In the Spotlight: Sale-Leasebacks of Multiple Properties

Since the seller/lessee (Tenant) owned the property before sale, its indemnities and other obligations are often expanded to include those arising prior to the commencement date. Unknown pre-existing environmental contamination is often the most significant issue.

Bondable Lease

The buyer/lessor (Landlord) often endeavors to get as close to a bondable lease (a triple net lease on steroids in which rent continues come “hell or high water”) as is consistent with the business understandings and leverage of the parties.

The Tenant's termination rights in the event of a casualty or condemnation, regardless of its scope and whether or not insured, may be very limited. Sometimes, the Tenant buys the property, perhaps pursuant to a declining price structure that is sufficient to pay off the The Landlord's lender, in lieu of continuing to pay rent, but which party has the right to trigger this purchase is one of the items to be negotiated.

• The Landlord may have few, if any, obligations and is fully indemnified.
• Structural repairs and other required capital expenditures are often the Tenant's obligation.
• Since the property is owned by the Landlord at the end of the lease term, it would not be unusual for the Tenant to seek contribution by the Landlord for capital improvements that will benefit the property (as distinguished from those benefiting only the Tenant's specialized use), with the sharing formula related to the extent to which the useful life of the improvement extends beyond the term of the lease.

True Lease Issues

It is beyond the scope of this article to provide comprehensive analysis of “true lease” issues (whether a lease in a sale-leaseback transaction should be characterized as a financing arrangement for bankruptcy or tax purposes), but the transactional real estate attorney should consult his or her bankruptcy and tax colleagues to avoid unintended consequences, especially if at least one of the factors listed below is applicable. (Note that there is significant case law [and IRS guidance as to tax issues] regarding the characterization of a lease as a financing transaction. The listed factors are not exhaustive.)

Bankruptcy

A number of factors are examined to determine intent of the parties and to ascertain which party has the right to benefit from appreciation of the property and which bears the risk of loss of property value. For example, an option of the Tenant to buy the property at expiration of the term for a value expected to be below market value (giving the Tenant the effective right to appreciation) would be an argument for characterization as a loan.

Potential bankruptcy consequences if characterized as a loan are as follows.

If the Tenant files for bankruptcy and if the transaction is deemed a loan: 1) Would a bankrupt tenant have the opportunity to redeem the property at a foreclosure sale as it would in certain types of foreclosure, depending upon state law? (Any foreclosure would occur only after the automatic stay is terminated, and, hence, technically be outside of the bankruptcy.) 2) Would the Tenant's right/obligation to assume or reject the lease within the statutory period under the bankruptcy code be compromised? 3) Would the Landlord lose its statutory right to receive post-petition rent payments until rejection (and, if so, could it nevertheless make an equitable argument for receipt of some interim monthly payment, even if not the contracted rent amount)? 4) Would the Landlord, as lender, be secured or unsecured, and if secured, would it be fully or only partially secured (depends upon the fair market value of the asset).

If the Landlord files for bankruptcy and if the transaction is deemed a loan (and the property is therefore not part of the Landlord's estate), would the automatic stay no longer apply, making it more difficult for the Landlord to ward off its creditors? Although the Landlord no longer would own the asset subject to the lease, there still may be a right of repayment that would redound to the benefit of creditors.

Tax

The following general questions are relevant in determining whether a lease structure might be characterized as a financing transaction for federal income tax purposes: 1) Are the burdens and risks of the Landlord and Tenant inconsistent with customary lease transactions? For example, when viewed in the aggregate, would the use of a net lease structure in combination with one or more of the following indicate that the Tenant has retained the economic indicia of ownership: (i) the obligation of the Tenant to continue to pay rent notwithstanding an uninsured casualty; (ii) participation by the Tenant in, or benefit from, appreciation; and (iii) below market rent? 2) Is there a repurchase option in favor of the Tenant? If so, is the repurchase option at a price that is currently expected to be below market value when exercised? 3) Potential tax consequences if characterized as a loan: If a sale-leaseback transaction is characterized for income tax purposes as a financing transaction, the “purchase price” paid by the purported buyer to the purported seller will be treated as a loan from such buyer to such seller. The purported seller would continue to be treated as the tax owner of the property, and such seller would not recognize any taxable gain or loss from the “sale.”

Additionally, only the portion of the “rental payments” that would be characterized as interest could be deductible by the purported seller. The remaining portion of “rent” not characterized as interest would be treated as repayments of principal. The purported buyer would not be entitled to claim depreciation deductions with respect to the property (because it is not the tax owner of the property), and it would recognize taxable income only to the extent of the interest component of the “rental payments” received. If and when the purported buyer retains ownership at the end of the term, the sale-leaseback transaction would then constitute a sale of the property.

