute a sale-leaseback?
Logical team members include a trusted real estate consultant with experience in sale-leasebacks, a financial adviser to ensure the projection and assumption are correct, and a legal adviser with a specific focus in real estate.

Investors should also talk with ownership to understand their short- and long-term objectives. These deals can be a benefit to all parties involved, as long as both sides are open and honest about their intentions when negotiating terms.

Insights Real Estate is brought to you by Cushman & Wakefield/CRESCO Real Estate