Real Estate Sale-Leaseback: Making a Comeback

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In 2007, there was more than $16 billion in U.S. real estate sale-leaseback transactions. By 2009, that volume had shrunk to under $4 billion. With the “Great Recession” coupled with the uncertainty of the announced convergence of U.S. and international accounting standards, some industry analysts predicted that real estate sale-leasebacks would be eliminated from the array of possible corporate fundraising strategies. That possible demise appears to be greatly exaggerated.

According to a January 2014 CBRE Update, U.S. Sale/Leasebacks: Unlocking Value, available at http://bit.ly/13I6TvW, the volume of U.S. real estate sale-leaseback transactions grew 149% from 2009 to 2012. So sellers and investors should consider dusting off their real estate sale-leaseback playbook (while sale-leaseback treatment is possible for asset types other than real estate, this article focuses on real estate sale-leasebacks, which have their own unique accounting rules ' primarily former FASB Statement 13, now codified as Accounting Standard Codification (ASC) 360-20 (Real Estate Sales) and 840-40 (Sale-Leaseback Transactions)).

The Basics

Nearly any commercial enterprise that owns and occupies real estate is a potential candidate for sale-leaseback fundraising. (While often referred to as a “financing,” that term is misleading because the sale of the real property is absolute: The owner sells its real estate to an investor group and simultaneously leases it back from that buyer, typically in triple net-lease arrangement on a long-term basis (e.g., more than 20 years), with base rent rate set to provide for amortization of the purchase price with some rate of return for the buyer's equity.) The purchase price should be based on the fair market value of the real estate (although according to the January 2014 CBRE Update, sale-leaseback purchase prices can carry up to a 13% premium).

The typical sale-leaseback document set consists of a purchase agreement, lease, and (where the buyer-lessor uses financing to acquire the real estate) a lender-recognition agreement. The sale-leaseback lease should not have terms that are substantially different from those terms that an independent third-party lessor or lessee would accept, and to the extent that such terms do exist, according to ASC 840-40-25-10, they represent an exchange of some stated or unstated rights or privileges, which can be the basis for denying sale-leaseback accounting treatment. While there can be other reasons for pursuing sale-leaseback transaction, sale-leaseback accounting is most often the critical decision driver.

If the sale-leaseback transaction is properly structured, the seller-lessee (A) records the sale, (B) removes the property and related liabilities from its balance sheet, (C) recognizes gain or loss on the sale and (D) classifies the leaseback as either a capital lease (if the lease meets one or more of the four lease classification criteria in ASC 840-10-25-1) or an operating lease (if the lease does not qualify as a capital lease). If the transaction qualifies for sale-leaseback accounting and is classified as an operating lease, the entire lease payment stream should be treated as an expense that should be fully deductible for federal income tax purposes. If the transaction fails to qualify for sale-leaseback accounting treatment, the transaction must be accounted for by the deposit method or as a financing, which for most sellers-lessees means the transaction has failed.

Advantages and Disadvantages of Sale-Leaseback

The advantages of sale-leaseback should appeal not only to most owner-occupants of real estate but also to private equity buyers as a means to finance an acquisition or obtain cash from their portfolio company:

• A sale-leaseback monetizes 100% of the market value of an owner-occupant's real estate generally at favorable terms compared with more traditional forms of fundraising such as debt financing or equity sales. That added cash can be used by the seller-lessee to reinvest in its core business or pay down other debt.
• Compared with equity sales, the typical sale-leaseback transaction can be “paper-light” and often less expensive and time-consuming.
• Compared with debt financing, the typical sale-leaseback transaction can have fewer financial covenants.
• If the sale-leaseback transaction is properly structured so it achieves sale recognition treatment, the gain can be amortized into the seller-lessee's income statement. Also, if the lease qualifies as an operating lease, the seller-lessee's rent obligation should not be a liability on its balance sheet, which improves its current ratio (this advantage will largely disappear as it appears the FASB and IASB are moving forward with a lease accounting overhaul that will bring substantially all leases onto the balance sheet of lessees and may change expense recognition, affecting many key financial metrics (http://pwc.to/1wxtLZK)).
• A sale-leaseback can have disadvantages, which makes it unsuitable for some owner-occupants (or for some properties):
• The seller-lessee has no upside appreciation.
• Sale-leaseback is less than ideal for site-specific, business-essential property because eventually the term ends and the seller-lessee must surrender possession and effectively its site-specific licenses and permits. If the seller-lessee wants to receive sale-leaseback accounting, the lease cannot include an option to repurchase the property.
• The seller-lessee surrenders title to its property and with it the flexibility that comes with ownership. With transferring ownership of the property, the seller-lessee can be disincentivized from expanding or altering the improvements, because they too become the buyer-lessor's property. And even if the seller-lessee wanted to expand or alter the improvements, the typical sale-leaseback lease prohibits the seller-lessee from doing so without the buyer-lessor's approval.
• The rate of return used to set the sale-leaseback rent can be higher than other forms of fund- raising.
• The change of ownership can trigger property tax reassessment or require reapplication for or approval of transfer of property specific entitlements, such as a special use permit.

Sale-Leaseback Accounting

While the advantages of a real estate sale-leaseback transaction can often outweigh the disadvantages (after a careful review of all aspects of the proposed transaction), the critical decision driver frequently is whether the transaction achieves sale-leaseback accounting treatment for the seller-lessee under ASC 360-20 and 840-40. Generally, a seller's continuing involvement with the property after its sale will disqualify the transaction for treatment as a sale, so the sale-leaseback is considered an exception to that general rule. Consequently, ASC 360-20 and 840-40 set “extremely restrictive criteria” for real estate transactions, with the goal being to reduce significantly the number of transactions that qualify for real estate sale-leaseback accounting (E&Y's Financial Reporting Publication Lease Accounting (October 2013)).

Sale-leaseback accounting can only be used by a seller-lessee if a sale-leaseback transaction meets all of the following criteria:

1. It is a “normal” leaseback (defined as the active use of the property by the seller-lessee in consideration for payment of rent, including contingent rentals that are based on the future operations of the seller-lessee and excluding other continuing involvement). “Active use” is in relation to the seller-lessee's business, so subleasing the leased back property must be “minor.” Minor subleasing is that where the present value of the sublease rental payments plus the fair rental value of space not occupied by the seller-lessee does exceed 10% of the fair value of the property sold.

The “normal” sale-leaseback lease should not have terms that are substantially different from those terms that an independent third-party lessor or lessee would accept, and to the extent that such terms do exist, according to ASC 840-40-25-10, they represent an exchange of some stated or unstated rights or privileges, which must be considered in evaluating the continuing involvement provisions.

2. The sale-leaseback agreement terms must adequately demonstrate the buyer-lessor's initial and continuing investment in the property.

3. The payment terms and provisions transfer all of the other risks and rewards of ownership as demonstrated by the absence of any other continuing involvement by the seller-lessee (than the normal sale-leaseback lease).

Absence of Continuing Involvement

The third criterion ' absence of the seller's-lessee's continuing involvement ' is the most frequent source of scrutiny for the sale-leaseback team and represents the inherent conflict under the accounting rules ' the seller can lease back the property as long as the lease terms are not “substantially different from those terms that independent third-party lessor or lessee would accept,” unless those terms would in the context of a sale-leaseback transaction constitute continuing involvement, in which case, their mere inclusion in the lease could cause the transaction to fail for sale-leaseback recognition. The following is a non-exhaustive list of examples of continuing involvement (or suspected continuing involvement) that would prohibit sale-leaseback recognition, even though they are only present in the event of a contingency:

• The seller-lessee receiving an option to repurchase the property sold, even though the option price is equal to the then fair value of the property. A “right of first refusal” does not constitute an option to repurchase, although auditors have questioned whether common lease terms that modify the ROFR (such as adjusting the ROFR terms for seller financing, brokers, in-kind consideration, etc.) will still be considered a right of first refusal for sale-leaseback recognition.
• For a seller-lessee default, the right of the buyer-lessor to force the seller-lessee to purchase the property from the buyer-lessor (rental acceleration alone should not run afoul of continuing involvement as long as title to the property remains with the buyer-lessor).
• Front-loading lease payments could be a form of prohibited collateral or seller-lessee financing.
• A sales price that is significantly less than fair market value could be interpreted as a form of seller financing.
• Buyer-lessor obligation to make capital improvements to the property during the term of the lease.
• Seller-lessee imposing deed covenants that would restrict use of the property after the lease has expired.
• An obligation of the seller-lessee to repurchase the property sold, or the power of the buyer-lessor to compel the seller-lessee to repurchase the property at any time in the future.
• The seller-lessee (or a related party) guarantees the buyer-lessor's investment or a return on that investment for either a limited or extended period of time.
• Seller-lessee's right to lease the property for substantially all of the property's remaining life ' 90% or more ' including options to lease at a fixed price rental rate (although E&Y's Lease Accounting indicates that if the options to renew are at fair value as determined upon renewal, then that would not constitute continuing involvement).
• Any form of continuing ownership in the property (through common ownership of the buyer-lessor).
• The seller-lessee providing non-recourse financing to the buyer-lessor for any portion of the sales price or providing recourse financing in which the only recourse available to the seller is the property sold.
• The seller-lessee remaining obligated under any existing debt related to the property.
• The seller-lessee providing collateral to lenders or the buyer-lessor other than the property directly involved in the sale-leaseback transaction, or the seller-lessee (or a related party to the seller-lessee) guarantees the buyer-lessor's debt.
• The seller-lessee's rental payments being contingent on some predetermined or determinable level of future operations of the buyer-lessor.
• The seller-lessee entering into a sale-leaseback transaction of real estate that also involves property improvements or equipment without selling or leasing the underlying land to the buyer-lessor.
• The seller-lessee continues to operate the property at its own risk, for an extended period, for a specified limited period, or until a specified level of operations has been achieved.
• Partial sale-leaseback (seller sells-leases back less than 100% of its interest in the property).

To the extent continuing involvement arises after entering into the sale-leaseback, such continuing involvement should be evaluated on a facts and circumstances basis to determine if it were contemplated when the sale-leaseback was entered into.

This list illustrates the sometimes counterintuitive and conflicting nature of sale-leaseback recognition rules ' terms that stray from “normal” (that is, those independent lease parties would accept) can trigger continuing involvement scrutiny, while otherwise “normal” lease terms (such as a fair market option to the lessee to purchase the leased property) can turn what was intended to be a lease into a financing.

Conclusion

While a real estate sale-leaseback transaction is relatively straightforward, the accounting rules are anything but. Rarely do the accounting rules provide clear “yes or no” answers. More often the outcome of real estate sale-leaseback accounting turns on a nuanced understanding of those accounting rules, knowledge of the marketplace and, most importantly, the exercise of judgment (ASC 360-20-15-2). For that reason, the seller-lessee and its sale-leaseback team must be well-versed in sale-leaseback accounting and how those accounting rules can affect the transaction documents, particularly the provisions of the lease. For those sale-leaseback parties who can meet the intentionally difficult accounting standards, the advantages of sale-leaseback fundraising and the increasing number and volume of willing investors coming out of the Great Recession should put the sale-leaseback transaction device back in the financing toolbox.

Update on FASB/IASB Joint Proposal

The FASB and IASB Boards have continued their “redeliberation” on sale and leaseback accounting. As of Oct. 28, 2014, the FASB's website (http://bit.ly/1AiGcwr) included an update on the evolving standards. See especially Repurchase Options. While the FASB confirmed that a repurchase option exercisable only at the then-prevailing fair market value would not preclude sale treatment, provided that the underlying asset is: 1) non-specialized; and 2) readily available in the marketplace, the FASB staff expressed the view that real estate would not be considered non-specialized. So under the FASB/IASB joint proposal on leases, a repurchase option in a real estate sale leaseback transaction would prevent favorable sale and leaseback accounting.

Thomas L. Hefty is a partner in the law firm of McDermott Will & Emery LLP.

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