Sale Leaseback Leases of Multiple Properties

One Master Lease vs. Individual Leases

The Landlord is likely to prefer one master lease for all properties so a bidder at an auction in the event of the Tenant's bankruptcy is less likely to have the freedom to cherry pick assets under the master lease. The Tenant is likely to prefer individual leases to provide maximum flexibility to assign and finance individual properties.

Potential Compromise: More than one master lease but not separate leases for each property. For example, if there are 18 properties in the portfolio, there could be three master leases, each for six properties. Each master lease would have an aggregate rent for its six properties. (The Landlord would not want to specify rent for each property to avoid providing a road map for a bidder at a potential bankruptcy by the Tenant.)

Issues Related to Master Leases with Multiple Assets

Cross Default

The Landlord would prefer to have remedies as to all of the master leases even if the default only relates to one master lease (or just one property). Cross default also might lower the risk of any default given the severe consequences to the Tenant. The Tenant would prefer to manage the risk and be able to give back a “bad” property (say, one that is losing money or one with an expensive environmental problem) without losing them all and having rent be accelerated for all. An alternative to cross default among the three master leases would be cross default only within one of the master leases.

The Tenant's ability to assign a lease would be materially impaired if the assignee were subject to a default over which it has no control. How about the reverse (Tenant becoming subject to assignee's default)? If the Tenant remains liable in the event of assignment (which is often the case), it could probably live with this result, but suppose the Tenant later assigns another one of the other two master leases to a different third party? Should there be cross defaults in either direction as to the two third party assignees?

Limitations Calculated by Reference to the Entire Portfolio

Suppose the deal is that: 1) The Tenant has the right to sublease a property in its entirety without the necessity of obtaining the Landlord's consent only with respect to a limited number of properties in the overall portfolio; and 2) The Tenant generally covenants to operate the properties, but is entitled to cease operating with respect to a limited number of properties in the overall portfolio?

Should restrictions that are based on the entire portfolio be binding on the Tenant's assignee of the leasehold under one of the master leases? For example, should the assignee be entitled to sublease its properties in their entirety even if the assignor has already subleased the maximum number of properties under another master lease? The assignee would have no control (absent a separate agreement with the assignor) of its subleasing rights. However, from the Landlord's perspective, its business deal would be full of holes if the Tenant could get around it merely by assigning. A compromise might be that the assignee is not limited by the number of subleases by the assignor, but is limited by the number of its own subleases.

Should restrictions and obligations that were negotiated because of the portfolio structure of the deal run to the benefit of a buyer of a property after a conveyance by the Landlord? From the Tenant's perspective, a one-off buyer from the Landlord (perhaps a passive investor pursuant to a 1031 tax deferred exchange) should not have the same rights as the original buyer of the entire sale leaseback portfolio (likely an established investor and perhaps one with whom the Tenant has a business relationship). The Landlord, on the other hand, wants to maximize its ability to sell the properties individually at a profit. It might be necessary to negotiate an entire mirror image lease (and attach it as an exhibit to the master lease) that will be entered into by the Landlord's buyer and the Tenant. This gives the Landlord comfort that it need not rely on the Tenant to negotiate such a lease (and ask its buyer to wait until the lease is negotiated) and allow it to market the precise lease to prospective buyers. It also gives the Tenant comfort that it will have fewer restrictions than it has under the master lease.

Option to Renew

Should the Tenant be required to exercise its option with respect to: 1) all of the properties in the entire portfolio? 2) all of the properties under one of the three master leases? 3) some percentage of either of the foregoing? 4) any one or more properties? The Tenant would of course prefer as much flexibility as possible, but the Landlord does not want to be stuck with the losers at the end of the initial term. Would a compromise be based on the percentage of properties in the entire portfolio? If so, and if there is a partial exercise with respect to the first option period, does the percentage utilized for the second option period relate to the number initially leased, the number then in the portfolio (after the partial exercise), or (as a compromise) the number then in the portfolio but no fewer than an agreed number of properties?

Rent reductions when properties are removed from the portfolio include: 1) partial exercise of an option to renew; 2) termination as to a property in the event of casualty or condemnation of that property; 3) sale of a property by the Landlord.

Approaches and Issues: 1) Based on a schedule agreed upon when the lease is signed (but the same cherry-picking issue discussed above may arise); 2) Pro rata based on number of properties (but one of the parties could get hurt if this valuation of that property was higher or lower than its real value; 3) Value agreed by the parties at the time, subject to appraisal; 4) In the event of casualty or condemnation, is the reduction limited by the insurance proceeds or condemnation award received by the Landlord?

In the event of a sale by the Landlord, should the Landlord have the unfettered right to set the rent payable by the Tenant to the buyer (to facilitate the sale) so long as the rent payable under the master leases in the aggregate is economically neutral to the Tenant?

Right of First Offer: Should the Tenant have a right of first offer before the Landlord sells one or more of the properties in the portfolio? From the Tenant's perspective, it would be good to have the option to own in fee properties that it previously owned and is currently operating under the master leases. The Tenant's argument is that if the Landlord is getting the price it is seeking, why shouldn't the Tenant have the first opportunity to buy the property? The Landlord's concerns are the same as the concerns of any grantor of such right ' avoiding Tenant tying up a sale by contesting some issue that was not negotiated up front ' for example, should certain transfers, like sales to affiliates and foreclosures, be carved out and, if so, in what manner?

Replacements: Should the Tenant have the right to replace one or more of the properties in the portfolio with other properties owned by the Tenant but not subject to a master lease? Reasons may include the need to dispose of certain properties in the portfolio for antitrust issues, or the need to include certain properties in the portfolio in a package deal with a third-party buyer to satisfy the buyer's requirements. The Landlord would need substantial discretion in approving any such replacement, not only to make sure it is receiving equivalent value but also to make sure the replacement property passes muster after appropriate due diligence. Moreover, the Landlord would need its lender's approval, and the lender would be constrained if the property being replaced is part of a Real Estate Mortgage Investment Conduit (REMIC).

Sheldon A. Halpern is a partner in the Los Angeles office of Pircher, Nichols & Meeks, a national real estate law firm with offices in Los Angeles and Chicago. His primary practice areas include substantial lease transactions, development transactions (with an emphasis on mixed-use REAs and related documents), acquisitions and dispositions. E-mail: [email protected].

There are a number of published articles describing the financial and accounting advantages and disadvantages of sale leaseback transactions, especially when compared with alternatives like traditional financing and synthetic leasing. There is little guidance in published articles, however, as to sale leaseback transactions involving multiple properties. This article focuses on some significant differences between leasebacks of multiple properties and leasebacks of a single property after a discussion of some significant differences between sale leasebacks of a single property and other single-property leases. (This article does not deal with the sale portion of a sale leaseback transaction involving multiple properties since the issues are often similar to those in any multi asset sale.)

Special Attributes of Single-Asset Sale Leaseback Leases

Pre-existing Obligations

Since the seller/lessee (Tenant) owned the property before sale, its indemnities and other obligations are often expanded to include those arising prior to the commencement date. Unknown pre-existing environmental contamination is often the most significant issue.

Bondable Lease

The buyer/lessor (Landlord) often endeavors to get as close to a bondable lease (a triple net lease on steroids in which rent continues come “hell or high water”) as is consistent with the business understandings and leverage of the parties.

The Tenant's termination rights in the event of a casualty or condemnation, regardless of its scope and whether or not insured, may be very limited. Sometimes, the Tenant buys the property, perhaps pursuant to a declining price structure that is sufficient to pay off the The Landlord's lender, in lieu of continuing to pay rent, but which party has the right to trigger this purchase is one of the items to be negotiated.

• The Landlord may have few, if any, obligations and is fully indemnified.
• Structural repairs and other required capital expenditures are often the Tenant's obligation.
• Since the property is owned by the Landlord at the end of the lease term, it would not be unusual for the Tenant to seek contribution by the Landlord for capital improvements that will benefit the property (as distinguished from those benefiting only the Tenant's specialized use), with the sharing formula related to the extent to which the useful life of the improvement extends beyond the term of the lease.

True Lease Issues

It is beyond the scope of this article to provide comprehensive analysis of “true lease” issues (whether a lease in a sale-leaseback transaction should be characterized as a financing arrangement for bankruptcy or tax purposes), but the transactional real estate attorney should consult his or her bankruptcy and tax colleagues to avoid unintended consequences, especially if at least one of the factors listed below is applicable. (Note that there is significant case law [and IRS guidance as to tax issues] regarding the characterization of a lease as a financing transaction. The listed factors are not exhaustive.)

Bankruptcy

A number of factors are examined to determine intent of the parties and to ascertain which party has the right to benefit from appreciation of the property and which bears the risk of loss of property value. For example, an option of the Tenant to buy the property at expiration of the term for a value expected to be below market value (giving the Tenant the effective right to appreciation) would be an argument for characterization as a loan.

Potential bankruptcy consequences if characterized as a loan are as follows.

If the Tenant files for bankruptcy and if the transaction is deemed a loan: 1) Would a bankrupt tenant have the opportunity to redeem the property at a foreclosure sale as it would in certain types of foreclosure, depending upon state law? (Any foreclosure would occur only after the automatic stay is terminated, and, hence, technically be outside of the bankruptcy.) 2) Would the Tenant's right/obligation to assume or reject the lease within the statutory period under the bankruptcy code be compromised? 3) Would the Landlord lose its statutory right to receive post-petition rent payments until rejection (and, if so, could it nevertheless make an equitable argument for receipt of some interim monthly payment, even if not the contracted rent amount)? 4) Would the Landlord, as lender, be secured or unsecured, and if secured, would it be fully or only partially secured (depends upon the fair market value of the asset).

If the Landlord files for bankruptcy and if the transaction is deemed a loan (and the property is therefore not part of the Landlord's estate), would the automatic stay no longer apply, making it more difficult for the Landlord to ward off its creditors? Although the Landlord no longer would own the asset subject to the lease, there still may be a right of repayment that would redound to the benefit of creditors.

Tax

The following general questions are relevant in determining whether a lease structure might be characterized as a financing transaction for federal income tax purposes: 1) Are the burdens and risks of the Landlord and Tenant inconsistent with customary lease transactions? For example, when viewed in the aggregate, would the use of a net lease structure in combination with one or more of the following indicate that the Tenant has retained the economic indicia of ownership: (i) the obligation of the Tenant to continue to pay rent notwithstanding an uninsured casualty; (ii) participation by the Tenant in, or benefit from, appreciation; and (iii) below market rent? 2) Is there a repurchase option in favor of the Tenant? If so, is the repurchase option at a price that is currently expected to be below market value when exercised? 3) Potential tax consequences if characterized as a loan: If a sale-leaseback transaction is characterized for income tax purposes as a financing transaction, the “purchase price” paid by the purported buyer to the purported seller will be treated as a loan from such buyer to such seller. The purported seller would continue to be treated as the tax owner of the property, and such seller would not recognize any taxable gain or loss from the “sale.”

Additionally, only the portion of the “rental payments” that would be characterized as interest could be deductible by the purported seller. The remaining portion of “rent” not characterized as interest would be treated as repayments of principal. The purported buyer would not be entitled to claim depreciation deductions with respect to the property (because it is not the tax owner of the property), and it would recognize taxable income only to the extent of the interest component of the “rental payments” received. If and when the purported buyer retains ownership at the end of the term, the sale-leaseback transaction would then constitute a sale of the property.

Sale Leaseback Leases of Multiple Properties

One Master Lease vs. Individual Leases

The Landlord is likely to prefer one master lease for all properties so a bidder at an auction in the event of the Tenant's bankruptcy is less likely to have the freedom to cherry pick assets under the master lease. The Tenant is likely to prefer individual leases to provide maximum flexibility to assign and finance individual properties.

Potential Compromise: More than one master lease but not separate leases for each property. For example, if there are 18 properties in the portfolio, there could be three master leases, each for six properties. Each master lease would have an aggregate rent for its six properties. (The Landlord would not want to specify rent for each property to avoid providing a road map for a bidder at a potential bankruptcy by the Tenant.)

Issues Related to Master Leases with Multiple Assets

Cross Default

The Landlord would prefer to have remedies as to all of the master leases even if the default only relates to one master lease (or just one property). Cross default also might lower the risk of any default given the severe consequences to the Tenant. The Tenant would prefer to manage the risk and be able to give back a “bad” property (say, one that is losing money or one with an expensive environmental problem) without losing them all and having rent be accelerated for all. An alternative to cross default among the three master leases would be cross default only within one of the master leases.

The Tenant's ability to assign a lease would be materially impaired if the assignee were subject to a default over which it has no control. How about the reverse (Tenant becoming subject to assignee's default)? If the Tenant remains liable in the event of assignment (which is often the case), it could probably live with this result, but suppose the Tenant later assigns another one of the other two master leases to a different third party? Should there be cross defaults in either direction as to the two third party assignees?

Limitations Calculated by Reference to the Entire Portfolio

Suppose the deal is that: 1) The Tenant has the right to sublease a property in its entirety without the necessity of obtaining the Landlord's consent only with respect to a limited number of properties in the overall portfolio; and 2) The Tenant generally covenants to operate the properties, but is entitled to cease operating with respect to a limited number of properties in the overall portfolio?

Should restrictions that are based on the entire portfolio be binding on the Tenant's assignee of the leasehold under one of the master leases? For example, should the assignee be entitled to sublease its properties in their entirety even if the assignor has already subleased the maximum number of properties under another master lease? The assignee would have no control (absent a separate agreement with the assignor) of its subleasing rights. However, from the Landlord's perspective, its business deal would be full of holes if the Tenant could get around it merely by assigning. A compromise might be that the assignee is not limited by the number of subleases by the assignor, but is limited by the number of its own subleases.

Should restrictions and obligations that were negotiated because of the portfolio structure of the deal run to the benefit of a buyer of a property after a conveyance by the Landlord? From the Tenant's perspective, a one-off buyer from the Landlord (perhaps a passive investor pursuant to a 1031 tax deferred exchange) should not have the same rights as the original buyer of the entire sale leaseback portfolio (likely an established investor and perhaps one with whom the Tenant has a business relationship). The Landlord, on the other hand, wants to maximize its ability to sell the properties individually at a profit. It might be necessary to negotiate an entire mirror image lease (and attach it as an exhibit to the master lease) that will be entered into by the Landlord's buyer and the Tenant. This gives the Landlord comfort that it need not rely on the Tenant to negotiate such a lease (and ask its buyer to wait until the lease is negotiated) and allow it to market the precise lease to prospective buyers. It also gives the Tenant comfort that it will have fewer restrictions than it has under the master lease.

Option to Renew

Should the Tenant be required to exercise its option with respect to: 1) all of the properties in the entire portfolio? 2) all of the properties under one of the three master leases? 3) some percentage of either of the foregoing? 4) any one or more properties? The Tenant would of course prefer as much flexibility as possible, but the Landlord does not want to be stuck with the losers at the end of the initial term. Would a compromise be based on the percentage of properties in the entire portfolio? If so, and if there is a partial exercise with respect to the first option period, does the percentage utilized for the second option period relate to the number initially leased, the number then in the portfolio (after the partial exercise), or (as a compromise) the number then in the portfolio but no fewer than an agreed number of properties?

Rent reductions when properties are removed from the portfolio include: 1) partial exercise of an option to renew; 2) termination as to a property in the event of casualty or condemnation of that property; 3) sale of a property by the Landlord.

Approaches and Issues: 1) Based on a schedule agreed upon when the lease is signed (but the same cherry-picking issue discussed above may arise); 2) Pro rata based on number of properties (but one of the parties could get hurt if this valuation of that property was higher or lower than its real value; 3) Value agreed by the parties at the time, subject to appraisal; 4) In the event of casualty or condemnation, is the reduction limited by the insurance proceeds or condemnation award received by the Landlord?

In the event of a sale by the Landlord, should the Landlord have the unfettered right to set the rent payable by the Tenant to the buyer (to facilitate the sale) so long as the rent payable under the master leases in the aggregate is economically neutral to the Tenant?

Right of First Offer: Should the Tenant have a right of first offer before the Landlord sells one or more of the properties in the portfolio? From the Tenant's perspective, it would be good to have the option to own in fee properties that it previously owned and is currently operating under the master leases. The Tenant's argument is that if the Landlord is getting the price it is seeking, why shouldn't the Tenant have the first opportunity to buy the property? The Landlord's concerns are the same as the concerns of any grantor of such right ' avoiding Tenant tying up a sale by contesting some issue that was not negotiated up front ' for example, should certain transfers, like sales to affiliates and foreclosures, be carved out and, if so, in what manner?

Replacements: Should the Tenant have the right to replace one or more of the properties in the portfolio with other properties owned by the Tenant but not subject to a master lease? Reasons may include the need to dispose of certain properties in the portfolio for antitrust issues, or the need to include certain properties in the portfolio in a package deal with a third-party buyer to satisfy the buyer's requirements. The Landlord would need substantial discretion in approving any such replacement, not only to make sure it is receiving equivalent value but also to make sure the replacement property passes muster after appropriate due diligence. Moreover, the Landlord would need its lender's approval, and the lender would be constrained if the property being replaced is part of a Real Estate Mortgage Investment Conduit (REMIC).

Sheldon A. Halpern is a partner in the Los Angeles office of Pircher, Nichols & Meeks, a national real estate law firm with offices in Los Angeles and Chicago. His primary practice areas include substantial lease transactions, development transactions (with an emphasis on mixed-use REAs and related documents), acquisitions and dispositions. E-mail: [email protected].